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

The Little Book That Builds Wealth: The Knock-out Formula for Finding Great Investments (Little Books. Big Profits): Amazon.co.uk: Pat Dorsey: Books

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 it lasted [sic]. Effective Patents of great products are a licence to print money as they provide monopoly conditions. But patent lawyers are not poor, and litigation can be rife… so be careful. Patents also expire, so watch out for single patent companies.
  • Regulatory Approvals - excellent returns can be found in such eclectica as waste disposal sites, credit rating agencies or financial services firms. Look for big barriers to entry due to high regulatory hurdles which can lead to pricing power.

2. Switching Costs

Banks historically have been able to charge nosebleed fees to their customers because people just can't be bothered with the hassle of switching banks. Similarly costs of switching are high for companies or individuals that rely on integrated software - data processing, tax or accounting can be great businesses (e.g. Sage (LON:SGE) , Intuit).

3. Network Effects

This is a form of switching effect that is so powerful it deserves its own category. Think about Ebay and the fact that no other auction site can compete, or Facebook in the social graph. But its not just internet companies. Credit Card companies like Visa or Amex with millions of pay points benefit from massive network effects as does Microsoft with a virtual monopoly in office software due to the fact that everyone needs to open .doc and .xls files. But watch out - network effects can break down - witness falling margins in stock exchanges as new competition enters.

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4. Cost Advantages

When considering investing in an industry always consider whether there are easily available substitutes as a company's cost advantage can be small or temporary - witness the poor economics in Airlines, Autos or microchips. But cost advantages can be sustained for a long time in certain situations - Dorsey discusses four sources - cheap process, better location, unique assets and scale benefits…

  •  Cheaper Processes  - While some companies (think Dell or Southwest Airlines) have been able to carve out unseemly profits due to a better process, Dorsey cautions that they are not as enduring as other moats. A company like ASOS (LON:ASC) may be winning with web savvy marketing at present, but it may not last!
  • Location, Location, Location - Think quarries, waste haulage and local steel mills. Heavy, cheap products are best in local networks as competitors can't ship in products to compete economically - gravel can be a better business than liquid natural gas due to the low value to weight ratio.
  • Unique Assets - If you can own commodity assets with lower extraction costs than any other competitor then obviously you'll have a great moat.

5. Greater Scale

Dorsey describes scale as the king of cost advantages and breaks it further down into distribution, manufacturing and niche markets.

  • Distribution Networks - Industries with higher fixed costs relative to variable costs tend to be more consolidated - think Fedex vs Estate Agents. Any guy with a phone can be an estate agent but you can't easily compete with a national parcel distribution network! Half full vans cover fixed costs so additional parcels go straight to bottom line, difficult to compete with.
  • Manufacturing Scale - Massive upstream oil refining scale at Exxon Mobil is an example. But its also evident in massive sales distribution networks - for example in marketing video games. Electronic Arts can spread the cost of developing a game over a massive sales network. British Sky Broadcasting (LON:BSY) in the UK can dominate its rivals with massive subscriber network and the satellite dish switching cost.
  • Niche Markets - Small niche markets, like local cable networks, or school software can also be incredibly profitable niches.

How can you screen for economic moats?

We've been thinking hard about how to screen for economics moats as part of Stockopedia Premium. The most obvious financial sign of an economic moat is the ability to generate a higher rate of free cash flow. This is the cash generated by the business after all capital expenditures (factory improvements etc) have been paid off. Effectively, this is cash in the pocket of the firm which can either be reinvested or paid out in dividends. Valuation 101 shows that a company is only worth the present value of its future cashflow so the higher the rate of cashflow generation, the higher the value of the company. If free cashflow to sales is 5% or greater you may have found a company that can print money.

Warren Buffett also looks to companies that can generate high sustainable returns on capital and returns on equity compared with their peer group. Returns of 12% and higher on a long term basis may indicate a company with pricing power or cost advantages. The Dupont Formula shows that higher ROE can be due either high profit margins, high asset turnover or from high leverage - make sure a high ROE isn't just coming from high leverage!

