Dig a Moat for Your Investments

Economic moats--forces that sustain monopolistic profits--are a virtue Morningstar assiduously seeks among the more than 1,500 stocks we research. Companies boasting wide economic moats, such as  Fidelity National Financial (FNF) or  Moodys  (MCO), earn high returns on capital because they are difficult to compete with--a benefit that translates into outsized returns for investors over long periods. Conversely, companies that lack moats lead a hardscrabble existence confronting brutal competition and eking out unappealing returns.

We think the moat concept has broader applicability. In our view, investors who compete for returns in the financial markets can take concrete steps to widen their "investment moat"--which in this context refers to an ability to consistently outperform a market benchmark. By focusing on market segments in which they boast a competitive edge, developing private valuation insights and reducing temperament-driven errors that impede rational thinking, investors can meaningfully improve their returns. Although we view these as the three key ingredients for widening an investment moat, we caution that we are offering a framework rather than a prescriptive recipe. Investment moats take many shapes, and the most successful investors will be those who adapt the framework to amplify their unique strengths.

Only Enter Competitions You Can Win
Who among us would bet their portfolio that they could beat Wayne Gretzky in a hockey shootout, Tiger Woods over 18 holes at Augusta or Michael Jordan in a little one-on-one? Hopefully no one, as these are clearly bets that mere mortals couldn't hope to win. Similarly, we're not sure why anyone in their right mind would knowingly sell a stock to Warren Buffett. While these are comical exaggerations, a moment's reflection can reveal the serious financial consequences of competing for the "wrong" returns. Let's illustrate with an example from the market for short-term returns.

The competition for short-term returns is brutal. The proprietary trading desks at giant Wall Street firms and hedge funds such as  Goldman Sachs (GS),  Bear Stearns , and Citadel risk billions of dollars trying to profit from near-term price movements. So it's not surprising that these firms have made huge investments in market information systems and well-connected traders to maintain their position at the head of the queue for the highly perishable information that drives short-term prices. Hedge fund SAC Capital is notorious for seeking the "first call" from analysts with news--but when your fund single-handedly generates 2%-3% of the NYSE's daily volume, the sheer dollar value of your commission payments cements your perch at the head of the information-flow queue.

It's crazy to compete with these firms--despite the tidal wave of near-term-focused information and recommendations that TV networks, newspapers, and bulletin boards bombard the market with. By the time it's on TV, its already too late. Even with the wide array of market-data tools we have at Morningstar, we doubt we could come close to generating an attractive return this way. But why bother? If the majority of the market is focused on the near term, why not simply seek long-term returns that attract far less competition? Many investors must either report their returns each quarter or are simply too impatient to hold stocks that don't appreciate immediately. This trading frenzy often leaves attractive returns on the table. Take  Anheuser Busch (BUD), for example. Unlike many companies that  Berkshire Hathaway (BRK.A) (BRK.B) has disclosed as investees, Anheuser Busch's stock price is still lower than when Berkshire declared its hand. While the street ignores it in favor of stocks with more exciting near-term earnings prospects, a patient investor could readily accumulate a sizable stake in this 5-star stock. Less competition equals wider moat.

Develop Private Valuation Insights
"Buy what you know"--or conversely, don't buy what you don't know--is a useful concept popularized by Peter Lynch, Fidelity's master fund manger. Lynch's idea is that investors should focus on businesses they understand. For example, an investor who frequently shops at  Gap (GPS) and notices an increase in store traffic has arguably gained an informational advantage. We think this is useful advice, but in our view, investors must push further to convert such insights into an investment moat. Investing at a discount is the key. It's little use investing to exploit Gap's rising sales if the stock price already reflects it--the competition has beaten you to it! Insights must be private to be valuable. Thousands of people read the Wall Street Journal looking for ideas.

The good news is that many investors already boast above-average expertise in select fields. Physicians are likely well acquainted with pharmaceutical and hospital management businesses, while bankers probably possess more than a few insights on the financial sector. What's more, it's possible to develop additional areas of expertise through a program of diligent reading and field research. When it comes to valuation the going gets a little tougher, although a motivated investor enjoys many options. But perhaps the easiest is to limit your research and investing to stocks bearing Morningstar's 5-star rating. That was a shameless plug, although we do think Morningstar's research has a lot to offer.

