Seeking Moats And Durable Competitive Advantages

by: Alex Rasmussen

Over the long haul value creation comes down to one simple thing: continuing to maintain above average returns on invested capital. Put a dollar in and get more than a dollar out. Many companies can do this for a short while but then the forces of capitalism either erode market share, shrink margins, or make their demand for their product or service wane.

Mr. Buffett has given us significant insights into how to identify companies with durable competitive advantages and economic moats. Over decades of letters of shareholders have given us a checklist of sorts to refer to. I have screened for companies that get by this checklist and included the results below.

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Profitability is much more important to value investors than growth (or at least it should be!). Even the father of growth investing, Phil Fisher, emphasizes the importance of investing in companies with industry leading margins. These firms can handle downturns in the economy better and still participate during bull markets. I believe this is one of the single greatest insights in investing. It is reflective in Buffett's own investing history. If you do some analysis, you'll notice the majority of his outperformance comes when markets get creamed and his portfolio manages to tread water. It's not by coincidence; it's because of the types of companies he buys.

So to identify profitability the most important metrics are margins (gross and net), SG&A as a percentage of gross income, interest expense as a percentage of gross income, and returns on invested capital. We don't want to buy labour intensive companies nor companies that need to pay a significant portion of their income out in interest to finance growth.

Analysis of Results

From the list, I have liked Freeport (NYSE:FCX) in the past. It depends on your appetite for the copper market. As opposed to Cliff's (NYSE:CLF) in the iron ore market, I actually like the outlook. Southern (NYSE:SCCO) also pops up on my screen quite a bit.

There's a reason Buffett doesn't buy many commodity businesses - you are always paranoid about where we are in the economic cycle as well as if margins can be maintained (the price of the underlying). Jeremy Grantham is a super smart guy and very bullish on certain resources, including potash via Potash Corp. (NYSE:POT). CF Industries (NYSE:CF) may offer similar value. Again, it all depends on your view of the underlying commodity.

I own Contango (NYSEMKT:MCF) as my favourite natural gas play, but many hedge funds have been choosing the larger Occidental Petroleum (NYSE:OXY) for it's large natural gas exposure. I don't know the company in-depth, but this seems like a great play at the moment, with natural gas rallying and the long term fundamentals looking good.

I was close to pulling the trigger on Infosys (NASDAQ:INFY), but ultimately the space is too crowded. I also am not a fan of the business and believe jobs will come back to the U.S at some point. The outsourcing trend isn't fully sustainable, in my view. As well, the fierce competition with larger firms like IBM is a big negative.

Apple (NASDAQ:AAPL) is a puzzle in itself. It is undervalued. The problem is that I don't know if I can put my money in at this point, with the best case outlook being a double over the next 2-3 years. That being said, I'd have to agree with Whitney Tilson - people still don't understand Apple.

Haven't done my due diligence on Techne (NASDAQ:TECH), but it is constantly on my screen when looking for moats and DCAs. It requires more work, but I'm loving it from the bottom up so far.

I've been wanting to buy McDonalds (NYSE:MCD) for months now. I'm sticking to my disciplined buy price (has to be below $80) but I think it has to be up there as the best dividend growth story in the market. How it has managed to come under fire and completely upgrade its store design, menu, and ultimately steal market share like crazy is awesome.

Lastly (and most importantly), is Baidu (NASDAQ:BIDU). I keep thinking about this one. At a 40B market cap give or take, I just keep wondering what it will be worth in 5 years. The key here is that the question is what will it be worth, not if it will be struggling or losing market share. This is a true leader, it owns its space, and it makes a ton of money. I think it could easily be over 100B market cap in 2-3 years. Unfortunately, I have modeled its growth very carefully and the market is pricing it to perfection. Below are my inputs and resulting valuation.

My valuation came within 1% of the current quotation. That doesn't mean I'm right, and it certainly doesn't mean the market is right, but that close a connection gives you pause. I am sticking to my disciplined buy price of $86 based on the margin of safety I would demand in owning a Chinese company that does not offer a dividend. I'm hoping that sellers on Chinese growth fears will push this below $90.

Happy investing, and keep seeking moats and DCAs.

Disclosure: I am long MCF.