I recently wrote an article comparing Rentokil Initial (LON: RTO) to some criteria I want my investments to meet.

Two of the most important of those criteria, in my mind, are 1) a competitive advantage or hard to replicate assets that I understand and 2) a fair growth outlook for the sector and business.

If you manage to collect ownership stakes in businesses of this ilk and show enough patience to buy in at a reasonable valuation and hold, you will probably do just fine over the long-term. That is, if you were correct about assessing the moat, growth opportunities and valuation in the first place.

The rest of this article looks at two companies that I think exemplify these two qualities: a commanding moat that I can understand and solid growth prospects. I do not directly own shares in either of these companies. But I would love to one day, at the right price.

Criteria 1: A competitive advantage that I can understand

If you are trying to execute a buy and hold approach to investing, you are probably going to want to invest in companies that benefit from some kind of structural competitive advantage.

This is important because the returns on your investment in a company over time are likely to reflect the company’s ability to remain profitable, make lucrative investments back into its business and grow profits. Without something protecting its ability to do this, the relentless competition of capitalism will likely drive those profits and ability to reinvest profitably above the cost of capital down towards zero.

The second half of this criteria – that I can readily understand the source of competitive advantage – is equally important to me. This is because industries and their competitive dynamics are not static. Having a real understanding of why a company is competitively advantaged will make it a lot easier for me to monitor the health and width of that moat over time.

Wide Moat Taiwan Semiconductor (NYS: TSM), for example, would not meet my criteria. Here is how our analyst starts describing the moat: “TSMC’s long-standing leadership in node advancement comes from its ability to correctly and consistently prioritise the right areas in which to innovate for nodes, while maintaining fiscal discipline”.

I’m sure that is all accurate and would mean a great deal to somebody familiar with semiconductors. But I do not have the faintest idea what most of those words mean.

Contrast this to the moat source that Angus Hewitt ascribes to Narrow Moat Bapcor (BAP) – it has far more trade locations than its smaller peers and can therefore stock more car parts across its network and get these parts to customers faster. I understand the source of advantage and could keep an eye on it over time by looking at things like number of locations versus peers, market share and profitability.

Criteria 2: A fair growth outlook for the sector and business

Stock prices on any given day, or in any given year, can be affected by a million things. Investor sentiment. Interest rate expectations. Supply and demand in a single security. Et cetera. In the long-term though, company valuations (and therefore stock prices) usually follow earnings growth.

This is why Warren Buffett’s 1996 letter to Berkshire Hathaway (NYS: BRK.B) shareholders included the following piece of advice:

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”

My earlier article “how to find companies that can grow forever” highlighted seven potential sources of long-lasting sales and profit growth. My piece on a 15 step checklist from growth investing legend Phil Fisher touched on a few more.

2 companies that embody these qualities

Visa Inc (NYS:V)

Is there a better asset on earth than VISA’s payment network?

Seriously – it is essentially a tollbooth on a huge percentage of the card payments made worldwide every day, every minute and every second. Here is how our analyst Brett Horn describes Visa’s network effect, which he sees as the main source of its Wide Moat rating:

“The more consumers that are plugged into a payment network, the more attractive that payment network becomes for merchants, which in turn makes the network more convenient for consumers, and so on. This explains why a small number of networks have come to dominate electronic payments."

A network effect is where the addition of each additional user makes a product or service more useful or powerful for other users and makes it more valuable. Once this reaches a tipping point, it becomes incredibly hard for new entrants to tempt users away to an alternative. Hence the opportunity for durable profits and growth.

This is reflected in Brett’s assessment of how likely it is that Visa’s network will be usurped:

“We don’t believe that building a new network with a comparable size and reach is realistic over any foreseeable timeline. We view Visa’s position in the current global electronic payment infrastructure as essentially unassailable.”

When it comes to the company’s growth opportunity, I think that also looks rather solid. The shift towards electronic payments from cash still has a long way to go – especially in several emerging markets where VISA holds a strong position.

And guess what? More and more payments being made electronically will lead to more and more tollbooth payments to VISA. Nice.

WiseTech Global (WTC)

WiseTech sells software that helps logistics companies digitise their operations.

Its main product is the CargoWise suite of software for freight forwarders, who select and co-ordinate operators of freight assets like ships, airplanes, trains, trucks, and warehouses to move goods worldwide.

The Narrow Moat rating assigned to WiseTech by Roy Van Keulen stems mainly from switching costs.

CargoWise takes a long time for clients to implement. Lots of staff training is also required and, once implemented, the software becomes deeply embedded into mission critical processes that the business completes every day.

Moving away from CargoWise would take a lot of effort while undoing past investments of time and money. It could also risk severe business disruption. These switching costs are reflected by WiseTech’s customer retention rate of near 100% despite continued price increases.

As for the growth outlook, that looks fairly rosy too. For one, the global logistics industry is still in a relatively early innings when it comes to digitalisation. And for WiseTech specifically, Roy Van Keulen sees four major growth levers it can benefit from:

  • Existing freight forwarder clients moving more offices, tasks and shipments to CargoWise
  • Further price increases
  • CargoWise clients taking more market share and using the software more
  • More freight forwarders implementing CargoWise to avoid falling behind their peers

These sources of growth stem purely from WiseTech's initial area of focus on freight forwarders and specific parts of the logistics spectrum rather than the industry at large. You can read more about WiseTech’s growth opportunity in this edition of 'Ask the analyst'.

The price usually won’t be right

As much as I love the moat and growth outlook for Visa and WiseTech, I am not tempted by either share at current price levels. This will usually be the case. Why? Because companies with widely acknowledged moats and attractive long-term outlooks rarely trade cheaply.

The exception can be where some kind of short-term problem arises and investors run for the exists. If the fall in valuation becomes overdone and you think the problem can be overcome, you may be able to scoop up shares at attractive prices.

For reference, Visa currently trades at around USD 307 per share versus our analyst’s Fair Value Estimate of USD 272 per share. Meanwhile, WiseTech trades at around $125 versus a Fair Value estimate of $105.

At the time of writing both had a two-star Morningstar rating out of five.

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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.