How To Find Companies With Strong Competitive Moats

by: Stockopedia

In medieval times, castles that were best protected from sieges were those with the widest, deepest moats. On the investment battlefields of the stock market, moats are a figurative pointer to some of the strongest, most durable companies. But how do you find them?

The ‘economic moat’ is a metaphor first used by the billionaire investor Warren Buffett to describe the type of business he likes to buy. These days it’s often used as a measure of durable competitive advantage.

The idea is that a select few companies not only churn out persistently strong returns, but they have extra advantages that make it difficult for rivals to copy them. As a result, their investors can benefit from superior returns that are compounded over the long term.

What makes a moat?

One of Buffett’s examples is the American auto insurance giant Geico, which is owned by his Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) group. In recent years he’s regularly noted: “The company’s low costs create a moat – an enduring one – that competitors are unable to cross.”

In Geico’s case, the moat is the sheer scale of the business that allows it to dominate the market by operating at low cost. But moats aren’t always about size, scale and cost. They can be market leading brands or products that consumers are reluctant to stop using. Classic examples are big drinks manufacturers like Coca-Cola (NYSE:KO) and Diageo (NYSE:DEO) and FMCG companies like Reckitt Benckiser (OTCPK:RBGLY).

Sometimes they’re businesses with large distribution infrastructure that would be difficult and expensive to replicate. Others have products and services with ‘networking effects,’ which encourage customers to feel part of an exclusive club. Or they may have brands that customers closely identify with. Examples here range from Facebook (NASDAQ:FB) to Harley-Davidson (NYSE:HOG) to Apple (NASDAQ:AAPL).

In his book, The Little Book that Builds Wealth, Pat Dorsey, a fund manager and former Morningstar analyst, explained: “Just as moats around medieval castles kept the opposition at bay, economic moats protect the high returns on capital enjoyed by the world’s best companies. If you can purchase their shares as reasonable prices, you’ll build a portfolio of wonderful businesses that will greatly improve your odds of doing well in the stock market.”

Digging around for a moat

Huge amounts of research - such as this from Credit Suisse’s (NYSE:CS) Michael Mauboussin - have looked at what it really takes for a company to have a wide moat. The challenge for investors is that there isn’t a definitive way to measure one. Indeed, some stocks can mistakenly appear to have moats, while others that do can see them eroded away over time.

With that in mind, careful research is needed on a stock-by-stock basis to understand why a company may be more durable than others. But there are some screening rules that can be used to work up a potential list.

In terms of company financials, durable businesses often have high operating margins and high levels of free cash flow. They’re able to produce strong, stable returns from invested capital, which can be seen in measures like return on capital employed (ROCE) and return on equity (ROE).

We took these rules and sorted the results based on Stockopedia’s QualityRank, which takes into account long-term quality factors, balance sheet strength and any potential accounting or insolvency risk red flags - from zero (poor) to 100 (excellent). We also included the ValueRank as an indication of how expensive (or otherwise) these types of stocks can appear.

Name Yield % Rolling 1y FCF/ Sales % ROCE % 5y Avg ROE % 5y Avg Op Mgn % 5y Avg Quality Rank Value Rank
AVEVA 2.06 14.7 24.6 18.8 25.4 100 13
Taylor Wimpey 7.14 14.5 15.4 15.7 17.3 99 67
PayPoint 5.59 15.0 35.2 26.1 17.3 99 40
Wizz Air Holdings 3.21 14.6 30.3 76.2 10.2 98 95
Fresnillo 1.43 24.3 15.0 14.3 29.2 98 13
Moneysupermarket 3.39 26.3 33.1 30.8 24.0 97 30
Reckitt Benckiser 2.38 20.5 22.1 25.7 24.0 94 22
Rightmove 1.46 63.4 2,146 1,432 71.4 93 11
Sage 2.64 16.2 19.2 17.7 20.2 92 27
Hargreaves Lansdown 3.12 50.0 90.7 75.7 58.7 89 11

We periodically write about the moats ‘approach’ to the market and the top names really don’t change very much. That’s really what you’d hope or expect in a search for moat-like qualities.

This snapshot taken from the top 20 results reveals familiar names like Paypoint (OTC:PYPTY), Rightmove (OTCPK:RTMVY), Sage (OTCPK:SGPYY), Hargreaves Lansdown (OTCPK:HRGLY) and Moneysupermarket (OTC:MNSKY). These have all been consistently strong performers against these moat rules. But others are perhaps more questionable. Housebuilders like Taylor Wimpey (OTCPK:TWODY), the airline Wizz Air (OTCPK:WZZAF) and mining companies like Fresnillo (OTCPK:FNLPF) are in economically-sensitive sectors and don’t necessarily fit into the typical moat checklist, but they do have the signs of strong returns.

Since Warren Buffett first uttered the words, economic moats have captured the imagination of many investors. In the UK, even with simple rules, this approach tends to highlight some of most admired companies in the market. In terms of investment ‘factors’ these stocks are often firmly positioned as high quality, high momentum firms that we call High Flyers. They’re rarely cheap to buy, and they’re not immune from setbacks, but they can be very powerful long-term compounders.

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