Medieval kings might seem like an odd group to invoke when discussing modern-day stock investment advice. But when it came to protecting their assets, those kings of yore did a pretty good job by using wide, deep moats to surround their castles, and hundreds of years later many of the world's best businesses and their investors are profiting from a similar approach.
Just ask Warren Buffett. The world's most famous investor is credited with coining the term "economic moat" to describe a long-lasting advantage that a company has over its peers, and the topic is one he often discusses. "A truly great business must have an enduring 'moat' that protects excellent returns on invested capital," he wrote in his 2007 letter to Berkshire Hathaway shareholders, for example. "The dynamics of capitalism guarantee that competitors will repeatedly assault any business 'castle' that is earning high returns. Therefore a formidable barrier such as a company's being the low- cost producer [GEICO, Costco (NASDAQ:COST)] or possessing a powerful world-wide brand [Coca-Cola (NYSE:KO), Gillette, American Express (NYSE:AMX)] is essential for sustained success."
Other forms of moats can include high switching costs that make it difficult for customers to change allegiances, or size that gives a company economies of scale that its competitors don't share. The important thing with these type of advantages is that they are long-lasting. Having a great manager, by contrast, will certainly give you an advantage, but such an advantage lasts only as long as the manager stays around. The advantage that Coca-Cola has from its worldwide name recognition, on the other hand, is one that should last for decades regardless of who's running the company.
Identifying companies with economic moats may seem like a subjective process, and to a certain extent it is. But there are fundamental indicators that can be signs that a company has a moat. My Buffett-inspired Guru Strategy, which is based on the approach Buffett used to build his empire, views a lengthy history of a high return on equity as a sign that a company has an economic moat -- the 10-year average ROE should be at least 15%, and the ROE should not be below 12% in any of those 10 years.
In a recent piece for Canada's Globe and Mail, Morningstar Canada's Craig McGee highlighted 20 stocks Morningstar analysts deem to have economic moats of one sort or another, and which met several other fundamental criteria, including high returns on equity. He also looked for stocks with low price/sales and price/earnings ratios, and he wanted the P/E to be less than its historical average and the ROE to be greater than its historical average.
Those are pretty stringent criteria, but I thought I would whittle things down even further by running these 20 stocks through my Guru Strategies. By looking for companies with moats that also get high marks from approaches inspired by some of history's greatest investors, we can really identify some potential winners.
A number of the stocks on the list got at least some level of interest from my models. Here's a look at some of the best, along with details on why Morningstar considers them to have economic moats. Keep in mind that for all five of these, Morningstar classifies their moats as "narrow", so they aren't impenetrable. But they should have some good protection against the competition.
CA, Inc. (NASDAQ:CA): This New York State-based IT firm ($14 billion market cap) has an economic moat that is derived from high switching costs and limited substitutes, according to Morningstar analysts. The stock is a favorite of the model I base on the writings of hedge fund guru Joel Greenblatt. Greenblatt's approach is a remarkably simple one that looks at just two variables: earnings yield and return on capital. My Greenblatt-inspired model likes CA's 9.7% earnings yield and 105.1% ROC, which combine to make the stock the 33rd best in the entire U.S. market right now, according to this approach.
NetApp Inc. (NASDAQ:NTAP): This California-based tech firm ($12 billion market cap) offers storage and data management solutions. Its moat is a result of high customer switching costs, according to Morningstar.
My Peter Lynch-based model is high on NetApp. Lynch famously used the P/E-to-Growth ratio to find bargain-priced growth stocks, and when we divide NetApp's 21.5 price/earnings ratio by its 26.7% long-term earnings per share growth rate (I use an average of the three-, four-, and five-year EPS growth rates to determine a long-term rate), we get a 0.8 PEG. That comes in under the model's 1.0 limit, a sign NTAP is a bargain. The stock also passes one of my Lynch model's balance sheet bonus tests, the net cash/price ratio. Lynch defines net cash as cash and marketable securities minus long-term debt, and a high net cash/price ratio (above 30%) dramatically cuts down on the risk of a security. At 46.4%, NetApp easily makes the grade.
PetSmart (NASDAQ:PETM): With offerings that range from pet supplies to pet grooming to pet boarding to pet medical care, this Phoenix-based firm ($7 billion market cap) has 1,289 stores and more than 196 in-store dog and cat boarding facilities in the United States, Canada and Puerto Rico.
PetSmart's moat comes from its having a broad suite of premium products and services that are not generally available at discount retailers (limiting potential price competition), and which attract an affluent customer base, according to Morningstar. PetSmart gets high marks from my Buffett-inspired model, thanks in part to the fact that its earnings have decreased in only one year of the past decade. The firm has also averaged a 22.5% return on equity over the past 10 years and has almost as much in annual earnings ($415 million) as it does long term debt ($452 million), two more reasons the Buffett-based model likes it.
My Lynch-based model also likes PetSmart, which has a 17.3 P/E ratio and 24.4% long-term growth rate, making for a 0.71 PEG ratio.
Myriad Genetics (NASDAQ:MYGN): Shares of this Salt Lake City-based molecular diagnostic company, whose products assess a person's risk of developing disease, guide treatment decisions and assess risk of disease progression and recurrence, soared in January and February. It got another big boost this week when the government announced it would be paying a higher reimbursement for one of Myriad's main tests than expected. Myriad's moat "primarily stems from its proprietary database of mutant variations amassed through its previous monopoly position in BRCA testing", according to Morningstar analysts.
Myriad gets high marks from my Greenblatt-based model, which thinks it has more room to run. It likes the stock's 11.1% earnings yield and 48.6% return on capital.
Apple Inc. (NASDAQ:AAPL): Growth has slowed significantly at the California-based tech giant, but it still has an economic moat, according to Morningstar, which cites switching costs that may make current iOS users "more reluctant to stray outside the Apple ecosystem for future purchases". While Apple's not growing like it used to, my Peter Lynch-based model still thinks it's a good bet. The firm's 41.5% long-term growth rate and 13.4 P/E ratio make for a very strong 0.32 PEG ratio. (It's also worth noting that even if we use the analysts projected growth rate of 21.3%, Apple's PEG would still be well under the Lynch model's 1.0 upper limit.) The strategy also likes Apple's very reasonable 13% debt/equity ratio.
Disclosure: I am long NTAP, PETM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.