5 Stocks With an Economic Moat

Includes: EXPD, JNJ, KO, ORCL, SYK
by: John P. Reese

The Federal Reserve's second -- and perhaps final -- round of quantitative easing has ended, and some Congressional leaders continue to talk tough on deficit reduction. But make no mistake: The U.S. is still far from a state of conservative fiscal and monetary policy. Interest rates remain near zero, and, for all of the deficit-reduction talk, many of the cuts being proposed by various politicians only scratch the surface of our $1.4 trillion annual shortfall.

That climate and other factors have many top strategists saying that significant inflation will, finally, hit the U.S. economy in a big way sometime soon. Just in the past couple weeks, hedge fund titan Carl Icahn, top-performing mutual fund manager Chuck Akre, and insightful strategist Rob Arnott all said they see inflation on the horizon. Icahn says it will come as Asia's growing middle class creates competition -- and rising prices -- for commodities and finished products from that part of the world. Arnott, meanwhile, says that the U.S. will likely try to get out of its debt hole by printing more money, which will lead to an inflation spike.

History has shown that when it comes to beating inflation, stocks are a better place to be than bonds, or even gold and commodities. David Dreman, one of the investing greats upon whom I base my "Guru Strategies", has noted that unlike bonds or bills or gold, stocks can produce increasing earnings streams during inflationary climates, as companies raise prices.

Certain companies are better positioned than others in terms of pricing power, however (Akre says those are the types of firms he's keying on right now), and often such firms have what Warren Buffett famously calls “economic moats”. These “moats” provide “durable competitive advantages” (another Buffett term) that give a company an inherent leg up on its competitors. They can come in a variety of forms: Size and economy of scale; brand name recognition; status as the low-cost producer in an industry; status as the elite service provider in an industry; high switching costs for customers.

Determining whether a firm has one of these or another type of "economic moat" can be a subjective process, of course. But there are ways to use quantitative metrics to help confirm whether a moat exists where you think it does. Buffett, for example, has looked for firms with high returns on equity and total capital as a way to find "wide moat" companies. My Buffett-based Guru Strategy (based on the book Buffettology, by Buffett’s former daughter-in-law and colleague Mary Buffett) looks for firms that have averaged ROEs of at least 15% and ROTCs of at least 12% over the past decade.

Take Oracle Corporation (NASDAQ:ORCL) as an example. While Buffett isn’t known for investing in tech stocks, the California-based software giant appears to have the sort of wide moat typical of many Buffett picks. According to Morningstar, its moat comes from "its ability to cross- and upsell a wide range of enterprise software solutions bundled and well-integrated with its pervasive database products." Unlike competitors like IBM (NYSE:IBM), Oracle tries to be a "one-stop shop" for its customers, Morningstar analysts say. To that I'd add to that the firm's size ($167 billion market cap; $35 billion in annual sales) and name recognition are also part of its moat. And when my Buffett-based model looks at Oracle's fundamentals, it does indeed see signs of a moat. The firm has averaged a 26.2% ROE and 22.1% ROTC over the past decade. The Buffett approach also likes that Oracle has been remarkably consistent, upping earnings per share in every year of the past decade, and that it has enough annual earnings that it could pay off its debt in less than two years. Overall, it gives the stock a sparkling 99% score.

At the end of the day, a moat is a very good thing to have in inflationary climates, but it's also a good thing to have in just about any climate. Given the wide range of fears in the market right now (including inflation), I thought it would be a good time to focus on some companies that, like Oracle, appear to have wide moats. Each of the firms below seems to fit the bill, and gets high marks from my Buffett-inspired model.

Stryker Corporation (NYSE:SYK): This Michigan-based medical technology firm offers products used in the reconstructive, medical and surgical, and neurotechnology and spine arenas. The $23.4-billion-market-cap company has a wide moat around its business, according to Morningstar, because of high switching costs. Once a doctor is familiar and comfortable using a certain type of product, like a joint replacement product, they're not very likely to switch. That's because switching means taking time, and money, to familiarize oneself with a whole new product.

My Buffett-based model also sees Stryker as having a durable competitive advantage, as it has averaged a 19.2% return on equity and 17.3% return on total capital over the past decade. The strategy also likes that Stryker has upped EPS in all but one year of the past decade -- and that was a $0.01 decline two years ago. The company also has more annual earnings ($1.25 billion) than debt ($997 million). Overall, it gives the stock a 93% score.

Expeditors International of Washington (NASDAQ:EXPD): Based in Seattle, this shipping and logistics company offers air and sea shipping, as well as customs broker services. The firm ($10.9 billion market cap) doesn't own ships or planes, but instead purchases space on those of other companies. It has a wide moat, according to Morningstar, because of its steady growth, high margins, and high returns on invested capital, and my Buffett-based model agrees. It gives the firm a 92% score, because it has upped EPS in all but one year of the past decade; has no long-term debt; and has averaged a 19.4% ROE and ROTC over the past decade.

Johnson & Johnson (NYSE:JNJ): New Jersey-based Johnson & Johnson is one of the largest, steadiest healthcare companies in the world, and is a longtime holding of Berkshire Hathaway (NYSE:BRK.A). It has more than 250 operating companies in 60 countries, and has upped adjusted earnings in 27 straight years and dividend payouts in 49 straight years.

Morningstar analysts say Johnson & Johnson's moat comes from a "diverse revenue base, a robust research pipeline, and exceptional cash-flow generation". I'd add that many of its product lines -- Band-Aid, Purell, Tylenol, and Listerine, to name just a few -- have incredible brand recognition. The numbers reflect all of that. Johnson & Johnson has averaged a 25.7% ROE and 23.1% ROTC over the past decade. It also has more annual earnings than debt, and has had only two minor EPS dips over the past decade. Overall, it earns an 86% score from the Buffett approach.

The Coca-Cola Company (NYSE:KO): Coca-Cola, another longtime Berkshire holding, has an extensive distribution network, which reaches just about anywhere in the world, which Morningstar says is its competitive advantage. But just as important, I would say, is its incredible name recognition. Coke has become such a part of our culture and lexicon that many people even refer to any dark-colored soda, be it Coca-Cola-made or not, as "a Coke". That sort of brand recognition is something that's nearly impossible for upstarts to compete with.

Coca-Cola's moat shows up clearly in its fundamentals, and it earns a 92% score from my Buffett-based model. Over the past decade, it's averaged a 30.8% ROE and and 26.5% ROTC. Throw in manageable debt (it has enough annual earnings to pay off all debt in just over a year) and persistent EPS growth (EPS have declined only once in the past decade), and you've got a quintessential wide-moat "Buffett-type" stock.

Disclosure: I am long ORCL, KO.