This article looks at four key considerations to take note of when investors evaluate moat trends. This is a continuation from an article I wrote on three types of moat trends – positive, negative and stable. You can also refer to the first two articles in this moats series here and here, where I discuss the different types of competitive moats and how to identify them.
Moat And Trend Ratings Are Independent
Moat ratings are separate and independent from trend ratings. Therefore, it is possible for a company to have a strong narrow moat which has a negative rating (i.e. a declining moat), while another company may have a “no moat” rating but has a positive trend (i.e. strengthening).
The difference between wide moats and narrow moats is that narrow moats mean the company specialises in a niche aspect, while wide moats combine quantitative and qualitative characteristics to confer a strong and durable competitive advantage to the firm. Moat ratings would define how strong the moat is, and would depend on the type of firm, its competition, its area of expertise and unique selling proposition. Moat trend shows the direction the moat is headed – a “no moat” company may have a positive trend because it is slowly but surely building up some semblance of a competitive moat.
Changes In ROIC May Not Correlate To Changes In Moat Trends
A company’s return on invested capital (ROIC) may or may not be a result of a change in moat trends.
The ROIC measures the returns per unit of capital invested, and a higher ROIC is normally a signal that the company is efficient in generating profits per unit of capital. Higher or lower ROIC may result from factors which are non-moat related, and therefore, changes in ROIC are not automatically a sign that moat trends have altered.
Moat Trends Are Not Necessarily Related To Growth
It’s important to note that revenue growth or decline may not correlate with a positive or negative moat trend, and may simply be a factor of the industry. If an industry is growing, revenue would also grow along with it as all players enjoy better business prospects; but such growth could attract more competition and be a negative moat trend for the company in question. Observing moat sources (i.e. what contributes to the firm’s moat) and how these change over time is more reliable.
Sales Mix May Affect Moat Ratings But Not Trends
A company may, over time, alter its business mix towards higher margin products and services which end up driving ROIC higher. Morningstar, however, sees this more as a change from a narrow moat to a wide moat (i.e. effecting a change in moat rating) rather than a shift in the moat trend. For myself, I prefer an approach where a change in sales mix may cause the moat to become stronger, and thus I would see it as “positive”, assuming other competitors do not follow suit.
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