Caution 1: False Moats

There are a few busines attributes that you should be aware of that are potentially false moats… beware of companies that promote their great management, great execution, great products and big market share. These attributes do not bring a sustainable advantage on their own. The history of business is littered with the wrecks of companies with false moats - RBS (Fred the Shred), Palm Pilots (Product), Kodak/Blackberry (Market Share) to name a few.

Caution 2: Steer clear of industries with bad economics

Investing is a game of odds, and investors should take another leaf out of Buffett's book by playing the game of the 'Snowball'. If you invest in an industry with good economics you are far more likely to end up a winner as the odds are more stacked in your favour.

Dorsey highlights that far wider economic moats are found in industries like Media, Healthcare, Business Services, Asset Management, Consumer Goods and Software than in industries with occasionally brutally awful economics like Hardware, Industrial Materials and Retail (switching costs too low!).

Bet rarely, bet heavily...

The stock market allows you to play any strategy you like from trying to pick growth stars to going after turnaround 'cigar butt' stocks. But many of these strategies only shine temporarily and year to year market stars have a tendency to burn out. Transaction costs will kill your returns. Buffett has shown that choosing only to invest in easily understood companies with durable moats at favourable prices is the best route to investment success, as the miracle of compounding does the rest of the hard work for you.

The trouble is these companies can be very rare and hard to find. Which companies do you know in the UK market that have the above attributes? And at what price are they bargains? Let me know in the comments below.

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Tesco PLC, incorporated on November 27, 1947, is engaged in retailing and associated activities in the United Kingdom, China, the Czech Republic, Hungary, the Republic of Ireland, India, Malaysia, Poland, Slovakia, South Korea, Thailand and Turkey. The Company also provides retail banking and insurance services through its subsidiary, Tesco Bank. The Company’s operations in the United Kingdom is the within the Company, with over 3,000 stores. The Company’s in-store picking model is complemented by a small number of specialized dotcom-only stores, which allow the Company to respond to customer demand. The Company’s Click & Collect service is a part of its multichannel offering and enables customers to pick up their shopping when and where it suits them. It has over 1,500 Click & Collect collection points for general merchandise and over 150 Grocery Drive-thrus in the United Kingdom. more »

Share Price (Full)
188.15p
Change
-5.3  -2.7%
P/E (fwd)
12.2
Yield (fwd)
2.5
Mkt Cap (£m)
15,710

ASOS Plc is a holding company. The principal activity of its subsidiary is Internet retailing. The Company’s geographical business segments include United Kingdom, United States, European Union and Rest of World. The Company offers a wide variety of fashion-related content. The Company sells over 65,000 branded and own-brand products through localized mobile and Web experiences. The Company’s products include its own brand plus around 800 brands ranging from big names to up-and-coming designers. Each week up to 2,500 new styles go live, whilst ASOS Marketplace offers a further 145,000 products. more »

Share Price (AIM)
2546p
Change
52.0  2.1%
P/E (fwd)
53.6
Yield (fwd)
n/a
Mkt Cap (£m)
2,081

The Sage Group plc provides small and medium sized company with a range of business management software and services-from accounting and payroll, to enterprise resource planning, customer relationship management and payments. The Company also offers adjacent products and services involving technology, which is integrated, such as payments and customer relationship management (CRM). The Company provides business management software and services for small and medium sized businesses. The Company offers guidance, advice and support to its customers through its global network of local experts. The Company’s subsidiaries include Sage (UK) Ltd, Sage Pay Europe Limited, Sage Hibernia Limited, Sage Pay Ireland Limited, Ciel SAS, Sage FDC SAS, Sage Holding France SAS, Sage Software GmbH and Sage SAS. In September 2014, The Sage Group PLC completes acquisition of Exact Software Deutschland GmbH. more »

Share Price (Full)
406.9p
Change
5.6  1.4%
P/E (fwd)
16.3
Yield (fwd)
3.2
Mkt Cap (£m)
4,320



  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.  

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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. 

 

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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.

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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.

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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 !!

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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.

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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.

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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

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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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