How to find companies with strong competitive moats

Tuesday, Apr 11 2017 by
33
How to find companies with strong competitive moats

In medieval times, castles that were best protected from sieges were those with the widest, deepest moats. On the investment battlefields of the stock market, moats are a figurative pointer to some of the strongest, most durable companies. But how do you find them?

The ‘economic moat’ is a metaphor first used by the billionaire investor Warren Buffett, to describe the type of business he likes to buy. These days it’s often used as a measure of durable competitive advantage.

The idea is that a select few companies not only churn out persistently strong returns, but they have extra advantages that make it difficult for rivals to copy them. As a result, their investors can benefit from superior returns that are compounded over the long term.

What makes a moat?

One of Buffett’s examples is the American auto insurance giant Geico, which is owned by his Berkshire Hathaway group. In recent years he’s regularly noted: “The company’s low costs create a moat – an enduring one – that competitors are unable to cross.”

In Geico’s case, the moat is the sheer scale of the business that allows it to dominate the market by operating at low cost. But moats aren’t always about size, scale and cost. They can be market leading brands or products that consumers are reluctant to stop using. Classic examples are big drinks manufacturers like Coca-Cola and Diageo and FMCG companies like Reckitt Benckiser.

Sometimes they’re businesses with large distribution infrastructure that would be difficult and expensive to replicate. Others have products and services with ‘networking effects’, which encourage customers to feel part of an exclusive club. Or they may have brands that customers closely identify with. Examples here range from Facebook to Harley-Davidson to Apple.

In his book, The Little Book that Builds Wealth, Pat Dorsey, a fund manager and former Morningstar analyst, explained: “Just as moats around medieval castles kept the opposition at bay, economic moats protect the high returns on capital enjoyed by the world’s best companies. If you can purchase their shares as reasonable prices, you’ll build a portfolio of wonderful businesses that will greatly improve your odds of doing well in the stock market.”

Digging around for a moat

Huge amounts of research - such as this from Credit Suisse’s Michael Mauboussin - have looked at…

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31 Comments on this Article show/hide all

Ramridge 12th Apr '17 12 of 31
2

In reply to post #179650

I have been adding SYS1 over the last few days. Has good moat-like signs. From latest accounts for FY2016
- FCF/ Sales 21%
- Operating Margin 20%
- ROCE 64%
- no debt
- broker forecast eps growth 30%

Current PE is 27 but justified by the above ratios.

BTW there is a definite bug with the ticker translation. I entered SYS1 and it comes out as SYS

All IMO and please DYOR

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SMinvest 12th Apr '17 13 of 31
1

Its all well and good to "find" moats using stats, but there's no substitutes for company research, checking the products, understanding the industry, and where its going...ideally for multi-bagger investments one wants to identify the companies with large moats BEFORE the stats start to reveal this...

my two cents...would love to hear others' thoughts on this...

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PhilipHanson 12th Apr '17 14 of 31
2

In reply to post #179686

I agree with SMinvest in part, there is definitely a level of qualitative analysis which is needed to understand why and how a company is able to sustain its moat into the future.

However there are characteristics in the numbers which such competitive advantage provides. So the screen gives you a much reduced selection to look at in more detail. I don't think anyone is saying that the screen is the be all and end all of the process.

For example, if you look at Rightmove (LON:RMV) ROE it's just under 2,000%. That is not a mistake, it made £160m net profit last year off net equity of £8m with no debt. So £8m invested in the business and it produced 20x that in profit. What is this telling you? Well, it's telling you that the real "assets" of the business, i.e. the things which allow it to produce such apparent super-normal returns are in fact not being measured on the balance sheet, not even in intangible assets or goodwill.

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SMinvest 12th Apr '17 15 of 31

In reply to post #179700

I agree - but go back to 200x...whenever right move started out...or even 2006-7-8...how would you have identified its "moat" back then?

