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.

  •   4 October 2018
  • 1
  •      
  •   

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

Ray Dalio on 2025’s real story, Trump, and what’s next

The renowned investor says 2025’s real story wasn’t AI or US stocks but the shift away from American assets and a collapse in the value of money. And he outlines how to best position portfolios for what’s ahead.

Making sense of record high markets as the world catches fire

The post-World War Two economic system is unravelling, leading to huge shifts in currency, bond and commodity markets, yet stocks seem oblivious to the chaos. This looks to history as a guide for what’s next.

3 ways to fix Australia’s affordability crisis

Our cost-of-living pressures go beyond the RBA: surging house prices, excessive migration, and expanding government programs, including the NDIS, are fuelling inflation, demanding bold, structural solutions.

Is there a better way to reform the CGT discount?

The capital gains tax discount is under review, but debate should go beyond its size. Its original purpose, design flaws and distortions suggest Australia could adopt a better, more targeted approach.

How cutting the CGT discount could help rebalance housing market

A more rational taxation system that supports home ownership but discourages asset speculation could provide greater financial support to first home buyers.

Welcome to Firstlinks Edition 648 with weekend update

This is my last edition as Editor of Firstlinks. I’m moving onto a new role though the newsletter will remain in good hands until my permanent replacement is found.

  • 5 February 2026

Latest Updates

Property

The 5% deposit scheme is bad for homeowners and Australia

An ‘affordability’ scheme making the county more vulnerable to economic shocks and contributing to the deteriorating financial situation of everyday Australians.

Investment strategies

Is defensive the new offensive?

Relatively boring, unglamorous, defensive stocks like Kroger and Allstate have quietly outperformed gilded tech giants, offering steady growth, visibility, and resilient returns in a market captivated by AI and flashier industries.

Shares

How the RBA scores on its inflation goal

The Reserve Bank continues to face criticism from all sides. A reminder of the RBA's mandate and a review of their track record in maintaining price stability since the early 1990s.

Investment strategies

Levered credit: A late cycle ingredient for drawdown pain

As credit spreads normalised through 2025, yield‑hungry investors have turned to leverage for high returns, uncomfortably echoing pre‑GFC behaviours. Investors need to be careful to understand the true risk‑return trade‑off.

Planning

The more things change… longevity just goes on increasing

Australia needs a major shift in longevity awareness, attitudes and behaviour if, as a community, we are to reap the benefits of increasing longevity. Adopting a national strategy is well overdue.

Property

The improving outlook of Australian commercial real estate

The sector is positioned to benefit from defensive and resilient income streams supported by embedded rental increase opportunities. 

Property

Seize hidden opportunities among 50+ home buyer schemes in Australia

There is a laundry list of government schemes to help Australian's struggling with housing affordability. Savvy buyers should take advantage to break into the property market.

Sponsors

Alliances

© 2026 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.