Inflation in the UK recently hit a record 40-year high of 9.4%. This coincides with an increasing number of claims from actively managed equity funds that their portfolios will benefit from the effects of ‘economic moats’.

The term refers to a company’s economic advantage over rivals that enables it to increase prices without losing business to a competitor. In the same way as a traditional moat would have protected a castle from attackers in the medieval period, an economic moat helps a business ward off competition from rivals.

PRICING POWER FUNDAMENTAL

According to Warren Buffett ‘the single-most important decision in evaluating a business is pricing power’.

He added: ‘If you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business.’

Buffett’s comment is becoming particularly relevant as a surge in input costs has resulted in a slew of profit warnings for companies that have been unable to pass these on to an increasingly cash constrained consumer.

In marked contrast, companies that have been able to raise prices to offset the jump in input costs have maintained or even improved their gross margins and profitability.

For investors who believe the increase in global inflation is structural and enduring as opposed to transient, then gaining exposure to companies with economic moats and the pricing power they confer makes sense.

Morningstar has developed an economic moats rating system under the auspices of its director of equity research Patrick Dorsey.

FUNDS FULL OF ‘MOATY’ STOCKS

Their research has highlighted two key equity funds with the highest number of economic moat holdings. These are Natixis Loomis Sayles US Equity Leaders (B8L3WZ2), and Fundsmith Equity (B41YBW7).

A lower cost alternative which provides exposure to businesses with strong moats is the VanEck Morningstar US Sustainable Wide Moat ETF (MOGB).

In 2021 Morningstar examined which funds held the largest proportion of equities with either wide or narrow economic moats.

Morningstar awards a narrow moat when it finds at least one source of competitive advantage and that economic profits are expected to be positive for at least 10 years.

A company is deemed to have a wide moat if economic profits will endure for at least 20 years.

The Natixis fund had 77.21% of stocks with wide economic moats, and 21.86% of stocks with narrow economic moats.

Fundsmith Equity had 73.96% of stocks with wide economic moats, and 22.75% of stocks with narrow economic moats.

WHAT MAKES A MOAT

• Switching costs: These give a company pricing power by locking customers into its unique ecosystem. Beyond the expense of moving, they can also be measured by the effort, time and psychological toll of switching to a competitor.

Stryker Corp (SYK:NYSE) features as a key equity holding in Fundsmsith Equity.

It is a top-tier competitor in a number of medical markets. These include orthopedic implants, surgical equipment, endoscopy and neurovascular devices.

Since switching costs can be significant for surgeons when it comes to orthopaedic implants, this is, according to Morningstar, one of Stryker’s ‘moatiest divisions’ in support of the company’s wide economic moat.

• Intangible assets: Though not always easy to quantify, intangible assets may include brand recognition, patents and regulatory licenses. They may prevent competitors from duplicating products or allow a company to charge premium pricing.

Until recently Starbucks Corp (SBUX:NASDAQ), the leading specialty coffee retailer in the world, was another key equity holding in Fundsmith Equtiy.

According to Morningstar Starbuck’s economic moat comes from its ‘brand strength evidenced by pricing power, attractive unit-level economics, successful international replication and strong results in the retail channel underpinning its brand intangible asset’.

Terry Smith recently sold Starbucks as the coffee giant faced unionisation of its American workforce.

In May 2022 the chain decided to pull out of Russia, where it has 130 stores.

• Network effects: This occurs when the value of a product or service grows as its user base expands. Each additional customer increases the product’s or services’ value exponentially.

Meta Platforms (META:NASDAQ) which is a key holding in both the Natixis Loomis Sayles US Equity Leaders Fund, and Fundsmith Equity is a good example of a stock that benefits from network effects.

Meta Platforms operates online social networking platforms that allow people to connect share and connect with friends and communities.

It continues to have significant advantages arising from its network of almost three billion daily users of its family of apps, 200 million businesses that use its platforms and tools every month and 10 million advertisers which consistently paid more per user for access to its network.

Across this family of apps – Facebook, Messenger, WhatsApp and Instagram – Meta now reaches over 3.6 billion customers monthly, approximately 79% of which are daily users.

Alphabet (GOOGL:NASDAQ) is another beneficiary of network effects. It also features as a key holding in both the Natixis Loomis Sayles US Equity Leaders Fund, and Fundsmith Equity.

With a global share of over 80%, Alphabet leads the online search market. The company’s network effect comes primarily from its Google products, which includes search, Android Maps, Gmail and YouTube.

According to Morningstar ‘Google has the world’s most widely used search engine, and such a large and growing user base has created a network difficult to replicate’.

• Cost advantage: A firm that can provide goods or services at lower cost than its peer group has an advantage because it can undercut rivals on price. The firm may also wish to sell products and services at the same price but get a larger profit margin than competitors.