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iwright7 12th Apr '17 16 of 31
5

SM,

Not sure I agree that you need to find companies with Moats before the screens do. The whole point with Moats is that they endure for a long time so it doesn't matter whether you buy in Year 1, Year 3 etc, The other trick I have used is to buy recent "improving" companies from within a Moat screen, knowing that the company already has a good track record and is now further out-preforming.

A good recent example was Brainjuicer who passed Ed's 5Y Moat screen and in Mid-Sept 2016 boldly announced; "It's enormously gratifying being back to double-digit growth" - Not something you would say if you thought the next half year was likely to be single digits! I brought BJU at £4.79 on the day of that announcement and it’s £7.80 (+63%) and rising some 6 months later. You don't need many of these to multi bag your portfolio over 5-10 years. Ian

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bestace 12th Apr '17 17 of 31
2

In reply to post #179708

For anyone prepared to do their homework, the evidence was readily available in the prospectus. Even before it listed, Rightmove (LON:RMV) was generating 30% operating margins, ROCE of 40%+, had over 40% of the marketplace, contracts in place with 62% of the estate agencies in England and Wales and had 90% retention rates with its customers.

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Edward Croft 12th Apr '17 18 of 31
20

I've got a better idea about how we can identify companies with moats.

Why don't we use the hive mind of Stockopedia to identify moat factors in stocks... e.g. brand names, network effects, scale advantages. We could all tag stocks and then we could score the output and score the contributors... we'd then be able to use these factors in screens. 

Best way to do this would be via a LinkedIn style "Does this company have... [network effects]?  Yes/No"


Anyone who agrees - click like or reply.

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PhilipHanson 12th Apr '17 19 of 31

In reply to post #179732

I think that's a good idea to try to crowdsource some qualitative factors, Ed.

I'm currently re-reading the Buffettology book and Chapter 17 highlights three areas where you will find businesses with durable competitive advantage. I suppose it's a good start point:

1. Businesses that fulfil a repetitive consumer need with products that wear out fast or are used up
quickly, that have brand-name appeal, and that merchants have to carry or use to stay in business. Typically fast moving consumer goods (FMCG) businesses.

2. The advertising business, which provides a service that manufacturers must continuously use to
persuade the public to buy their products. This is a necessary and profitable segment of the business world. Whether you are selling brand-name products or basic services, you need to advertise. It's a fact of business life.

3. Businesses that provide repetitive consumer services that people and businesses are consistently in need of. This is the world of tax preparers, cleaning services, security services, and pest control.

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iwright7 12th Apr '17 20 of 31
3

Pat Dorsey of Morningstar splits up Moats into these categories:

1. Intangible Assets
• Brands
• Patents
• Regulatory Approvals
2. Switching Costs
3. Network Effects
4. Cost Advantages
• Cheaper Processes
• Location, Location, Location
• Unique Assets
5. Greater Scale
• Distribution Networks
• Manufacturing Scale
• Niche Markets

It can be one or more of these plus something that makes the company unique, or that causes it's customers to love it.

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PhilipHanson 12th Apr '17 21 of 31
1

The other good "model" when thinking about business moats and competitive advantage is Porter's Five Forces analysis.

- Threat of new entrants
- Threat of substitutes
- Bargaining power of customers
- Bargaining power of suppliers
- Industry rivalry

https://en.wikipedia.org/wiki/Porter%27s_five_forces_analysis

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herbie47 12th Apr '17 22 of 31

accesso Technology (LON:ACSO) is another one I think has a moat, it fails on the sales rank on that screen. In fact quite a few I have checked fail on that only, Ashtead (LON:AHT), Photo-Me International (LON:PHTM) and Unilever (LON:ULVR).

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shipoffrogs 12th Apr '17 23 of 31
1

Judging by their lack of competition two companies that have very wide moats are Games Workshop (GAW) and Hornby (HRN).

The only retailer selling fantasy figures and games that you're likely to come across when out shopping is GAW.

And most people will have no trouble naming Scalextric as a slot car brand and Hornby as a model train brand, and most people will then be hard pressed to name another.

