A new way to discover 'economic moats'

However, all is not lost. You may not be a maths prodigy or know a loose-lipped finance director prepared to share the odd piece of useful-but-not-inside information, but there are a couple of ways to approximate or fast-track an informational or skill-based edge.

One is to be humble, recognise both your own (statistically possible) mediocrity and the inability of most professional investors to beat the market after fees, and build a simple portfolio based on low-cost passive products and a tolerable balance of risk and reward. By removing the drag of trading and management fees, this can be viewed as one highly accessible edge over the crowd.

Another is to focus on the types of investments that should outperform the market. In this genre, there are few better candidates than the shares of companies with an economic moat. Beyond the traditional factors of valuation, size and momentum, companies with a structural competitive advantage are best placed to earn above-average returns on capital over the long term. When this happens, equity gains tend to follow.

As Arizona State professor Hendrik Bessembinder has shown, around one in every 30 stocks has accounted for the entire net shareholder wealth creation in the US stock market since 1926. These, in turn, have compensated for the 17 or so stocks in every 30 that reduced shareholder wealth. And among the wealth creators, one common thread is the economic moat.

Working out what is a moat, or how long it is likely to persist, isn’t easy. Nor is it the case that an economic moat is a guaranteed or only route to excess returns. Lots of average, undifferentiated businesses manage to outperform the market over time.

But that shouldn’t curtail our hunt. Conveniently, research firm Morningstar has for several years scored the largest blue-chips on their economic moats, to try to quantify this subjective corner of fundamental analysis.

To do so, Morningstar breaks down companies into five sources of potential moats: cost advantages, scale efficiencies, intangible assets, network effects and switching costs. On top of a combined score, the research firm also determines if an economic moat is wide or narrow, to signal how many years investors can expect a competitive edge to be preserved. Coca-Cola (US:KO), that quintessential brand equity story, has a wide moat and a perfect score thanks to its cost advantages and intangible assets.

The data and methodology aren’t perfect. Wide or narrow ratings do not always correspond with a positive economic moat score, while some judgements appear inconsistent. Quite why Morningstar’s analysts view Lloyds’ (LLOY) cost base and customer stickiness as sources of economic advantage, but do not in the case of NatWest (NWG), is unclear.

Still, there’s plenty to like. The rankings are continually updated, and amount to what I think is an excellent set of non-financial measures for evaluating stocks. That doesn’t make them a cheat code for finding Bessembinder multi-baggers. Because Morningstar looks for proven (rather than potential) economic moats, lots of market value has usually been created by the time a perfect score is awarded. High-quality, high-return and market-leading listed companies rarely stay unnoticed.

The rankings are especially useful for understanding US shares. This is partly because Morningstar’s coverage is much wider, but also because seven in 10 of the S&P 500’s constituents are judged to have at least one moat source. By contrast, just 29 members of the FTSE 100 can point to at least one.

Interestingly, the only UK large cap judged to have three, London Stock Exchange (LSEG), has also posted the index’s fifth-best total return over the past decade – a dynamic that is reflected more broadly across both markets. In short, the long-term stock returns of companies with wide moats and at least two sources of advantage far outstrip market averages.

Though somewhat self-selecting, that’s meaningful information. Over the coming weeks and months, readers can expect a lot more references to these moats and rankings in the ideas pages.