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

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

The 2025 Australian Federal election – implications for investors

With an election due by 17 May, we are effectively in campaign mode with the Government announcing numerous spending promises since January and the Coalition often matching them. Here's what the election means for investors.

Finding the best income-yielding assets

With fixed term deposit rates declining and bank hybrids being phased out, what are the best options for investors seeking income? This goes through the choices, and the opportunities and risks involved.

What history reveals about market corrections and crashes

The S&P 500's recent correction raises concerns about a bear market. History shows corrections are driven by high rates, unemployment, or global shocks, and that there's reason for optimism for nervous investors today. 

Howard Marks: the investing game has changed

The famed investor says the rapid switch from globalisation to trade wars is the biggest upheaval in the investing environment since World War Two. And a new world requires a different investment approach.

Welcome to Firstlinks Edition 605 with weekend update

Trump's tariffs and China's retaliatory strike have sent the Nasdaq into a bear market with the S&P 500 not far behind. What are the implications for the economy and markets, and what should investors do now? 

  • 3 April 2025

Latest Updates

Investment strategies

4 ways to take advantage of the market turmoil

Every crisis throws up opportunities. Here are ideas to capitalise on this one, including ‘overbalancing’ your portfolio in stocks, buying heavily discounted LICs, and cherry picking bombed out sectors like oil and gas.

Shares

Why the ASX needs dual-class shares

The ASX is exploring the introduction of dual class share structures for listed companies. Opposition is building to the plan but the ASX should ignore the naysayers and bring Australia into line with its global peers.

The state of women's wealth in Australia

New research shows the average Australian woman has $428,000 in net wealth, 40% less than the average man. This takes a deep dive into what the gender wealth gap looks like across different life stages.

Investing

The two most dangerous words in investing

Market extremes are where the biggest investment risks and opportunities lie. While events like this are usually only obvious in hindsight, learning to watch out for these two words can alert you to them in real time.

Shares

Investing in the backbone of the digital age

Semiconductors are used to make microchips and are essential to a vast range of technology and devices. This looks at what’s driving demand for chips, how the industry is evolving, and favoured stocks to play the theme.

Gold

Why gold’s record highs in 2025 differ from prior peaks

Gold prices hit new recent highs, driven by a stronger euro, tariff concerns, and steady ETF buying – all while the precious metal’s fundamental backdrop remains solid amid a shifting global economic landscape.

Now might be the best time to switch out of bank hybrids

In this interview, Schroders' Helen Mason discusses investing in corporate and financial credit securities, market impacts of tariffs, opportunities for cash investments, and views on tier two and hybrid bonds.

Sponsors

Alliances

© 2025 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.