• Efficient scale: This when a market of limited size is effectively served by one of just a few companies. It is not worth another party entering the market because their participation would result in insufficient returns for all players.

TERRY SMITH, ECONOMIC MOATS AND PRICING POWER

In July 2022 Terry Smith of FundSmith Equity released his semi-annual letter to investors. It highlighted the importance of pricing power in an inflationary environment:

‘Inflation causes an increase in the costs of the ingredients, components and their inputs which constitute companies’ Cost of Goods Sold (COGS). The best defence against this inflation is a high gross margin – the difference between the sales revenue and COGS. On average last year the companies in our portfolio had a gross margin of 60% compared with about 40% for the average listed company.

‘Our companies make things for £4 and sell them for £10 whereas the average company makes things for £6 and sells them for £10. A 10% rise in the COGS clearly has much less effect on the profitability of the companies in our portfolio than the average. Moreover if they want to compensate for say a 10% rise in the COGS our companies can achieve this with a much smaller price rise than the average company.

‘An illustration of the problems if a company has low gross margins was recently supplied by the US retailer Target (TGT:NYSE) – a stock we would never own – in its first quarter results. Gross margin contracted from 30.0% in the same quarter last year to 25.7%, a fall of 4.3 percentage points-driven largely by inventory impairments, lower-than-expected sales in discretionary categories as well as higher costs related to freight, supply disruptions and increased competition and headcount in distribution centres.

‘The operating margin fell from 9.8% in the prior quarter to 5.8%, so by a similar 4.5 percentage points. Operating profit declined 43%. The combination of low gross margins and high fixed costs is dangerous and we seek to avoid it.

ECONOMIC MOATS AND LONGEVITY

James Bullock, co-portfolio manager of Lindsell Train Global Equity (B644PG0), believes that whilst the term economic moat is ‘overused’, it is nevertheless a powerful concept.

Bullock focuses on companies with economic moats that have endured for many decades, believing that ‘longevity is undervalued and mispriced by the market’.

This is reflected in the average age of companies in the fund which is 115 years. This compares with the average life of a business that is 15 years.

Founded in 1922, Unilever is a good example of a significant fund holding (5.3%), with a heritage of brands that have endured for many decades.

Unilever’s recent first half trading update
(26 July), provided some validation to Nick Train’s thesis that its earnings growth is inextricably linked to its brand heritage.

The firm posted underlying sales growth significantly ahead of analysts’ forecasts whilst raising its full year outlook.

UNILEVER’S BRANDS ARE ECONOMIC MOATS

The pricing power of Unilever’s brands was a standout feature of the results. The group posted underlying sales growth in the second quarter of 8.8% driven by an impressive 11.2% increase in prices.

In the second quarter the home care division (20% of sales) increased prices on products including Comfort, Radiant and Domestos by an eye watering 16.6% as the group succeeded in passing on ‘very high increases’ in raw material costs.

During the same period the personal care division (40% of sales) secured price increases of 10.5% on brands including Pond’s and Dove, with volumes declining by a mere 2.3%.

The foods and refreshment division (40% of sales) implemented price increases of 9.4%, resulting in a modest 1.2% fall in volumes.

The power of the Unilever’s brand franchise and its associated economic moat has enabled has enabled management to raise its forecast for full year underlying sales growth ahead of its previous 4.5% to 6.5% guidance.

THE ECONOMIC MOAT ETF

For investors who wish to avoid the higher charges associated with buying an active equity fund the VanEck Morningstar US Sustainable Wide Moat ETF
provides an interesting low cost alternative.

It tracks the Morningstar US Sustainable Moat Focus Index which contains at least 40 attractively priced equities with sustainable competitive advantage.

This is based on research undertaken by Morningstar’s equity research team. The equities selected for the fund are screened for ESG risks.

Technology (30.3%), Financials (13.4%), and Consumer Discretionary (11%) make up the largest sector weightings.

Top holdings include Microsoft (MSFT:NASDAQ) (2.44%), Bank of New York Mellon (BK:NYSE) (2.28%), Kellogg Company (K:NYSE) (2.91%), Alphabet (GOOGL:NASDAQ) (2.35%), and Constellation Brands (STZ:NYSE) (2.7%).

The £383 million fund has an ongoing charge of 0.49% per annum.

Over the last year the fund has served up a negative return of -2.73%, however on a three-year basis it has delivered a 33.67% return. (Note: returns are in sterling and include dividends).

Disclaimer: Financial services company AJ Bell referenced in this article owns Shares magazine. The author of this article (Mark Gardner) and the editor (Tom Sieber) own shares in AJ Bell.

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