Key Points:
- Investing in companies with a strong competitive advantage, or moat, can lead to rewards for investors.
- Market power, or the ability to gain a larger share of the market and increase profit margins, is an important factor to consider.
- Fund managers who actively monitor a company’s market power tend to outperform the average equity fund.
- Companies with fewer competitors can be set up for higher share price returns in the long run.
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.” — Warren Buffett
In the investment world, there is a lot of talk about investing in companies with a moat, which refers to a long-lasting competitive advantage that is difficult for competitors to overcome.
This concept has gained attention because Warren Buffett often discusses it. However, the idea of a moat is difficult to measure and quantify.
A moat can take the form of a strong brand like Coca-Cola or Disney, or it can be intellectual property held by a pharmaceutical or biotech company.
However, recent research suggests that instead of focusing on moats, we should be considering market power. Stefan Jaspersen’s study on mutual fund bets on market power shows that companies with fewer competitors tend to be older, have higher valuations, lower liquidity, and are followed by fewer analysts.
These companies usually operate in small market niches with a few highly specialized competitors. Because these markets are not widely followed by investors, news and information about them tend to travel slowly.
The study found that companies with little market power had returns similar to their high market power peers. However, fund managers who invested in high market power firms outperformed the average actively managed equity fund.
The key is that market power is not stable and can change over time. Fund managers who monitor a company’s competition and its ability to convert research and development investments into sales tend to invest in companies with high or rising market power and sell those with low or declining market power.
Fund managers who take market power into account are often older and more experienced. They focus on identifying companies that have the potential to hold a monopoly in their niche market.
Ultimately, companies with fewer competitors are well-positioned for higher share price returns in the long run. Market power becomes an advantage for both the company and the fund manager.
For more from Joachim Klement, CFA, don’t miss Geo-Economics: The Interplay between Geopolitics, Economics, and Investments, 7 Mistakes Every Investor Makes (And How to Avoid Them), and Risk Profiling and Tolerance, and sign up for his Klement on Investing commentary.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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