Seeking Alpha

How To Track Down The Strongest Company Moats This ISA Season

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Includes: BURBY, DEO, HRGLY, IGGHY, MNSKY, PSMMY, RELX, RNSHY, RTMVY, RTOXY, VTXPY
by: Stockopedia

With the end of the tax year around the corner, the eyes of the UK investment industry are all on ISA season. It's the time when the tax-free savings allowance for the current year expires, and next-year's allowance kicks off.

For some investors, it will be imperative to get funds invested quickly. But for others, there will be no rush. Last year, ISA season coincided with benign market conditions that were kind to equities. But this year, it comes after a modest pullback in index prices. For some, that's heightened a sense of uncertainty about the direction markets will go in this year.

One of the themes that I've previously covered at ISA season is the idea of economic moats. Companies with durable moat-like features tend to be sought after. With strong competitive advantages, the idea is that they can compound returns fairly reliably over many years. But while moats are quite easy to define, it's not quite so easy to be definitive about which companies actually have them.

What makes a moat?

It's Warren Buffett who takes credit for the concept of moats. He often mentions the idea of finding and holding good quality firms that generate high returns on capital and are well-protected from competition.

In his 2007 letter to Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) shareholders, Buffett explained:

"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) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with "Roman Candles," companies whose moats proved illusory and were soon crossed."

Low cost and powerful brands (or patents) are two characteristics of firms with defendable businesses, but there are others.

Sheer scale in areas like manufacturing and distribution can be very hard for other companies to compete with. Switching costs are another major factor. When customers are turned off by the hassle of changing from one product or service to another, then that can be a sign of a strong moat. Likewise, some services have a network effect, where they become more valuable as more and more people use them, which again can be a powerful moat.

In his book, The Little Book that Builds Wealth, Pat Dorsey, a fund manager and former Morningstar analyst, explained the appeal of these features. "The company with the moat is worth more today because it will generate economic profits for a longer stretch of time. When you buy shares of the company with the moat, you're buying a stream of cash flows that is protected from competition for many years. It's like paying more for a car that you can drive for a decade versus a clunker that's likely to conk out in a few years."

Screening for durable companies

By definition, there's a lot of qualitative assessment in figuring out whether a firm has a moat or not. It's not quite so easy to see one just through the lens of a set of accounts. But having said that, there are aspects of company moats that can materialise in the numbers.

For a start, you'd expect durable businesses to have high levels of free cash flow as a percentage of their sales. You might also expect to see high operating margins and an ability to produce strong, stable returns from invested capital, which can be seen in measures like return on capital employed (ROCE), return on equity and return on assets (ROA).

My FTSE 350 Moat Screen take these principles and uses a set of rules that could be useful in the hunt for company moats. The rules include:

  • Companies in the top 20 percent of the market based on their percentage of free cash flow to sales.

  • A minimum average 10% return on capital employed and return on equity over five years.

  • Companies producing above average operating margins in their respective sectors over five years.

The list is sorted 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).

Name

Forecast P/E Ratio

Forecast Yield pc

FCF/ Sales pc

ROCE % 5y Avg

ROE % 5y Avg

Quality Rank

Burberry (OTCPK:BURBY)

20.7

2.58

19.2

26.9

24.2

99

Victrex (OTC:VTXPY)

19.1

4.91

34.8

25.8

23.5

99

Rotork (OTCPK:RTOXY)

24.3

2.06

16.5

28.7

26.7

98

Jupiter Fund Management

13.6

6.42

41.2

26.4

22.1

98

Renishaw (OTC:RNSHY)

26.8

1.26

16.4

21.6

24.4

98

Persimmon (OTCPK:PSMMY)

9.75

6.78

23.6

21.3

20.7

98

Hargreaves Lansdown (OTCPK:HRGLY)

30.0

2.71

52.2

88.5

75.1

97

Diageo (NYSE:DEO)

19.6

2.89

21.2

15.5

32.3

97

Relx (NYSE:RELX)

16.9

2.94

20.3

21.4

52.1

97

IG (OTCQX:IGGHY)

15.1

4.81

37.0

32.3

26.1

96

Having covered moats a few times in recent years, one of the encouraging aspects of this strategy is just how stable the results tend to be. Whether they've each got justifiable moats is debatable, but these companies do have appealing characteristics. Burberry, Jupiter, Hargreaves Lansdown, Diageo, Relx and IG often make this screen.

Plus it's just as interesting to see what isn't here as what is. Moneysupermarket (OTC:MNSKY), which unsettled some investors recently, has often rated highly on this screen, but it only just misses out (at number 11). That's followed by Rightmove (OTCPK:RTMVY), another moat-like business, at number 12.

In search of quality

Whether or not you see ISA season as a cause to dive into the market, or whether you're simply reviewing an existing portfolio, thinking in terms of moats could be helpful. While there's almost a whole industry that revolves around this approach, a look at company financials can offer a pretty good idea of which companies have the genuine signs of durable financial and business quality. It's important to be wary of moats that might be a mirage, but orienting around a strategy that looks for firms with a track record of generating strong, sustainable returns sounds like a reasonable idea.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.