The 5 Key Signs of an Economic Moat

Tuesday, Jan 24 2012 by
15
The 5 Key Signs of an Economic Moat

In spite of a dozen years of sideways markets that have just about ground the philosophy of buy and hold into the dust, Warren Buffett's purchase decisions are still able to turn a thousand heads. Investors know that what really interests Buffett are companies with 'durable competitive advantages' which promise enduring high returns on capital and free cashflow in his pocket.

By upping his stake in Tesco (LON:TSCO) last week Buffett was signalling his confidence in the longevity of its advantage especially as the argument for Tesco's investment case on valuation grounds alone is perhaps only moderate.

So how can we as investors learn to spot companies with durable competitive advantages?

What is a durable competitive advantage?

Buffett likened businesses to castles at risk of siege from competitors and the marketplace. Great companies are able to dig deep economic moats around their castles that become increasingly impregnable to competition and market pressures. These moats bring either pricing power or cost reductions which help sustain very high returns on capital, leading to higher cashflows and returns for investors. Clearly everyone would like to own a business with a wide economic moat but Buffett has been most systematic in tracking them down.

How to think about Economic Moats

One of the best books on the subject is very small and easily digestable - "The Little Book that Builds Wealth" by Pat Dorsey of Morningstar - and comes extremely highly recommended. Morningstar have developed the concept of an economic moat into a structured framework. Essentially 'wide' moat businesses have one of 2 attributes - high pricing power or low cost advantages - which in turn lead to sustainably high margins and returns on capital investe. These advantages can be split into the following categories…

1. Intangible Assets

Intangibles are basically things you can't see - i.e. Brands, Patents and Regulatory approvals rather than tangible assets like factories or distribution systems. Intangible assets can be unique to companies and deliver fantastic pricing power.

  • Brands - While Brands are a dime a dozen these days, not all give the owner the ability to price at a premium. While Coca Cola may be able to charge a fortune for sugared water, French Connection can't charge a premium for its bargain bucket fashions. Be careful and pick only premium brands.
  • Patents - think Viagra while…

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Tesco PLC is a retail company. The Company is engaged in the business of retailing and retail banking. The Company operates in four segments: UK, Asia, Europe and Tesco Bank. It has retailing and associated activities (retail) operations across the United Kingdom, Asia and Europe. It is engaged in the retail banking and insurance services through Tesco Bank in the United Kingdom (Bank). The Bank offers a range of personal banking products, which include mortgages, credit cards, personal loans and savings. The Company operates approximately 7,817 shops around the world. Its subsidiaries include Tesco Stores Limited, One Stop Stores Limited, Tesco Ireland Limited, Tesco-Global Stores Privately Held Co. Limited, Tesco Polska Sp. z o.o., Tesco Stores CR a.s., Tesco Stores SR a.s., Homeplus Co. Limited and Homeplus Tesco Co. Limited, among others. more »

Share Price (Full)
181.3p
Change
4.3%
Mkt Cap (£m)
14,149
P/E (fwd)
20.5
Yield (fwd)
n/a

ASOS Plc is a United Kingdom-based global online fashion destination .The Company sell cutting-edge fast fashion and offers a variety offashion-related content, making ASOS.com the hub of a thriving fashion community. It sell 75,000 branded and own-brand products through localized mobile and web experiences, delivering from United Kingdom(UK) hub to almost every country in the world. It tailors the mix of own-label, global and local brands sold through each of nine local language websites: UK, United States, France, Germany, Spain, Italy, Australia, Russia and China. It sell Womenswear products in sizes 2 to 28 and Menswear in sizes XXXS to XXXL, and have introduced an increased range of men’s waist, leg-length and shoe sizes. more »

Share Price (AIM)
2671p
Change
2.4%
Mkt Cap (£m)
2,177
P/E (fwd)
41.6
Yield (fwd)
n/a

