Four Tips For Finding And Tracking Economic Moats

4th Dec '19 by Jack Brumby

9 comments 3663 reads

Is value investing set to come back into fashion? That seems to be one of the findings in the November 2019 Bank of America Merrill Lynch Global Fund Manager Survey.

More than half of respondents to the survey (52%) said that equities will be the best-performing asset class in 2020, followed by commodities and cash. Global growth optimism has jumped the most in 20 years to an 18-month high, further suggesting that demand for equities might increase.

Since the Brexit vote in 2016, there has been a marked divergence in the performance of the FTSE 100 and the S&P 500. If you think the UK and sterling will both recover then valuations today might be an opportunity.

There are some cheap, high-quality UK small and mid caps out there just waiting for a wave of institutional money.

In a world where sustained quantitative easing has led to massive amounts of poorly allocated capital, global growth could continue to struggle. But away from the large-caps and huge, loss-making IPOs, retail investors can find winning companies with competitive moats that can keep growing even when the rest of the world is sluggish.

Here’s how I’m currently screening for, valuing and monitoring these prospects. If anybody else has any thoughts or tips on investing and screening processes, let me know in the comments below.

1. Screening for moats

The people that have done the most work and thinking on economic moats (such as Warren Buffett and Pat Dorsey) often reference persistently high returns on invested capital over many years and strong free cash flow generation as the hallmarks of such companies.

Return on invested capital can be tricky to calculate, though. The Quality Rank represents a pretty robust and accessible alternative that also captures some other desirable characteristics such as financial health.

With that in mind, the standard Top QualityRank page in the Browse section is a sound starting off point when searching for companies with moats. Historically, the Top QM Rank page has been an even better choice as it identifies high-quality stocks moving upwards (and the results show that positive momentum can be much more persistent than you might think).

A third screening idea that could yield some interesting results is a ‘Quality Value Breakout’ screen that seeks undervalued Quality stocks that are…

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Techno Trousers

4th Dec '19

Excellent as always Jack. I love your common sense approach and basic rules you follow. . Personally I like to see consistent cash flow growth over a period of years as well, so have less interest in ‘break outs’ per se although perhaps this is an area in which I need to do more work as I am interested in any chart breakout.
Keep up the good work! Love all the articles you publish.

TT

iwright7

Jack - I can't get the QV Breakout screen link to work - Could you check this at your end please?

I see what you are trying to do by selecting for Quality at a reasonable price, but this assumes that other investors have not realised that a High QV selection could be Moat companies in the making/in recovery.

Its my view that there are likely to be <5% of UK companies with a wide Moat and these are likely to priced above the market average, so maybe you risk fishing in the wrong pool? Very high Q (one of the characteristics of a wide moat) with < average V may be more promising. Of of course there's very High QM companies to consider as well.

If we look at the Top Decile Stockrank classifications the cumulative gains give us some clues to likely out-performance:

>90 QV = 80%
>90 Q = 101%
>90 QM = 127%

nathantrader

Also unable to get the link to work

Jack Brumby

It should be working now nathan. Let me know if not.

That's an interesting point re. QV... I suspect most of the moats are to be found in the QM part of the market too, but if you click through to the QV screen (the link should be working now) then you'll find that it does also capture some high QM stocks such as Strix (LON:KETL) and Rm (LON:RM.)

It could be useful as a secondary screen - for example, if you find a moat candidate looking just at the Top Quality Rank screen, then you see it qualifies for the QV Breakout screen as well so you know it has strong value and is beginning to show positive momentum...

An example of this right now is Ienergizer (LON:IBPO) (which I don't know anything about).

For now I'm going to run it in tandem with the other screens you have mentioned to see if it adds value. In future perhaps I'll experiment with being more lenient on the Value requirement.

Thanks TT, much appreciated!

I feel like basic rules are the best in a complex environment... Sometimes if I make a screen or checklist that is too prescriptive it ends up excluding way too many opportunities. That said, cash flow growth is such a fundamentally attractive feature that it's probably worth adding in somewhere

epo001

Not working for me, just repeatedly loads the quotations.

Rusty2

Still not working for me on the old system. Just blank, all it has is the Union Jack flag for each share.

Actually it does work but for some reason the link defaults to just the flag, if you click on overview it will show the companies. I'm considering RM (LON:RM.) at the moment, has been on my watchlist for a while now. Some such as Dart (LON:DTG) I consider over-extended. Strix (LON:KETL) I have considered in the past but growth is quite low.

5th Dec '19

Jack Thanks the JV screen link is working now

I am in the process of reading a new book Only the Best will Do - The compelling case for investing in quality growth businesses, by global fund manager Peter Seilern. The clue to his method of investing is in the title and he lists 10 Golden Rules he follows. These include sustainable competitive advantage and high ROIC%, both of which are characteristics of a Moat. The average ROIC% of his fund’s companies is 20%.

It struck me that the JV Breakout screen which has 68 candidates, would benefit from a >20% ROIC prune, to inject greater Quality emphasis and screen out the more Moaty candidates. Adding >20% ROIC drops us down to a more manageable 16 companies, including the 4 mentioned above. Of the >20% ROIC 16 select group, only 1 company has a QM score <80, so decent upward Momentum too.

In the chapter ‘Not Wanted Here’, Peter goes further and throws out whole sectors: “these include utilities, banks, telecommunications, commodity producers, airlines, vehicle manufacturers and industrials”. Not sure I agree with the last category though.

For those interested the book is an easy, read in a day type, that has a lot of Buffett type wisdom. Ian

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Four tips for finding and tracking economic moats

1. Screening for moats

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Jack Brumby

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