Building A Moat System

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Includes: ADBE, CRM, D, DUK, EXC, MSFT, NEE, ORCL, SAP, SO, XLU
by: Brad Kenagy

Summary

I recently read an article about a system to measure a moat through financial ratios.

I found the idea intriguing, so I created my own moat rating system.

My moat system compares a company to other competing companies in the same sector/industry.

I recently read an article titled: Can 20 Financial Ratios Measure A Company's Moat Just Like Morningstar? I thought the premise was interesting and I wanted to include my thoughts and methods in trying to determine if a company has a moat or not. While the article was intriguing there was one major flaw I found. The flaw can be explained by looking at the prominent example of Southern Company (NYSE:SO), which scored poorly on the authors moat scale.

The author used a 0-5 rating scale for a number of financial metrics and calculated scores for 98 dividend paying companies. The one major flaw in this system is there was no separation by sector/industry. I do not believe calculating a score for Southern Company when at the same time calculating a score for a technology company like Microsoft (NASDAQ:MSFT) and comparing the two as well as other companies is effective in determining if a company has a moat. Both have vastly different profitability profiles, capital needs, etc. The best way to see if a company has a moat in my opinion is to compare that company to other companies in the same sector/industry.

My Moat System

For my system of determining if a company has a moat, I looked at eight financial metrics, some of which are ones I created. I compared lists of five companies at a time, which are the leaders in their respective sector/industry.

  • Metric #1: Did revenue increase y/y? If Yes: Company Scores 5 points, If No: Company Scores 0 Points.

  • Metric #2: Gross margin rank. I scored companies 1-5 based on their gross margin rank.

  • Metric #3: (R&D + CAPEX) / Market Cap. I scored companies 1-5 based on their (R&D + CAPEX) / Market Cap ratio. I included this metric because if companies spend on R&D and CAPEX there is an increased chance that they will be able to maintain their advantage.

  • Metric #4: Operating margin rank. I scored companies 1-5 based on their operating margin rank.

  • Metric #5: (Int. Exp. + ST Debt) / Operating Income. I scored companies 1-5 based on their (Int. Exp. + ST Debt) / Operating Income ratio. I included this metric because if companies have to spend a large percentage of their income towards interest on debt or debt coming due in the short-term, this can take away from growth opportunities.

  • Metric #6: Debt/Equity. I scored companies 1-5 based on their debt/equity rank.

  • Metric #7: Did retained earnings increase? If Yes: Company Scores 5 points, If No: Company Scores 0 Points. I included this because if retained earnings are increasing that means the company has more earnings available to reinvest in the underlying business.

  • Metric #8: (Intangible Assets - Goodwill) / Market Cap. I scored companies 1-5 based on their (Intangible Assets - Goodwill) / Market Cap ratio. I included this metric because it takes into account items like patents, which can help a company maintain a moat.

Ratings Scale

For my system the best score possible is 40 and the worst score possible is 6. The table below shows how I classify each score in terms of where they lie on my moat scale.

Min

Max

Very Wide

34

40

Wide

28

33

Neutral

23

27

Narrow

12

22

Very Narrow

6

11

Example #1: Software & Services

For my first example, I will be comparing five large software & services companies to each other. The five companies I will be comparing are Adobe (NASDAQ:ADBE), Microsoft , Oracle (NYSE:ORCL), SAP (NYSE:SAP) and Salesforce (NYSE:CRM). Since I do not want to clog up the article with eight tables of data covering my metrics, I will provide a link here.

The table below shows the results of putting the companies through my moat test and the score each company received. Out of this group of software & services companies, Oracle has the highest moat score. What really surprised me was how low of a score Microsoft received. Microsoft score low on my rating system because they had the lowest margins in the group, they have a large amount of debt coming due in the next year and they have been using earnings to repurchase shares, which has caused retained earnings to decline for multiple years in a row.

Test

ADBE

MSFT

ORCL

SAP

CRM

Rev > Rev 1 yr

5

5

5

5

5

Gross Margin Rank

5

1

4

2

3

R&D + Capex

1

4

5

3

2

Operating Margin

4

2

5

3

1

Int Exp + CP LT Debt

5

1

3

4

2

Debt/Equity

4

1

2

5

3

Retained earnings Change

5

0

5

5

5

Intangibles

1

2

5

4

3

Score

30

16

34

31

24

Moat Rating

Wide

Narrow

Very wide

Wide

Neutral

Example #2: Utilities

I compared the five largest utilities in the Utilities Select Sector SPDR ETF (NYSEARCA:XLU) to see which one would have the highest moat score using my system. The five largest companies in the XLU are NextEra Energy (NYSE:NEE), Duke Energy (NYSE:DUK), Southern Company, Dominion Resources (NYSE:D) and Exelon (NYSE:EXC). As I did for my first example, here is a link to the data I used in making in the following table. As you can see, Dominion Resources slightly beat out Southern Company for the top company in this group.

Test

NEE

DUK

SO

D

EXC

Rev > Rev 1 yr

0

0

5

5

5

Gross Margin Rank

4

2

3

5

1

R&D + Capex

1

2

4

3

5

Operating Margin

4

3

2

5

1

Int Exp + CP LT Debt

5

3

2

1

4

Debt/Equity

4

5

2

1

3

Retained earnings Change

5

0

5

5

0

Intangibles

4

4

5

4

4

Score

27

19

28

29

23

Moat Rating

Neutral

Narrow

Wide

Wide

Neutral

Closing Thoughts

In closing, I believe my moat system is a tool that can be used as one part of the process in determining if a company has a moat. While I know it my moat system is not perfect by any means, I believe it is a step in the right direction. I believe comparing companies by sector/industry in this case is effective.

Disclaimer: See here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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