The Sage Group plc is a United Kingdom-based company, which provides small and medium sized enterprises (SMEs) with a range of business management software and services, including accounting, human resource (HR) and payroll, enterprise resource planning (ERP), payments, customer relationship management (CRM), mobility and business intelligence. The Company operates through three segments: Europe, which includes operations in France, the United Kingdom and Ireland, Spain, Germany, Switzerland, Poland, Portugal and Sagepay; Americas, which includes the United States, Brazil and Canada, and AAMEA, which include Africa, Australia, Middle East and Asia. The Africa operations are based in South Africa and the Middle East, and its Asia operations are based in Singapore, Malaysia and the United Arab Emirates. Its products include Sage One, Sage 100, Sage 50, Sage ERP X3, Sage Payment Solutions, Sage Office Line, Sage Murano, Sage Pastel, Sage VIP Payroll, Sage Handisoft and Sage 200. more »

Share Price (Full)
577p
Change
-0.4%
Mkt Cap (£m)
6,254
P/E (fwd)
21.4
Yield (fwd)
2.4



  Is Tesco fundamentally strong or weak? Find out More »


24 Comments on this Article show/hide all

monal1 24th May '12 5 of 24

In reply to UK Value Investor, post #4

Tesco are great at grabbing market share from non food retailers.If they are aggresive enough we may see the likes of Argos wiped off from the high street.Thier moat is thier presence in every format everywhere and ready to strike.

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gfourmoney 4th Feb '13 6 of 24

I think a large part of Tesco's moat is "Clubcard". It is a massive database of customers all providing market research to Tesco at very low cost to the company. The opportunities for cross selling are enormous. With Tesco having moved heavily into non food and finance the database is a pre existing customer set waiting to buy. Tesco own Clubcard so all of the opportunities are there's alone. Other supermarkets have gone the way of outsourcing rewards. I think that may prove to be a mistake.

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toddwenning 10th Feb '13 7 of 24
4

Hi Ed,

In Dorsey's book, The Five Rules for Successful Stock Investing, he provides the following metrics for moat evaluation

FCF/Sales > 5%
Net margin >15%
ROE > 15%
ROA > 6-7%

These figures also need to be evaluated over time, however, as one year of strong results is not necessarily indicative of an economic moat. In addition, some qualitative assessment is necessary before confirming a moat, but Dorsey's metrics are a good starting point for a screen.

As for Tesco's moat, despite some slip ups in execution and a misguided adventure in the US with Fresh & Easy, it still has a fair amount of bargaining power with suppliers and is thus able to offer low prices and generate a decent profit. As a shareholder myself, I'm disappointed that the company expanded so aggressively concurrent with the rise in online shopping and entered into a pricing war with domestic competition, but retail is a tough business. Longer-term, I think the company will retain some advantages, but perhaps not as much as in the past. Further, as gfourmoney mentioned, the Clubcard database is a valuable intangible asset.

Best,

Todd

Blog: Clear Eyes Investing
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Edward Croft 1st Nov '13 8 of 24
2

I just had an interesting question from Ramridge about how to screen for high Economic Moat companies with Stockopedia. Of course, given that so much of economic moat analysis is qualitative judgement, this can be hard to do. On the other hand, there are certain factors which can indicate companies with a great engine as indicated in the above article.

What I've done is search for the following criteria in the database:

i.e. to find companies with strong cashflow,  better than average perpetual operating margins,  high long term and current profitability. These are the kinds of stats that can help people find companies with a good economic moat or engine.  There are 91 companies in the scan - see here - http://www.stockopedia.com/screens/economic-moats-13873/

It's no surprise to find so many of the market's favourite stocks in here -  glamour names like Rightmove, household names like Burberry, Astrazeneca, Next and Hargreaves Lansdowne.  There is a reason why these big companies have become FTSE 100 or 250 names - they are exceptional businesses.  There are also extraordinary niche businesses like Games Workshop in the mix - companies like these are just so hard to compete with which leads to great business economics.

