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We’re pleased to share this five-part series on investment, from one of our Directors, Paul Reilly. Paul has had a long-standing career providing financial advice and in this series digs into some important investment principles to increase your understanding of sound investment.

Exploring Investments: Article 5 - Investing in Businesses with Moats

Another concept of value when looking for good investments is to find companies that operate with an “investment moat.”

U.S. business magnate Warren Buffett popularised the theory of wide moat companies. He popularised the term investment moat to refer to a business that earns high returns on capital, which he likens to a castle that’s protected by a moat.

Companies who have exhibited these sorts of characteristics have some sort of model that displays a sustainable competitive advantage.

What Does Investment Moat Mean?

The term economic moat, popularised by Warren Buffett, refers to the ability of a business to maintain competitive advantages over its competitors in order to protect its long-term profits and market share. Just like a medieval castle, the moat serves to protect those inside the fortress and their riches from outsiders.

Buffett’s description of a wide moat company means that it can maintain an advantage over its competitors; the competitive advantage protects the company and ensures profits in the same way that a moat protects the castle.

What is An Example of A Wide Moat Company?

Businessman illustrating competitive advantage by playing chess

There are different types of investment moats, with varying depths and widths.

Let’s look at a good example in the mining sector that is Mineral Resources which is currently in the Financial Framework portfolio.

The company in question had a foundation of crushing ore, however with a single focus they were at risk when the resources market entered a downturn. The moat they created at this point was to lock in a fixed price per tonne, which protected them from volatility in the ore price.

The company also diluted their risk by diversifying into multiple parts of the supply chain. Contracts are negotiated by the company to provide a build, own and operate structure. The mining company spends their own capital to build a crushing plant for a customer and then locks them into a long term contract to operate the plant, generally in the order of seven to ten years.

This is an excellent example of a moat, or protected investment, the customer has to pay almost regardless of how much is put through the plant. This provides long term annuity style income.

If the customer wants to cut back, it’s not done at this operation because there are fixed costs. Operations are cut at another plant where costs can actually be reduced.

This company is therefore protected, at the end of any contract period it is almost a given that it will roll into another contract, it would be cost prohibitive to ask the company to dismantle their infrastructure.

That's a moat, and that’s why moats matter.

This is an example of a company “defending their own castle,” because they do an exceptional job of building moats around their economic castle or business.

Final Thoughts

At Financial Framework, we understand how to view these types of businesses. We conduct an analysis to determine the value of these companies which helps us ensure we build an investment portfolio that works for our clients.

We believe we have constructed some of the best managed funds in Australia, with a focus on beneficial ownership and transparency.

About The Author: Paul Reilly

Paul is one of the directors at Financial Framework and has had a long standing career providing financial advice. Out of the office, you'll see Paul taking part in charity events and championing steep inclines on his road cycle.