Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 274

Check 6 key ‘moats’ around small stocks

When we lift our vision from directly in front and look towards the horizon, we see much more. It’s similar with investing. Taking a long-term view forces us to think more broadly about the risks likely to confront a company and its ability to withstand them. This inevitably leads to assessing a company’s moat or barriers to entry.

'Understanding the moats' is relevant to any company but is particularly important for small cap stocks. The strengths of these moats may decide which small cap companies are destined to grow and which are consumed by the competition.

Are small cap valuations terminal?

It is little appreciated that approximately half a small cap company’s valuation is attributable to its terminal value when using the discounted cashflow method. Terminal value is a multiple of earnings roughly 10 years in the future, further underlining the importance of the long term.

So how do we assess a small cap company’s barriers to entry, and more importantly the direction of those barriers (rising or falling) given they often compete against larger companies?

The following six elements can determine the moats around small cap stocks:

1. The company’s industry: Ideally, investors are looking for a niche that requires specialist skill or an unusual product that caters for a market segment and is difficult to replicate. Larger companies typically focus on big markets, particularly during the growth phase, leaving space for smaller companies in niches to improve their barriers.

In the finance sector, for example, large banks leave gaps for smaller, specialist providers in areas like SME funding and debtor financing.

2. The product or service offered: Investors must consider the level of specialisation and the ability of others to replicate, especially a similar or better product or service at a lower price. Judgement, experience and the benefit of industry expert opinion is required for this assessment, and it must be constantly monitored due to changes through time.

Large players have more capital, so competing on cost does not create a convincing barrier for a small company, particularly when an industry matures and large companies look for new areas to grow. However, customer loyalty based on rational economic benefit is a barrier. Software often has high barriers particularly when delivered in an efficient, scalable model such as SAAS. Customer switching costs can be high when including training, human inertia and execution risk.

Some other areas to consider include benefits of scale, customer fragmentation, legal barriers (e.g. patents, ACCC restrictions), brand and reputation, contractual commitments and network effects.

At its core, investors must determine how sticky the customer is in the face of competitive threats and what price the customer would be willing to pay for the offering.

Healthcare companies often have sticky customers. Given conservative approaches to patient health, an established product can be difficult to replace when it becomes widely used and trusted. For example, Cogstate (ASX:CGS) benefits from over 10 years of data accepted by the FDA in the use of drug trials. Large pharmaceutical customers have a low tolerance for procedural error making this history a high barrier to new entrants. Nanosonics (ASX:NAN) has a large and growing installed base of Trophon machines within hospitals for which it sells highly profitable consumables. Note, investors must be aware valuations can at times be exuberant in this space.

3. Rising or falling barriers: A frequently overlooked yet exceedingly important element is the direction of barriers to increased competition i.e. are they rising or falling? This is probably the most important element of value creation as price and revenue will typically follow.

For example, Bravura Solutions (ASX:BVS) is enjoying rising barriers as it signs new customers with high switching costs, and Bravura’s greater scale enables increased product development.

The process of assessing a company’s barriers to entry never stops, and it is becoming harder to assess as technology causes rapid change.

4. The company’s management: Management’s ability to build and adjust the organisation to ever-changing circumstances will determine the success of the offering and thereby the stock price. Management with a long-term view will often reinvest in growth. This can be a very powerful earnings driver as scale enables greater investment.

We view EQT Holdings (ASX:EQT) as a good example of management taking a long-term view and balancing short and long term growth. Each additional dollar of revenue requires little additional cost meaning that profits could easily be boosted short term. But by re-investing in operating efficiencies and sales and marketing, the business reduces its cost to serve and increases customer awareness.

5. Company meetings: Meeting management is important, but the greatest insights are often gleaned by meeting other companies in an industry, particularly competitors. They are often more forthcoming with the weaknesses in a competitor’s moat and how it can be breached.

It’s also worthwhile talking to suppliers, customers and employees (past and present) to get a fuller picture of the business.

6. A measured approach: At times, meeting a new company CEO can appear an exciting opportunity, but by their nature, CEOs are typically good salespeople. Always take a measured approach to a stock’s weighting in the portfolio. Investors may like a company, but the prudent approach may be to start with a relatively small position and increase it over time as understanding increases. This is particularly the case with initial public offerings (IPOs) with time restrictions.

The process of assessing a company’s barriers to entry never stops. Barriers are rising and falling constantly and it is one of the most important aspects of small cap investing.

Richard Ivers is Portfolio Manager of the Prime Value Emerging Opportunities Fund, a concentrated fund which invests in micro and small cap stocks with a capitalisation of less than $500 million at first purchase www.primevalue.com.au. This article is general information and does not consider the circumstances of any investor.

RELATED ARTICLES

Social media’s impact is changing markets

Where we see growth opportunities in software stocks

Boring can be beautiful when investing

banner

Most viewed in recent weeks

Are term deposits attractive right now?

If you’re like me, you may have put money into term deposits over the past year and it’s time to decide whether to roll them over or look elsewhere. Here are the pros and cons of cash versus other assets right now.

Uncomfortable truths: The real cost of living in retirement

How useful are the retirement savings and spending targets put out by various groups such as ASFA? Not very, and it's reducing the ability of ordinary retirees to fully understand their retirement income options.

How retiree spending plummets as we age

There's been little debate on how spending changes as people progress through retirement. Yet, it's a critical issue as it can have a significant impact on the level of savings required at the point of retirement.

Where Baby Boomer wealth will end up

By 2028, all Baby Boomers will be eligible for retirement and the Baby Boomer bubble will have all but deflated. Where will this generation's money end up, and what are the implications for the wealth management industry?

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

20 US stocks to buy and hold forever

Recently, I compiled a list of ASX stocks that you could buy and hold forever. Here’s a follow-up list of US stocks that you could own indefinitely, including well-known names like Microsoft, as well as lesser-known gems.

Latest Updates

Property

Financial pathways to buying a home require planning

In the six months of my battle with brain cancer, one part of financial markets has fascinated me, and it’s probably not what you think. What's led the pages of my reading is real estate, especially residential.

Meg on SMSFs: $3 million super tax coming whether we’re ready or not

A Senate Committee reported back last week with a majority recommendation to pass the $3 million super tax unaltered. It seems that the tax is coming, and this is what those affected should be doing now to prepare for it.

Economy

Household spending falls as higher costs bite

Shoppers are cutting back spending at supermarkets, gyms, and bakeries to cope with soaring insurance and education costs as household spending continues to slump. Renters especially are feeling the pinch.

Shares

Who gets the gold stars this bank reporting season?

The recent bank reporting season saw all the major banks report solid results, large share buybacks, and very low bad debts. Here's a look at the main themes from the results, and the winners and losers.

Shares

Small caps v large caps: Don’t be penny wise but pound foolish

What is the catalyst for smalls caps to start outperforming their larger counterparts? Cheap relative valuation is bullish though it isn't a catalyst, so what else could drive a long-awaited turnaround?

Financial planning

Estate planning made simple, Part II

'Putting your affairs in order' is a term that is commonly used when people are approaching the end of their life. It is not as easy as it sounds, though it should not overwhelming, or consume all of your spare time.

Financial planning

Where Baby Boomer wealth will end up

By 2028, all Baby Boomers will be eligible for retirement and the Baby Boomer bubble will have all but deflated. Where will this generation's money end up, and what are the implications for the wealth management industry?

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.