I've sorted the list by our own 'Quality Rank' - which does factor in many of the above variables, but also weights heavily the F-Score amongst other predictive ratios.   Have a good dig through there,   this is the kind of scan/screen I've always used in the past to find names like Abcam, ASOS and other big market winners -  I wouldn't be surprised if there are some serious future market stars in there.  

Blog: Follow @edcroft on Twitter
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jraitt 1st Nov '13 9 of 24

Ed,
What do you suggest would be best criteria for building AIM portfolio for IHT purposes bearing in mind one has to hold for 2 years before exempt. AIM only not co-listed and trading companies only.
Most of my efforts seem to give very few AIM results. I feel I can't be alone in doing this.
John

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Ramridge 1st Nov '13 10 of 24

Hi Ed
Excellent. Much appreciated. Now let me get my spade and go digging for gold, or more to the point the next ASOS :)

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Edward Croft 1st Nov '13 11 of 24

In reply to jraitt, post #9

John, in answer to your question to the above screen I've added the following filter:



Hearteningly there are 32 companies in the resulting list that I've called 'Economic Moats on AIM' .  If you don't like looking at data tables you can of course view the list in the 'snapshot' view - - which makes for easier reading. 

As you might expect a lot of them are priced at a premium to the market - better quality companies get bid up.   But none of them are in the top quintile in terms of our Value Rank.  There's a lot of hot money on AIM and presumably a lot has gone into the more speculative areas and this list isn't really a list of stocks that the bulletin board maniacs go chomping after on the busy boards.

As you say for IHT purposes one has to hold for 2 years.  I'd certainly be looking to build a portfolio of stocks that I thought wouldn't need refinanced in the next 2 years - most speculative stocks do need refinanced regularly as they oftne don't have a good economic engine in place - so a screening approach like this could be a good place to start.   One just has to be careful on price - as ever !

There has historically been a good payoff over the long term to just buying cheap, good quality stocks and diversifying the portfolio - Joel Greenblatt's "Little Book that Beats the Market" is based on this entire thesis which is a recommended read.   Given that a 2 year timeframe is not a good timeframe for Momentum stocks - I'd be avoiding using any momentum indicators.  Momentum tends to work over a 6 month to 1 year timeframe. 

 

Blog: Follow @edcroft on Twitter
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Edward Croft 1st Nov '13 12 of 24
1

In reply to Ramridge, post #10

Ram, the one thing you have to be careful about when investing in stocks with v. high ROCE etc is that often the profitability 'mean reverts'. I was having supper with a friend of mine who has worked at SAC Capital for many years - he was telling me that his team tries to find companies with high ROCE that do NOT have a sustainable moat. He then shorts them.

I would imagine that a stock like Cupid (which is on that list) would have been the kind of target he'd look at last year. The thing about high ROCE companies is that they tend to attract the brokers and investors. But they also attract competitors (like flies to sh*t) who then eat away at margins and profitability.  It's the qualitative assessment that can really help you figure out if a company has a sustainable niche - and that's the kind of art that turns a good investor into a great investor.  Hopefully the above article helps in that regard.  Dorsey's book is highly, highly recommended btw.

Blog: Follow @edcroft on Twitter
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Ramridge 1st Nov '13 13 of 24

Hi Ed - Interesting twist in finding high ROCE stocks with the intention to short them. I am taking in your comments avidly.
I have now purchased the ipad version of Dorsey's book - that will be my bedtime reading today.

Now for an interesting request. How difficult would it be to perform a regression analysis? say running the above screen against a snapshot of your database as it was a year ago? The interesting thing would be to see the stocks that do well (confirmation of the premise) and equally those that do not. The latter might give us further thoughts on how to tweak your criteria.
Regards, Ram

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Edward Croft 1st Nov '13 14 of 24
1

In reply to Ramridge, post #13

We are working on it ! Backtesting is tricky as you need a 'point in time' database - it's very expensive to get historic data. We are trying to build up our own but obviously we don't have much history. I think in a couple of years we'll have built our own backtester and will have the revenues to buy the point in time data we need... in the meantime we have to work with what we've got.

