Blogs | January 3, 2018

Castles in the air – defensive “moats” and capital asset pricing

Studies cast new light on defensive share tactics, investing risk and market rivalry.


Conventional economic theory has for years been flat-out wrong about share prices. New research out in 2017 helps explain why.

Conventional theory says shares are properly priced so there are no bargains. It says the only reason one share might outperform another is as compensation for its extra risk, where that risk is defined as the extent a share moves when the market moves. This is the capital asset pricing model (CAPM). It’s wrong in two ways.

Firstly, defensive shares – those that are relatively insensitive to moves in the market – tend to do better than others. That’s the exact opposite of what the CAPM says. The other way the theory is wrong is that there is momentum in shares: ones that have risen tend to continue rising, while falling shares, on average, continue to fall.

The best form of attack?
The error was exposed in a 2017 paper by Eben Otuteye and Mohammad Siddiquee at the University of New Brunswick. They argue that the CAPM is wrong simply because investors cannot make perfect decisions and so cannot price shares correctly.

Good returns, they say, are not a reward for risk, but rather a reward for the skill and diligence required to find undervalued companies. In other words, we should forget textbook theory and rediscover the work of Benjamin Graham, the father of value investing. Some shares, Graham said, have a margin of safety: they are underpriced. Buying these gives you both decent returns and lowest risk. And defensive stocks do just this.

But why are these undervalued? It’s because they have what Warren Buffett, Graham’s most successful follower, calls economic moats. These are sources of monopoly power such as big brands – like the traditional water-filled moat around a castle, they allow them to fend off competition and maintain profits.

Investors have underestimated the importance of such moats; companies that possess them have been underpriced and offered good returns to the investor smart enough to appreciate them. Most companies in the past have not had these moats. Hendrik Bessembinder at Arizona State University has established this.

Value over the long term
Bessembinder studied the performance of all 25,782 shares listed on the US stock market at any point between 1926 and 2015. He found that only 42% of these had a return over their lifetime better than cash. “Most stocks do not out-perform Treasury bills over their lives,” he concludes.

This of course is yet more evidence against the CAPM, which says shares should outperform cash because they are riskier. In fact, he estimates that all the wealth created by the stock market since 1926 is due to less than four percent of all the shares that have existed since then. Historically, only a tiny minority of companies have been able to fight off competition and grow large. But this might be changing.

Undervalued shares can have what Warren Buffett, Graham's most successful follower, calls economic moats.

Jan Eeckhout and Jan De Loecker estimate that US companies’ monopoly power has risen since 1980; their moats have got stronger. This helps explain two big facts.

One is that productivity growth has slowed since then. A lot of such growth tends to come from efficient companies entering markets and inefficient ones leaving. If, however, monopolies are more entrenched, we’ll get less entering and exiting the market and hence less productivity growth – which is just what we’ve had.

Unrivalled in a market?
Fact two is that US shares have seemed overpriced for years and yet have continued rising; the cyclically-adjusted price-earnings ratio is now almost twice its long-term average. Greater monopoly power, however, should mean profits won’t be lost to competitors so much, which should justify high valuations.

If investors have underrated the importance of moats, they have overrated prospective growth; the counterpart to defensives being underpriced is that growth stocks have been overpriced.

Work by Charlie Cai at the University of Liverpool helps explain why. He and his colleagues show that investors have paid too much for growth stocks because they’ve neglected the tendency for growth to reduce future profits. As they expand, firms must cut prices to win more customers or fend off rivals, and managing the firm also becomes harder, and costs rise.

This has contributed to that other failure of the CAPM, the success of momentum investing. As a firm grows, it attracts the attention of investors heedless of dangers to profits, and so its price rises further.

Consider dangers and risk
Maastricht University’s Pieran Jiao adds another reason for this. Rising prices, he shows, lead to expectations of further rises; he calls this “payoff-based belief distortion”. A paper by Columbia University’s Michael Woodford and colleagues gives us another reason for the underpricing of defensive stocks. It lies in our attitude to risk. This, they say, depends on how we interpret expected gains or losses.

Now, the upside on a defensive stock is small: Unilever or Diageo are not going to double in price soon.

For small speculative stocks, it’s different. Investors might well think: “A €100 profit won’t make much difference to me, but €1000 would.” They therefore prefer the smaller speculative stock, even though this level of return is much less likely to actually occur. Investors buy speculative stocks rather than defensive ones for the same reason that gamblers prefer long shots to favourites – and with the same costly results.

Economics is often criticised for failing to explain the real world. Such criticisms are often valid for basic textbook economics. What they miss, though, is that economists are working hard to fix this, and this year they’re making progress.

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Chris Dillow
Chris Dillow

Investors Chronicle writer and economist

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