When I think of the word “moat”, the first companies that come to mind are giants. Coke. Diageo. Microsoft. Et cetera. Look further down the food chain, though, and you can still find companies with impressive competitive advantages.

This article brings you two small-cap ASX shares that our analysts think have a moat. This means they think the companies benefit from structural advantages and could earn excess returns on capital for an extended period of time. At least 10 years for a Narrow Moat company and at least 20 years for a Wide Moat firm.

As for what constitutes a small-cap, I went for a maximum market value (a company’s share price multiplied by the number of shares) of $1.5 billion.

Investors often gravitate towards small-caps looking for companies that are earlier in their lifecycle and have the potential to grow faster. They also might be seeking exposure to different shares than those dominating common market indices. For example, over 40% of the ASX All Ords index is concentrated in just ten large-cap companies.

The two shares I’ll cover today probably make up less than 1.5% of the All Ords combined. However, our analysts think both companies have carved out strong competitive positions in attractive markets. What’s more, both shares trade at attractive discounts to Morningstar’s Fair Value estimate.

Don’t forget that a high Star Rating or big discount to Fair Value doesn’t necessarily mean a stock is right for you. Please see the foot of this article for an explanation of terms like Fair Value and Moat, and how our analysts assess them.

Audinate ★★★★

Market cap: $1.4bn
Moat: Narrow
Fair Value: $17 per share
Uncertainty: High

Morningstar’s Roy Van Keulen recently initiated coverage on audio networking business Audinate (ASX: AD8) and awarded it a Narrow Moat rating due to network effects.

Audinate’s Dante protocol has become the world’s most widely used protocol for digital audio networking. Over 400 OEMs, such as Bosch, Bose, and Yamaha, license the Dante protocol to enable digital delivery and management of audio for over 4,000 audio-visual (AV) products, such as microphones, mixers, and speakers. Dante is enabled in over 10 times as many products as its nearest competitor, Ravenna. AV products using the same protocol work well together, while products on different protocols experience more friction.

As a result, AV professionals prefer using products on the same protocol and prefer using protocols with a large catalogue of available products and widespread adoption. Given Dante’s extensive lead over its competition, Van Keulen sees AV professionals gravitating towards the Dante protocol. Equipment manufacturers, in turn, prefer building products that are in demand by AV professionals, thereby creating a network effect.

While it is possible for manufacturers to install two digital protocols on the same device, it is rare because it entails material extra costs for them. As a result, Van Keulen thinks that Audinate's network effect puts it in a strong position to win the audio networking market. He estimates that digitally enabled audio devices accounted for 10% of new device sales in 2023, up from 5% in 2016. This leaves Audinate plenty of room for growth as the industry digitizes.

Van Keulen thinks Audinate can grow its sales at an average of 22% per year for the next decade, driven primarily by the firm expanding the market for digital audio networking. He expects Audinate to keep more of these sales as profit, with his forecast including an improvement in operating margins to 36% in 2033 from 1% in 2023. Van Keulen thinks this improvement could stem from Audinate’s sales and marketing expenses falling as a percentage of sales, as well as the firm’s network effect making it easier for them to charge higher prices. He expects Audinate to continue its push into the nascent video networking market, which is more challenging technically and looks less prone to network effects.

Audinate currently trades at around $15.60 per share. Van Keulen thinks the company is worth $23 per share given his assessment of Audinate’s moat and market opportunity. He assigns an Uncertainty Rating of High to his valuation, given that it is impossible to know how big the audio networking market will prove to be. He also sees technological disruption and cyclical demand for audio devices as other potential risks.

Go here to read about 3 more ASX companies that benefit from network effects.

Fineos ★★★★

Market cap: $550m
Moat: Wide
Fair Value: $3.10 per share
Uncertainty: Very High

Fineos (ASX: FCL) provides core software to the global life, accident, and health insurance industry. Building on its leadership in claims and absence products, Fineos aims to cross-sell its broader product set including payments, billing, data and more. The firm is currently migrating customers from on-premises products to a cloud-based offering. This makes it easier to roll out new features and support at lower marginal costs, while also providing more recurring subscription revenue.

Morningstar’s Shaun Ler thinks Fineos has a Wide Moat because of switching costs. Insurers are generally averse to changing core systems as it entails a huge time investment and risks of data loss and business disruption. Even if a competitor were to market a better product to a Fineos customer, it would still have to overcome these impediments to win them over.

Fineos has a long growth runway as most insurers continue to use legacy systems with limited functionality. This is a double-edged sword as it could mean that the industry attracts substantial competition and discounting. Switching costs are likely to cushion the impact on Fineos’ ability to retain clients. However, it may limit their scope for price hikes and require continued investments in its product offering to stay competitive.

Ler believes Fineos has a fair value of $3.10 per share. This is based on the company reaching net profitability next year and continuing to gain market share from a small base of around 1.3% of the total addressable market. It is hard to project Fineos’ earnings with precision because the insurance software market is evolving quickly. The impact of Fineos transitioning to a cloud-based offering is also uncertain.

Client concentration, while falling, is also a risk as large Fineos customers could leverage their purchasing power to avoid price hikes. A wider range of potential outcomes is reflected in Ler’s Uncertainty Rating of Very High which denotes our opinion that investors should only invest with a large margin of safety. Nevertheless, at a current price of around $1.63 he believes the shares are attractive.

Before you get to choosing investments, we recommend you form a deliberate investing strategy. You can read more about how to do this here.

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.