Screening for strong economic moats to find large cap winners
Just what is it that makes a business truly great from an investment perspective? Warren Buffett, one of the world's most successful investors, says that greatness can be found in stocks that not only produce excellent returns, but can protect those returns with an enduring 'moat'.
For Buffett, it isn't enough for a firm to earn high returns from constantly reinvesting in itself. It also needs to be able to stave off the threat of competition by erecting formidable barriers. As he commented in his 2007 letter to shareholders of his Berkshire Hathaway conglomerate: “The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle" that is earning high returns."
Raising the drawbridge
In investing parlance, Buffett's moat has become a byword for companies that can generate terrific profits from dominant market positions, respected brands and strong pricing power. Ultimately these are firms in stable industries that boast long-term competitive advantages. Groups like Burberry and Reckitt Benckiser, for instance, operate in vastly different markets, one in high-end fashion and the other in health and hygiene. But both benefit from respected brands and pricing power that are very difficult to attack.
Moats can also be dug when a company's customers are reluctant to leave. They may feel a sense of loyalty or a sense of community with other customers. Or it may just be too difficult for them to leave. Just look at Sage, the UK-based software giant whose accounting tools are used by thousands of small and medium sized businesses. These customers would face major disruption if they switched platforms, which is why most of them don't. Terry Smith of Fundsmith - another proponent of buying great quality firms - began building a stake in Sage last year. He said the firm's move to an online subscription model would ultimately make it an even better business.
Companies with genuine economic moats also often have substantial scale in their manufacturing or distribution networks. This helps to drive down costs and make it much more difficult for challengers to compete against them. Take ARM Holdings, the technology chip designer behind components that power around 90% of smartphones. ARM has a design-led model (it doesn't actually make the chips) and works with partners around the world to develop components that are faster, smaller and use less energy. That makes it a very difficult beast to beat.
Best protected stocks
Given the multitude of factors at play, finding companies with wide moats isn't just about finding the market's biggest companies. Instead, some of the clues can be a found in a handful of signals in their financial results. Stocks with enduring moats typically boast long-term high operating margins and high levels of free cash flow. Those profits can then be reinvested in further growth, again at high rates of return, which can be seen in double-digit levels of return on capital… and this often turns into long term share outperformance.
The following list of FTSE 100 shares with moat-like characteristics is sorted according to Stockopedia's QualityRank. This scores and ranks every stock in the market against a range of financial health and quality measures (you can read more about it here). Topping the list ahead of the stocks already mentioned is retail giant Next, which has long been a huge generator of cash for shareholders and a textbook example of how to produce high returns from its store network.
Name | P/E Rolling 1y | FCF/ Sales % | ROCE % 5y Avg | ROE % 5y Avg | Op Mgn % 5y Avg | Quality Rank |
16.3 | 15.8 | 58.5 | 201.6 | 18.9 | 99 | |
11.1 | 15.1 | 12.2 | 10.4 | 14.1 | 99 | |
34.9 | 39.1 | 14.7 | 12.5 | 30.6 | 98 | |
24.3 | 21.7 | 25.1 | 29.3 | 24.2 | 95 | |
22.4 | 20.6 | 18.5 | 17.0 | 19.6 | 89 | |
20.1 | 68.9 | 21.8 | 31.7 | 27.0 | 89 | |
18.2 | 17.3 | 18.1 | 14.2 | 22.3 | 88 | |
13.1 | 39.6 | 17.3 | 18.9 | 30.1 | 86 | |
16.2 | 18.2 | 24.1 | 41.5 | 19.9 | 86 | |
14.5 | 13.7 | 24.6 | 26.8 | 36.8 | 84 |
Overall, this portfolio of stocks has produced a 25% return over the past 12 months. Stockopedia subscribers can see the full screen results here.
Of course, constructing the perfect enduring moat is likely to be a very difficult task for most companies. As Buffett himself observed: “Business history is filled with “Roman Candles," companies whose moats proved illusory and were soon crossed." Even when you do find them, it's likely that they'll be fully priced (Buffett would be a buyer on price dips and bad news). But a focus on stocks with high levels of cash flow that can invest and grow profitably and generate high returns will inevitably lead to some of the best quality companies in the market.
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8 comments
One thing to bear in mind is that the market often assumes companies with strong recent results will see their returns and margins revert to the mean in the longer-term. This will prove true for most companies, naturally, as the forces of capitalism erode temporary advantages, but firms with economic moats (i.e. durable competitive advantages) tend to resist mean reversion as they're able to protect margins and returns due to pricing power stemming from intangible assets (i.e. brands, patents), switching costs, network effects, etc.