Temperament: Steady Minds Earn More Than Steady Returns
If you were given the keys to  Suntrust Bank's  vault in downtown Atlanta, you'd soon have access to one of the 20th century's most closely guarded commercial secrets--the formula for  Coca-Cola (KO). While it's arguably less important for Coke to guard its secret today--much of its moat comes from its "share of mind" and global distribution network--in the early days secrecy was vital, as unscrupulous rivals could have duplicated Coke's unique taste--and appropriated its returns.

Intense secrecy is also common amongst institutional investors, but interestingly, this stealth is invariably concentrated amongst managers pursuing quantitative strategies. It's not hard to infer why--as soon as any educated competitor gained access to (or reverse-engineered) a quant shop's investment algorithms, their moat from that strategy would rapidly drain. What's more, the more successful the firm, the more fiercely they'll guard their secrets. For instance, Renaissance Technologies, a quantitative hedge fund that has a delivered an astounding 34% annual return each year since 1988, not only demands that employees swear to protect the firm's secrets, but also recently discontinued its Web site. And rather than assume the mantle of Wall Street hero, founder James Simons remains largely obscure.

But what are we to make of the procession of successful investors who openly, and for reasons other than personal profit, explain their methods? Warren Buffett, via his shareholder letters, may be the most famous example, but many others have followed suit. George Soros, Joel Greenblatt, Seth Klarman, John Neff, Marty Whitman, David Dremen, Bill Gross and Ben Graham have each authored how-to investment books. Savvy investors aren't in the business of aiding competitors, so we think it's wise to conclude that these businessmen believe their investment moats originate elsewhere. But we'll defer to the master (15th quote) to reveal the secret; "The most important quality for an investor is temperament, not intellect."

Let us concede that temperament is necessarily some function of intellect. Psychological research has concluded that a person's ability to evaluate his own competence is strongly related to capability. For our purposes, this is not important. What matters is a conscious effort to harness temperament to make fewer investment errors. After all, simple math demonstrates that it takes a 100% gain to offset a 50% loss, and the former are lamentably scarcer than the latter. We've selected three manifestations of temperament--overconfidence, independent conviction, and envy--to suggest some error-reducing ideas. No doubt there are hundreds more.

Overconfidence is a pervasive and often invaluable human trait. Without it, our ancestors may never have moved out of caves,  explored new worlds, or challenged gravity. Yet, as an infamous study that discovered that 90% of Swedes consider themselves "above-average" drivers demonstrates, overconfidence can have downsides--especially for investors. Excessive trading--or as we like to call it, voluntary taxation--is one. The more frequently you trade, the more likely you are to be pursuing low return strategies--such selling a stock in the hope of buying it back cheaper, trying to outwit impossibly resourced Wall Street trading desks or hoping to precisely time short term price jumps. We struggle to list investors who have accumulated serious wealth via furious trading, but we could spend all day showcasing wealthy families who owe their success to holding shares of great businesses for generations. Turnover is expensive. Why volunteer for more? The next time you find your finger on the trading trigger, stop and ask whether you can prove that action will be more profitable than inaction. Perhaps you really would be better off playing a round with Tiger.

Independent conviction was popularized by Ben Graham, one of Morningstar's idols. To paraphrase one of Graham's pithy quotes: You are neither right nor wrong because others agree with you. You will be right if your facts and reasoning are correct.

The challenge is that investment decisions bear important financial consequences, and are often made alone. It can be all too easy to submit to a need for emotional reassurance by "herding" with other investors--especially for those who must justify decisions to clients. But it can also be frightfully expensive, as investors who bought  Cisco (CSCO) in January 2000 or  Xerox (XRX) in December 1972 now lament. As with many temperament-honing strategies, basic awareness is a critical step. In this case we'd go further and prescribe a program of "fact-based" investing. In our view, investors who substitute a reference to "the crowd" with a reliance on verifiable stock-specific facts will inoculate themselves from the market's emotional swings. Building a fact base for your investments will also help you avoid getting spooked by temporary price declines. It's pointless to buy stocks with a large margin of safety if a transitory 10% price decline makes you sell--especially when a reference to your fact-base may have correctly prompted an additional investment. Granted, this is much easier said than done, but moats wouldn't be worth much if everyone could have one, would they?

