How to find companies with moats that are worth investigating

Seeing the conversations that have been stimulated by our recent stock research pieces, I thought it might be helpful to make this post as a forum to discuss promising companies that display moat-like characteristics. The scope can be international. Any comments or research ideas are welcomed.

At the moment, I have a list of candidates that is a hybrid of my own picks, subscriber suggestions and companies that qualify for various screens.

Below you'll find a quick refresher on economic moats followed by a compilation of recent notable activity in the moat candidates I've found so far.

Moat economics

Warren Buffett once said: ‘put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.’ It sounds simple. The challenge lies in identifying and sticking with these companies.

This is partly because highly profitable firms attract competition. Capital is drawn to the areas of the economy that have the highest expected returns. These competitors often undercut the incumbent on price. As a result of this pattern, most highly profitable companies become less profitable over time.

When you dig down to the individual company level, however, you can find candidates that buck this trend by consistently posting profitability figures above the norm. The chances are, these companies have economic moats that guard their margins.

Pat Dorsey, originally of Morningstar, has done a lot of work into mapping out this simple but powerful idea. In The Five Rules for Successful Stock Investing, he identifies five types of sustainable competitive advantage:

1. Real product differentiation through superior technology or features
2. Perceived product differentiation through a trusted brand or reputation
3. Being the low-cost producer
4. Locking in customers with high switching costs
5. Locking out competitors with high barriers to entry or high barriers to success

Identifying companies with potential moats involves a lot more qualitative research than other investing styles. At some point, you have to ask both why a company earns such high returns and how long this dynamic might continue. A lot of reading company reports, thinking about strategy and industry, and reading between the lines can go into answering these questions.

Last week saw a flurry of activity in the set of companies I have so far identified. There were buybacks, director deals, major shareholder moves and more. I’ve listed some of the more notable announcements below.

Are these signals to conduct further research, or is it all just noise?

Director deals and major shareholders

Keeping on top of what directors and major shareholders are doing with a company’s stock can give valuable insights. Tracking the buys and sells of experienced professional investors is a great way of unearthing new opportunities. Companies that attract a high-quality shareholder base are also worth taking a look at.

In the past week:

• Miton bought a stake in Strix Group
• Philip Meeson sold some of his Dart Group shares (but retains a c36% holding). Standard Life Aberdeen increased its holdings.
• Stadium Capital Management declared a stake in ScS Group
• Miton acquired a 13% holding in Hostelworld
• Liontrust increased its holding in Bioventix

Buybacks

Buybacks can be a powerful signal to the stock market, although large conviction buys are more valuable than small, token gestures. Here are some of the companies that have been buying back shares over the past week, and the percentages they have repurchased.

• SSE bought back 118,761 shares (0.0114% of the company)
• Rio Tinto bought back 414,784 shares (0.0254% of the company)
• Auto Trader bought back 744,300 shares (0.0806% of the company)
• Diageo bought back 1,468,644 shares (0.0626% of the company)

Trading updates

There were a number of interesting trading updates to catch up on, notably:

• Rotork Q3 trading update
• Dart Group half-year results
• Sage Group full-year results
• Creightons half-year results
• Liontrust half-year update
• The Property Franchise Group trading update
• Focusrite full-year results
• Eckoh half-year results

Of this Motley Crew, Dart Group catches my eye (even though airlines are a famously fickle and risky area of the market to invest in). There is something about Dart Group that has generated fabulous returns for long-term shareholders and I want to know what it is.

Dart Group is topical. It has just released its half-year results and its shares are hitting new all-time highs as a result. There have been major moves in its shareholder base that are worth investigating. It has a fantastic StockRank profile and qualifies for multiple screens. And the demise of Thomas Cook could be a source of significant growth for the company over the next couple of years.

Finally, Ed wrote this piece nearly five years ago in which he questions whether we should get over our biases and buy Dart at its new all-time high... of 365p. Given what the share price has done since then, it seems reasonable to ask that same question today at c1,400p.

I’d welcome any contributions from other investors - either in the form of company suggestions, news flow or comments on Dart.