As such, if the market assumes mean reversion for firms with bona fide moats, their current stock prices will likely be undervalued. By no means am I saying this is easily accomplished (if you're wrong on the moat, you'll probably overpay) or that the market always discounts firms with moats, but to me it's another compelling reason to seek out firms with moats, particularly those that aren't already well-known to the market.
The thing is some factors (low vol, boringness, illiquidity, maybe size) are perennially underpriced on average. That is, if you buy them price-blind, using diversified entry points to average out the odd extreme, you will do well (as long as what has been observed in past history persists).
Are moats among those? I don't know. It should be a testable hypothesis: try to reconstitute what sort of business contemporary investors found 'moaty' for each year in the past few decades, and see how they did against the market index.
Hi cig,
Can't argue with your logic: if moats were and are priced correctly then it wouldn't be possible to make the superior returns that we seek from identifying and investing in firms that have them.
Your premise is akin to the efficient market theory (EMT) that states that markets accurately price equities based on all available relevant data. To quote Buffett, "I’d be a bum on the street with a tin cup if the markets were always efficient”, and his investment style clearly incorporates looking for businesses with moat advantages.
However, the challenge in your question, even if you accept that Mr Market sometimes miss-prices equities, is to identify when the price is out of line and by how much. The solution to this is probably in Noble Prize winning territory!
Regards Maddox
Is there evidence that moats are persistently underpriced historically? This is the underlying assumption of moat investing -- there's no advantage in investing in moats, or any other positive factor, when the benefit is priced in.
I don't think they don't need to be underpriced persistently, just occasionally, i.e. long enough to buy them at a low price. I want the stocks I own to occasionally become overpriced so that I can sell them high.
A moat can also make it easier to decide if something IS underpriced or not. E.g. Buffett thought Tesco had a moat and was therefore underpriced when he bought, even though its PE etc were fairly "normal" . Tesco's moat was an illusion and therefore it wasn't underpriced. I am a Tesco shareholder as well, so I'm not picking on Buffett; we all make mistakes sometimes.
I use ROCE as the main sign of a moat, so I'd pretty much agree with everything that Ben wrote, as well as that list of companies.
Hi cig, the best book on this is "Why Moats Matter" by Morningstar Their entire equities business is based on ranking for moats across three categories... wide moat, narrow moat and no moat.
On page 116 there's a chart which shows that wide moat stocks actually underperform 'no moat' stocks. 'narrow moat' stocks slightly outperform.
They add a useful trick of 'volatility matching' the portfolios - i.e. by gearing up investments in low volatility wide moat companies to match the volatility of the no-moat companies. With this sleight of hand they just about outperform by 20 bps per month. But you are adding leverage of course.
As with any "Q" quality index... the performance is radically improved by adding in "V". The trick is buying cheap, good (moat) companies. They proclaim their wide moat focus index has returned 15.9% annualised since 20112 vs the S&P at 8.8%.
Interesting that an ETF based on this has only tracked the S&P though.
Thanks for the reference! So it seems a bit mixed as evidence. If they needed to add low vol to their criteria, do they need the original criteria at all and wouldn't it work as well with pureplay low vol? It's also naturally quality-biased. This seems to happen quite often in factor research (maybe using low vol on its own is still a bit taboo?).
The book is paywalled but from one of their videos and from the holdings of the ETF it seems they have a pretty broad definition of what a moat is. Miners are in because they have mines, and you can't make 'em new mines, foodies are there because they have brands, but then don't they all, the entire pharma industry, less pure play generics manufacturers maybe. That's probably 2/3 of the market... Almost makes me want to look at non-moat companies as a screening criteria, esp in large cap, if someone has managed to survive and grow/stay big doing something very clearly generic in a complete commodity market, they must be very good at it, and likely neglected... My idea of moat would be more narrow (e.g. Microsoft in the old days of Windows dominance, Harley Davidson is the one in the ETF, among the names I know, that strikes me as having a proper moat).
On the ETF perf, being ultra-concentrated with 20 stocks it was bound to be accident prone, it seems to have been on its way to modestly but steadily outperform 'til January, maybe the oilies and IBM got them? To see moat-the-factor, esp as widely defined by Morningstar, it would be more interesting to see a broader portfolio.
Hi Ben,
Just to join the dots I have just posted on Sage referencing your article http://www.stockopedia.com/content/sage-has-rediscovered-its-mojo-98464/. Sage clearly exhibits economic moat characteristics and now it looks like its rediscovered its organic revenue growth trajectory. Should be an attractive combination.
Regards, Maddox