Sustainable competitive advantage and stock performance: the case for wide moat stocks

ABSTRACT

‘In business, I look for economic castles protected by unbreachable “Moats”’. Warren Buffett Companies that have sustainable competitive advantages should be able to create a barrier (Moat) to prevent or lessen competition from other firms. The wider the Moat the greater the barrier and the more secure the company’s profitability. Using the Morningstar classification of ‘Wide Moat’ stocks, we construct annually rebalanced equal- and value-weighted portfolios to analyse their performance in order to determine if they deliver superior performance relative to standard benchmark portfolios. The period for our analysis extends from June 2002 through May 2014. We find that the ‘Wide Moat’ portfolios outperform both the S&P 500 and Russell 3000 indices generating higher average monthly and annualized returns, Sharpe Ratio, Sortino Ratio, Treynor Ratio, Omega Ratio, Upside Potential Ratio, M², M² Alpha, and cumulative returns. When we compute alpha using Carhart four-factor and Fama–French five-factor models, we find that ‘Wide Moat’ portfolios had significantly positive risk-adjusted alphas with both the models. ‘Wide Moat’ portfolios also lost less value during the 2007–2009 financial crisis compared to both S&P 500 and Russell 3000. In conclusion, we find that ‘Wide Moat’ stocks have created significant value for their investors over the course of our study.

KEYWORDS:

• Competitive advantage
• performance
• risk-adjusted returns

JEL CLASSIFICATIONS:

• G11
• G12
• G14

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ Porter’s five forces were later expanded to six with the inclusion of the impact of complimentary products.

² Morningstar (2012). See also Appendix 1 for type of Moats. Appendix 2 presents firm characteristics that do not necessarily represent and economic Moat.

³ Appendix 3 gives a good summary of why Moats expand or shrink with time.

⁴ http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

⁵ There were no microcap ($0–$300 Million) Wide Moat companies during the period of our study.

⁶ In addition to identifying ‘Wide Moat’ stocks, Morningstar analysts also introduced its ‘Tortoise and Hare’ portfolios in 2001 with the goal of identifying undervalued stocks. For an analysis of the performance of these portfolios see Kenny, Johnson, and Kunkel (2013).

⁷ The portfolios include the universe of Wide Moat stocks. We considered analysing multiple portfolios but given the relatively small number of Wide Moat stocks a random selection process could lead to unintentional under or overweightings in certain sectors.