Build a financial moat by investing in rivals

By Sean Somverille

The Daily Record Newswire

In an environment where stocks and bonds breed feelings of uncertainty, where can an investor turn for steady income and favorable odds of appreciation?

Dividend stocks have historically been a refuge from volatility because of their ability to outperform the overall market. But if the market is down 20 percent and a stock is down 15 percent, that's still tough to swallow. A loss is a loss.

One idea is to buy dividend-paying stocks of companies that compete directly against each other.

The choice of specific investments is best left to individuals and their financial advisors. But it's apparent to anyone watching even a little television that many industries are duopolies, dominated by two players. Examples include home repair stores, discount retailers, soft drinks, overnight delivery, chocolate and telecommunications. It's not hard to identify stocks and see how they have performed over time.

Investing in two dominant players within an industry might be a called a collective moat strategy.

Of course, the concept of an investment moat is nothing new. Warren Buffett invoked the image to describe a company with such strength that attacks by competitors would be easily thwarted: The stronger the company, the wider the moat, the safer the investment.

The idea of a collective moat is that an investor doesn't have to bet on only one player to potentially capitalize on the strength of a single company within an industry. Instead the investor can buy two, three or even four powerful competitors and may still prosper.

Quality vs. Value

Let's say there are two shoe manufacturers and they control 70 percent of the shoe market: Quality Shoes and Value Shoes. One makes inexpensive shoes and the other makes top-quality shoes. Chances are pretty good that when someone buys shoes, one of these two companies will make a sale.

Both companies arguably have moats: Quality Shoes makes great but expensive shoes, Value Shoes makes less expensive but serviceable shoes. Because you now own the main competitive threat to both companies, the collective moat that helps protect these two investments is wider.

By buying stock in Quality Shoes, you've lessened the threat to your portfolio if Value Shoes stumbles. Over the long term, if Quality Shoes loses sales, it's probably not a bad bet that Value Shoes will have added sales, and with it may also come profitability and some stock appreciation. Same is true in reverse.

Now throw dividends into the mix. With stock prices down, a lot of companies are sporting attractive dividend yields - including many that go toe-to-toe against each other every day. When you buy both, you could have not only the historical income that dividends provide, but also a collective moat investment less likely to collapse.

What has an investor given up by owning both? The benefit of picking the winner in a given industry space in a given time frame. Value Shoes stock might double, but Quality Shoes stock might decrease, meaning your overall gain is diluted. But that same dynamic could give an investor some protection against a decline.

And because these duopolies can make it very hard on a third competitor, this investor is getting a shot at upside. Back to our hypothetical shoe companies, they might gain some of that 30 percent of market share controlled by other companies should other competitors fail.

For the risk averse, one way to take the leap is to think of these stocks as you might bonds and pick a window in time when you are likely to sell them after collecting the dividends.

To get a solid return, you don't need each of the stocks to be higher; you just need the total of all of them to be higher. For instance, historical data indicates that two competing companies in one industry on average would provide an investor a blended dividend yield of about 3 percent.

So even if the companies don't raise their dividends, a $100,000 investment evenly split between the two companies could give you about $15,000 in dividend income over five years. In five years, even if these stocks have not increased in price, the investor's total return is positive.

Potential threats

The risk, of course, is that the stocks decline in price, cut their dividends, or both. A collective moat could be a way to mitigate that risk. But employing this strategy is not as easy as it looks. Potential threats could include:

* Substitutability: It might have been tempting to think of two major bookstore chains as a collective moat because they were dominant in brick and mortar book stores. Now one of them is gone, thanks to competing technologies.

* Deferability: No matter how strong a company or set of companies is, if the need for their products is weak, it might be hard to craft a collective moat. Think of high-end steakhouses.

* Inferiority of one competitor: Five years ago, there were two specialty stores where a shopper could find sheets, pillows, towels, blankets and kitchen stuff. To the casual shopper, they looked identical. But now one of them is gone and the other is posting record results.

* Pricing recklessness: If pricing is not rational, especially in a capital intensive business, it can feel a lot like an investing treadmill. One word sums up this dynamic: airlines.

* Expensive stocks: If the price-earnings multiples are high and the dividend yields are low, buying even successful companies can carry a risk of decline.

So what does make for a good collective moat? Talk to your financial advisor or dive into your favorite stock magazine or website. It might make sense to start with companies whose products are likely to be necessary in any environment, regardless of what Greece, the Fed or Congress does: Think food, clothing, shelter, toiletries and medical supplies.

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Sean Somerville is a financial advisor with RBC Wealth Management in Hunt Valley. He can be reached at 410-891-5031 or sean.somerville@rbc.com. RBC Wealth Management is a subsidiary of RBC Capital Markets LLC, member NYSE/FINRA/SIPC.

Published: Tue, Nov 29, 2011

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