3 Types Of Moat Trends An Investor Should Know About

This series on competitive moats now continues with the discussion on moat trends, which looks at whether a moat is getting stronger or weaker over time, and the reasons why this is so. I had previously written on the different types of competitive moats in two articles which can be found here and here.

Moat trends are important because the business world is dynamic and evolving, so companies may witness their moats becoming stronger or facing erosion. This has implications for the investor as his original thesis for purchasing the company may be invalidated should the moat of the company be severely eroded. Morningstar uses three types of ratings – positive when the moat is strengthening or growing, negative when the moat is shrinking or declining, and stable when there is no discernible movement either way. Let’s have a look at these three aspects.

Moat Trends – Positive

Companies which have positive moat trends would include those which have spent time, resources and effort in strengthening their competitive moat, and this will be reflected in a higher return on invested capital, better margins and healthier free cash flow generation over time.

Note that it may be an active process which helps build the moat further, such as the company undertaking research to ensure a better service experience for clients, thus making switching costs higher; or it may strengthen its network of products and services by on-boarding more suppliers and clients, thus building on its network effect.

Some moat trends are positive due to passive events which the company has no direct control over, such as a competitor (which offers a substitute product) going bust. The industry in which the company is in could also be growing and attracting more attention, and competing technologies may either fall by the wayside or be excluded from consideration, hence strengthening the moat without the company taking any active actions.

Moat Trends – Negative

It’s fairly common to see negative moat trends for many companies, as the pace of change in the last decade has been nothing short of breathtaking, resulting in many companies not being able to adapt or react fast enough to preserve their moat status.

Management is sometimes complacent when times are good and have a tendency to rest on their laurels, especially when they’ve been in a dominant market position for years or even decades. With rapid technological advancement, moats may be eroded much more quickly than, say, 50 years ago. Therefore, companies have to be always watchful and mindful of such potential shifts.

Moat Trends – Stable

Stability is not the status quo these days, as I mentioned that the pace of change is rapid and many industries are evolving at an accelerated pace. However, it’s still possible to find companies in staid industries with stable moat trends. These are industries where the risk of technological disruption is low, and where the companies have also built up a loyal customer base which is unlikely to embrace new changes.

In the next part of this series, I look at several factors which influence moat trends and whether they translate into a company being more, or less attractive. [Editor’s note: The article on the factors affecting moat trends has been published and it can be found here.]

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