Blog: Follow @edcroft on Twitter
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Ramridge 1st Nov '13 15 of 24

In reply to Edward Croft, post #14

Hi Ed - Presumably you need not just the historical prices data (which is not difficult or pricey to get) but the full accounts of every company going back say 2 years, including dividends and earnings history, splits, and so on. And then extracting and storing the necessary financial data. That's the tricky part. Oh well, I will just have to wait.
Regards, Ram

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Ramridge 2nd Nov '13 16 of 24
1

Hi Ed
"Dorsey's book is highly, highly recommended btw."
Couldn't agree more. It's a cracker for all serious investors.
Thanks, Ram

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Edward Croft 2nd Nov '13 17 of 24
1

In reply to Ramridge, post #16

Ram - I've found the 'Little Books' series to be a real goldmine. Many of the excellent authors have written longer investment books which they've had to condense into 150-200 pages max for the little books series. Some of the best include.... The Little Book of ... Valuation, Behavioural Investing, Beats the Market, Builds Wealth (economic moats), Stock Market Profits (about anomalies), Common Sense Investing (Bogle/index funds). http://lp.wileypub.com/LittleBook/

For anyone looking to give a nice Christmas present to an investor, that bunch would be very well received. There's something everybody appreciates about concise writing on dry topics... few people really like to read an investment book for a week... a couple of hours is plenty !

PS - I have no affiliation with Wiley publishing !!

Blog: Follow @edcroft on Twitter
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Ramridge 3rd Nov '13 18 of 24

Hi Ed - I have been looking a bit deeper into your screen criteria and I note that your are using ROCE. Both Dorsey's Little Book and other references that I have googled mention using ROIC. Now there are important differences between these two measures. In the numerator of the equations, ROIC takes Op Income net of taxes, ROCE ignores taxes (basically just EBIT). In the denominator, ROIC substracts surplus cash, ROCE doesn't.
When you think about it, ROIC has to be the better measure as surplus cash is not doing anything (think about Microsoft or Apple). I ran a simple screen just to see the differences between these two values for a range of shares and they can be substantial. As an example for Centrica, ROCE = 15.7% , and ROIC = 7.69%.
Regards, Ram

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Edward Croft 3rd Nov '13 19 of 24
1

In reply to Ramridge, post #18

Ram,

You do raise a v. good point. There are lots of definitions of ROCE and ROIC and often the terms are used interchangeably. We've released 3 different versions to the screener which are outlined in more detail at this link.  I've copied the important text below:

  • ROCE - 'Return on Capital Employed' - a plain vanilla version as reported on the StockReports, In the case ofROCE, the numerator is operating income and the denominator is 'capital employed' instead of total assets as in ROA. Capital Employed has many definitions unfortunately, but, in general it is the capital investment necessary for a business to function, often defined as fixed assets plus working capital, or total assets less current liabilities (which is what we use). See: http://en.wikipedia.org/wiki/Return_on_capital_employed.
  • ROCE Greenblatt.   This uses a specific definition of Return on Capital Employed based on Joel Greenblatt’s Magic Formula book (which is a quick and very good read that discusses return on capital in depth).  As denominator it uses the sum of 'Net Working Capital' and 'Net Fixed Assets'.   Net Working Capital excludes excess cash and 'non interest bearing payables', while Net Fixed Assets excludes goodwill and intangibles. These adjustments are quite specific and designed to come to a closer approximation of the genuine capital employed in the operating enterprise of the company .They are discussed in more detail in this article.
  • ROIC – 'Return on Invested Capital' - a popular term more often used in the USA.  In the case of ROIC, the calculation used is 'Net Operating income after tax' / Invested Capital where Invested Capital = Total Equity + Total Liabilities – Current Liabilities – Excess Cash.   (We use the Greenblatt definition of Excess Cash as cash at hand in excess of 5% of revenues).

 

Personally I prefer the Greenblatt version myself as it has a very well thought out handling of excess cash, intangibles and non interes bearing debt, but everyone seems to have their own preferred version.   We do actually have 5 year average ROCE using the Greenblatt version too which we probably could release to the screener.

