In the previous editor’s note I offered the hypothesis that perhaps we were at a historic inflection point as another golden era of globalisation draws to a close. This would not be the first time that an increasingly connected world retreated into itself. The guns of August in 1914 did not only usher in carnage at a previously unimaginable scale. It also ended a previous golden era of globalisation.

If we are going to trade with each other less and focus on the security of our supply chains than we need to be prepared to see a reversal of the benefits that flowed to us as investors. The expanding margins were a tailwind that pushed corporate profits to new heights. How do we invest when those tailwinds change direction?

The easy answer is that all companies will be impacted. Afterall, almost every company has benefited from the cost savings flowing from outsourcing and offshoring, lower interest rates and the rest of the deflationary forces in effect since the end of the Cold War. However, all companies will not be impacted to the same degree. There are companies that possess an elixir to the ill effects of higher costs. The ability to pass those costs along to their customers.

Companies with pricing power have competitive advantages over their rivals. They can fend off the rules of capitalism that state that having higher prices than your competitors will always result in less market share. That investing constantly in producing better goods and services is needed to keep up with the competition. Moats matter in all business climates. But they especially matter in a world of higher inflation and increasing cost pressures.
Building and growing a great business is easy in theory. Simply invest in the business at a rate that is higher than it costs to obtain the funds you are investing. Borrow at 5% and earn 10% from the new factory you build or employees you hire or whatever else you decide to do. Do that for long periods of time. In practice that is not easy. Most companies will keep cutting prices and investing in building better products and services until their cost of capital and the return they earn on that capital is equal. The company will continue operating and will grow. People will have jobs and plans will be made to improve the company. But in essence the company is just treading water.

Some companies protect themselves from this brutal and constant competition. They have attributes that allow them to consistently achieve higher margins than their competitors and earn returns in excess of their cost of capital. These companies are the ones we want to own as investors. These companies will excel in any environment.

To identify moats requires an investor to be a student of business. You must understand the sector or industry that the company operates in and what factors influence customer behaviour. And this is a skill you can develop. Start with an everyday product that you use and make a list of competitors that offer the same or similar products. Think about substitutes as well as direct competitors. Think about the things that influence your own behaviour as a consumer. What would it take for you to switch to a different provider? What would cause you to buy more or less of the product? What does it take for the company to keep you as a customer – constant sales, constant marketing, constant improvements in the product? Think about how that good or service is produced. What are the different things that may influence the cost of producing that good or service. Does producing it at scale make it cheaper? Is it reliant on inputs with shifting prices? Finally, think about the ease with which new competitors can enter the market. Are there low barriers to entry or are there structures in place to prevent competition like government licenses or patents.

Another great way to learn how to identify a moat is to read our analyst reports. Read about companies that have a Morningstar moat rating and read about companies that don’t. You will start to pick up patterns and understand the different factors explored by our analysts. Most of all you will learn about the competitive dynamics that impact each industry we cover.

If you choose to do a moat analysis of a product you use then send it to me. I would love to read it and would be happy to publish your work if I think it is particularly insightful. You can always reach me at mark.lamonica1@morningstar.com