Yet neither have been able to deliver consistent returns and growth over the years. So, I think there can be more to it than just identifying companies with moats.

There have been a few mentions of System1/Brainjuicer - but is their moat sustainable? Their novel approach to advertising seems replicable in the same way that Billy Beane (Moneyball) was copied in baseball.

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iwright7 13th Apr '17 24 of 31

System1/Brainjuicer pioneered Emotional market research some 10 years ago, whilst also offering traditional market research services, but it’s the Emotional part that is doing so well. Think of the heart-warming  John Lewis “Buster the Boxer” Xmas Ad as a classic SYS1 example - link below.

Innovation has given SYS1 clear First-mover advantage and sure others will try to copy. The numbers though indicate the outcome;  5+ years of excellent Moat metrics and more recently back to double digit sales increases whilst generating 64% ROCE and 43% ROE. Fairly impressive!    Ian

https://www.theguardian.com/global/video/2016/nov/10/meet-buster-the-john-lewis-2016-christmas-advert-video

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ken lowes 13th Apr '17 25 of 31

In reply to post #179676

Morning All--System 1 now I am not sure if I can ask this question but--System1 suddenly took off in February2016 and seems to be heading for the moon, I think I might have a nosebleed investing after such a rise but I am intrigued as to how anyone spotted it. The fundamentals are great but how does one screen for such a breakout, I seem to be missing something here, help anyone?
Ken

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herbie47 13th Apr '17 26 of 31

In reply to post #179794

Ken have you read the Mark Minervini interview post, I think that will give some ideas and Phil set up a screen that works well.

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Ramridge 13th Apr '17 27 of 31
1

In reply to post #179794

Hi Ken - Re. SYS1 Looking at the SP graph, there were two points when the price took off recently, once on 20/1/17 with the trading update, and the other in mid February shortly after the full year results.

The trading update gave a strong indication of a step change in the company's fortunes after many years of pedestrian growth.

The FY results in Feb gave the meat on the bones. All of my metrics given in the earlier post were derived from the published results.

Unfortunately I missed both signals and only got interested early March when I got round to analysing the results in detail.

All that the screens and filters, and methods such as Minervini VCP, do is to point you in the right direction. There is no getting away from the hard graft (90% perspiration / 10% inspiration), no magic minnervini dust.

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ken lowes 13th Apr '17 28 of 31

In reply to post #179820

Thanks Ramridge/Herbie I have been burning the midnight oil trying to understand the Minervini principles, I do like his approach and I will take a look at the screens Herbie and if I find a way to shortcut - Ramridge, I will share my thoughts.
Thanks again

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Ramridge 13th Apr '17 29 of 31
1

In reply to post #179834

Ken

A lot of the nuts and bolts of the Minnervini method is explained by him in    this youtube video  

Bit long, 1hr 45mn , but worth it.

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iwright7 13th Apr '17 30 of 31
2

In reply to post #179820

Ram,

You are absolutely right that graft is needed. I have been back though my notes and BJU had peaked my interest because it has been a 5Y Moat company for some time previous to the H1 results in September. These September results produced sales up +12%, but the EPS went up +41%, showing great operational gearing.

For me though the biggest September RNS clue though was the Chairman's;"It's enormously gratifying being back to double-digit growth" - There is relief and permanence about this statement. I brought in and my notes say that the share went up just +3% on the day, so a lot of people must have missed the significance too. 

I find that I can scan the 7am RNS of the few companies I have interest in, in about 15 mins each day. If a companies results looks particularly good it then takes me about 2 hrs of further background and checklist analysis before I decide to buy, or not. So in this case the Moat screen helped to narrow down the field, but its was the BJU improved metrics and news flow that got me to pull the buy trigger. - Perspiration does pay.  Ian 


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WarrantStar 14th Apr '17 31 of 31

In reply to post #179580

Bestace,
Thanks for the link to the article. It was very useful. I mostly invest in High Flyers and your post has lead me to make a significant improvement in in my process.

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