It's worth noting that Greenblatt's ROCE does strip out excess cash, much like the ROIC definition you refer to.   One difference appears to be the tax handling as you mention - the former uses EBIT whereas the latter NOPAT.   i.e. operating income before and after taxes.   Greenblatt preferred the former as he was using Enterprise Value multiples for the 'value' rule that incorporated the capital structure into the valuation - thus requiring the use of EBIT... or earnings due to the whole firm, not just shareholders.  

One can get caught up in detail on this.  I agree though that there's a better ROCE number than the bog standard definition I used in the screen above.   I think the easiest thing to do is to release the Greenblatt 5y avg ROCE number and re-run the screen.   If you'd like a more precise version of ROIC w.r.t. the Morningstar/Dorsey definition then we could probably make an adjustment - ultimately it's all about getting the best results possible.

Blog: Follow @edcroft on Twitter
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toddwenning 3rd Nov '13 20 of 24

In reply to Edward Croft, post #8

Hi Ed,

I think those are as good criteria as any to screen for companies with competitive advantages. Firms that pass the screen have clearly been doing something right in their businesses. The big forward-looking question, of course, is, "Is the advantage durable?"

Another way to put it is, are we confident that the company can out-earn its cost of capital over the next 10-20 years?

To begin to answer this question, I think it's important to consider each company in the screen results separately and determine which of the five sources of economic moats outlined in Dorsey's book best explains the company's advantage. Next, determine whether or not that advantage is increasing or diminishing.

If you're right on answering these two questions -- whether or not the company has a moat and whether or not the moat is widening -- that's more than half the battle of successful long-term investing.

Another moat resource to look at is the piece put out by Credit Suisse in July (here).

Best,

Todd

Blog: Clear Eyes Investing
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Ramridge 3rd Nov '13 21 of 24

In reply to Edward Croft, post #19

Hi Ed - Many thanks for a detailed reply. I agree with you that the ROCE Greenblatt appears to be a better tool for our purposes. The tax treatment in the numerator would probably make a constant difference across all results, so that can be factored in when comparing results. Some formulae I have seen use a standard 35%. Releasing the Greenblatt 5y average ROCE would be a very useful addition- thanks. I wouldn't have raised this query had I not noticed such a wide disparity between the ROCE and ROIC.
At the end of the day, we are after a screened set of results as a starter for further "grey cells" analysis. Whether there is existence of a wide,narrow or no moat comes down to a personal judgement based on hard and soft information at hand.
Regards, Ram

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Edward Croft 3rd Nov '13 22 of 24

In reply to Ramridge, post #21

Ram - we've added the 5 year average Greenblatt ROCE to screenable ratios. It may not show up until tomorrow though as the indexer may not run till then.

Blog: Follow @edcroft on Twitter
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Ramridge 3rd Nov '13 23 of 24

In reply to Edward Croft, post #22

Excellent. Much appreciated.

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Edward Croft 4th Nov '13 24 of 24

Ram - I've updated both of those screens to use the 'Greenblatt' versions of the ROCE and ROCE 5y Average:

 

I ought to add them to the article above - if anyone has any thoughts on how to improve the criteria, let me know and we'll adjust.  The group mind is often best when it comes to optimising these things !

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About Edward Croft

Edward Croft

CEO at Stockopedia where I weave code, prose and investing strategies to help investors beat the stock markets. I've a background in the City and asset management but now am more interested in building great stock selection tools for the use of investors online.   Traditionally investors online have had very poor access to the best statistics, analytics and strategies for the stock market and our aim is to set that straight.  High Quality fundamental information has been prohibitively expensive in the past and often annoyingly dull. People these days don't just want to know the PE Ratio and look at a balance sheet. They expect a layer of interpretation over data, signal from noise and the ability to know at a glance whether a stock is worth investigating or not. All this is possible using great design and the insights gleaned from quantitative research.  Stockopedia is where we try to make it happen ! more »

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