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

Simple maths says the AI investment boom ends badly

This AI cycle feels less like a revolution and more like a rerun. Just like fibre in 2000, shale in 2014, and cannabis in 2019, the technology or product is real but the capital cycle will be brutal. Investors beware.

Why we should follow Canada and cut migration

An explosion in low-skilled migration to Australia has depressed wages, killed productivity, and cut rental vacancy rates to near decades-lows. It’s time both sides of politics addressed the issue.

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Australian house price speculators: What were you thinking?

Australian housing’s 50-year boom was driven by falling rates and rising borrowing power — not rent or yield. With those drivers exhausted, future returns must reconcile with economic fundamentals. Are we ready?

Retirement income expectations hit new highs

Younger Australians think they’ll need $100k a year in retirement - nearly double what current retirees spend. Expectations are rising fast, but are they realistic or just another case of lifestyle inflation?

Welcome to Firstlinks Edition 627 with weekend update

This week, I got the news that my mother has dementia. It came shortly after my father received the same diagnosis. This is a meditation on getting old and my regrets in not getting my parents’ affairs in order sooner.

  • 4 September 2025

Latest Updates

Shares

Why the ASX may be more expensive than the US market

On every valuation metric, the US appears significantly more expensive than Australia. However, American companies are also much more profitable than ours, which means the ASX may be more overvalued than most think.

Economy

No one holds the government to account on spending

Government spending is out of control and there's little sign that Labor will curb it. We need enforceable rules on spending and an empowered budget office to ensure governments act responsibly with taxpayers money.

Retirement

Why a traditional retirement may be pushed back 25 years

The idea of stopping work during your sixties is a man-made concept from another age. In a world where many jobs are knowledge based and can be done from anywhere, it may no longer make much sense at all.

Shares

The quiet winners of AI competition

The tech giants are in a money-throwing contest to secure AI supremacy and may fall short of high investor expectations. The companies supplying this arms race could offer a more attractive way to play AI adoption.

Preparing for aged care

Whether for yourself or a family member, it’s never too early to start thinking about aged care. This looks at the best ways to plan ahead, as well as the changes coming to aged care from November 1 this year.

Infrastructure

Renewable energy investment: gloom or boom?

ESG investing has fallen out of favour with many investors, and Trump's anti-green policies haven't helped. Yet, renewables investment is still surging, which could prove a boon for infrastructure companies.

Investing

The enduring wisdom of John Bogle in five quotes

From buying the whole market to controlling emotions, John Bogle’s legendary advice reminds investors that patience, discipline, and low costs are the keys to investment success in any market environment.

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.