Envy, not greed, makes the world go round. And it's a serious problem. When we weigh its financial ill effects, it seems to us that envy may actually be the deadliest temperament-driven investment sin. We're frequently astounded that investors furiously scramble into the market's hottest sector, seemingly unable to miss out on the "easy" profits others are making. But rushing into a popular investment category strikes us as odd. Why buy when prices are highest and margins of safety lowest? Yet the lure of the 1990s dot-com bubble, today's real estate boom, or any of history's famous bubbles amply demonstrate envy's powerful siren song. But if someone else gets rich a little faster than you, so what? Some investor, somewhere, will always have earned a higher return over any recent period. In our view, the demons of envy can be thwarted with a combination of awareness and a disciplined strategy of limiting investments to those that can be purchased with a margin of safety. Sure, there will always be a "hot" market sector, but investing is a business in which the tortoise always wins in the end.

Temperament is merely a subset of the broader academic research into behavioral finance, and we've barely scratched the surface here. We urge serious investors to explore this field in much more depth than our space constraints permit. We'd recommend the final "talk" in Poor Charlie's Almanack for those seeking an experienced practitioner's overview, and the works of academic heavyweights Danny Kahneman, the late Amos Tversky and Richard Thaler for those desirous of a more rigorous presentation.

Profiting From Temperament: An Illustration
Temperament can be a slippery concept, so let's explore further with two investment examples. Investment A: You buy a stock for 50% of its estimated fair value. This stock never trades below your buy price, and although there are a few minor bumps along the way, consistently appreciates until you sell it at fair value five years later--pocketing a nice "double." This is a rare experience, but most importantly--it's EASY. Nothing soothes investors like repeated positive feedback from a consistently rising price. About the worst you could do here is to sell too soon, chasing near-term performance elsewhere.

Now let's try Investment B: Once again, you buy a stock for 50% of its estimated fair value. A year later, the stock has gone nowhere, while the fair value is unchanged. At this point, some investors--chasing performance--will have sold. After another year, the price has declined 20%, while the fair value is unchanged. More investors will have sold by now. Then, after year three, the stock has declined another 20%, while the fair value is still unchanged. By now, many investors will be selling, feeling sick, cursing analysts or engaging in other unproductive behavior spawned by the negative reinforcement generated by the declining stock price. What's interesting though, is that the investment thesis hasn't changed--buying and holding a stock that trades significantly below it's fair value. In fact, the investment is now more attractive in price/fair value terms. No matter--powerful temperament-driven forces are compelling investment return-reducing behavior. (Perhaps, upon reflection, you may see some of yourself in this scenario). Anyway, in year five the stock finally appreciates to fair value, and the remaining investors sell for a pleasing double. The result is the same as Investment A, but only those with a temperamental advantage pocketed the profit. But unlike Investment A, this profit is extremely hard to earn, and not everyone can do it. Those who can enjoy a fabulous advantage--a temperament-enabled investment moat. And those who can not only sit tight, but add to their positions while a price is declining, enjoy the widest moats--and the accompanying profits.

Integration and Alignment: Completing the Jigsaw Puzzle
No moat can protect a financial castle built upon contradictory foundations. No matter how you go about digging your own moat, make sure the pieces are complementary. It's little use attempting to develop the expertise to invest in highly technical fields like biotechnology if that means competing with research scientists with better and more rapid access to information.

Investment moats are hard-won, but worth the effort. If you can circumnavigate tougher competitors, invest with insight and make fewer emotional errors, we think you'll enjoy the fruits of higher returns for the remainder of your investment lifetime.

A version of this article was published on July 15, 2005.