In this article we will present the requirements in order to apply correctly the concept of moat or sustainable competitive advantage. We will illustrate why Ball Corp (BLL) meets these requirements.
Mr. Warren Buffett is known to have coined the word "moat" to represent a type of sustainable competitive advantage that a business possesses that makes it difficult for rivals to wear down its market share and profit.
The term moat is derived from the water filled moats that surrounded medieval castles. The wider the moat, the more difficult it would be for an invader to reach the castle. The term "moat" appears for the first time in its annual shareholder letter in 1986 in talking about the "difference between GEICO's costs and those of its competitors as a kind of moat that protects a valuable and much-sought-after business castle". It is now widely accepted that the idea of an economic moat refers to how likely a company is to keep competitors at bay for an extended period.
One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors. Companies that have generated returns on capital higher than their cost of capital for many years running usually have a moat, especially if their returns on capital have been rising. This line of reasoning is fundamental. It does not suffice for a business to have an unexpected or temporary competitive advantage to be able to declare that it has moat. Many writers think that they follow Warren Buffett's philosophy because they have found a business with a competitive advantage. As he mentioned in a November 22, 1999 Fortune interview: " The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors." You cannot expect to obtain abnormal return (alpha) as an investor if the business you invest in does not have a sustainable competitive advantage. We define moat or sustainable competitive advantage as the difference (the performance spread) between the return on capital and the cost of capital (correctly measured, that is after transforming GAAP numbers into a rigorous computation of economic profit, after deducting the full cost of capital, and eliminating accounting distortions).
The higher the performance spread, the bigger is the competitive advantage. However, the work does not stop there. You also need to find a business whose spread is stable or increasing over time.
Ball Corp meets these requirements. Ball is a provider of metal packaging for beverages, foods and household products. Founded in 1880, the company employs more than 14,500 people in more than 90 locations worldwide. Just see underneath a beverage can, and there is a strong probability that the name of Ball is there.
For Ball (see proxy materials) "Much of [its] financial success is attributable to the fact that [it] consistently focus on the key components of [its] financial strategy, which include: Generating free cash flow, disciplined and balanced capital allocation, growing earnings before interest and taxes by maximizing value in existing businesses, expansion into new markets and products, merger and acquisition activities, and generating incremental economic value added." Also, company employees own about 12% of Ball shares, and all employees participate in incentive schemes based on economic value added, which will help the company focus on increasing shareholder value.
With no surprise, we find that the trailing 12 months performance spreads (PS) as of September of 2008 to 2012 are respectively 3% (2008), 3.6% (2009), 5.8% (2010), 5.4% (2011) and 5.1% (2012). In reading theses results you need to keep in mind that, in competitive markets, a business that is able to maintain a positive spread over time has really a competitive advantage. It does not happen by chance. (For example, for the same five years, Owens-Illinois (OI), a close competitor, obtained negative PS for the last four years).
This kind of economic performance has produced a market value added (market value of all claims on the firm minus invested capital) that increased from $2.4 billions in 2008 to $4.6 billion in 2012.
The stock price appreciation over 1, 3 and 5 years is 18.4%, 84.4% and 124.3% respectively. Year to date: 4.2%. At the time of this writing, Ball market price on NYSE was $46.10. Our estimate of its intrinsic share value (ISV) is $54.18 for a PS of 5.0%, $58.09 for a PS of 5.5%. In case of a drop in its PS to 4.5%, the ISV would be $50.05.
Actionable advice: Wait until Ball's earnings conference call, January 31, 2013. If Ball misses its quarterly earnings per share by a penny, it could give you a "bonus" entry price at the expense of the short-sighted investors. Otherwise, the ISV above will help you decide.