A Quantitative Approach To Finding Wide-Moat Stocks
Summary
- Unarguably, companies with moats generate superior shareholder returns over the long run.
- But what is the easy way to identify and verify wide-moat stocks?
- Here is a quantitative approach along with a few picks.
In one of the previous articles, we focused on the importance and characteristics of moats when it comes to stock investing: by keeping the competition away, companies with wide moats are able to consistently capture a great portion of their economic value, and hence, generate superior returns for their shareholders over the long haul; a truly high-quality stock should possess a wide moat, demonstrating one or preferably a combination of such characteristics as brand power, network effect, economies of scale, proprietary technology.
In reality, investors (especially those individual ones) often find it time-consuming to evaluate and difficult to predict the competitive advantage of businesses one by one, and the qualitative analysis of economic moats is subjective and error-prone. Hence, we would like to introduce the quantitative approach consisting of several easy-to-get metrics for investors to filter out wide-moat stocks or as a sanity check to verify pre-determined moat width.
Return on Equity (or Return on Invested Capital)
Warren Buffett often uses consistently above average return on equity (ROE) as his favorite indicator for wide-moat stocks. ROE intuitively tells how efficient the management allocates equity capital (on behalf of shareholders) to generate returns.
A company with high leverage typically will have much higher ROE than a company with no leverage, but this advantage is a result of the capital structure instead of actual business performance. At the end of the day, debt can work for or against you (as equity investors), depending on whether management turns that money into reasonable profits. Therefore, ROE may give you a false picture. Instead, we believe that return on invested capital (ROIC) is a much better alternative performance metric to find quality investments as it measures the return on all invested capital, including the debt-financed capital.
Businesses with high capital efficiency over a long period demonstrate clear competitive advantages. Meanwhile, according to a study conducted by McKinsey & Company on publicly traded American businesses, we see a small level of decay at a slow pace for ROIC (see the chart below). For instance, top performing firms returning 25% or more returns on invested capital would very likely see their ROIC persist at above 15% (vs. average ROIC of 10% among U.S. companies) over the very long run. Therefore, a stock with a high ROIC (or high ROE with reasonable debt level) should be very likely possessing one or more durable competitive advantages.
Source: Valuation by McKinsey & Company.
Margins
First of all, gross margin represents the difference between the price charged to customers and the price paid to suppliers and workers to create and transport the product. This margin could indicate above-inflation pricing power, low-cost production and/or strong branding. We believe a consistent (under various economic conditions), high, and improving gross margin is strong evidence of a wide moat.Secondly, operating margin is dependent on the ability of companies to generate the revenue they generate while minimizing administrative and other costs not included in calculating gross margin. Companies with wide moats should be able to hold operating margin very steady, or actually improve as revenues grow, implying potential low-cost production due to economies of scales (as operating costs grow slower than revenues).
Lastly, net margin is all about management's overall performance, taking all other costs, such as debt, into consideration. A business moat should also lead to a fairly consistent, high, and preferably expanding net margin.
Capital Intensity
Low capital intensity means the company has consistently used a small portion of their net income (or operating cash flow) buying new equipment or investing in new facilities. This is a strong sign of economic moat, indicating that the business may require minimal investment to stay competitive and leave more free cash flow on the table for investors.
Historical Growth
A company with almost uninterrupted growth over at least a full economic cycle should also demonstrate resilience to economic downturns and competitions, and therefore, a possible strong economic moat. Here, long-term consistency should be more valued than high growth rate alone, as research shows that businesses with high current growth rate would very likely decelerate a lot over the next couple of years. Check out below the same study conducted by McKinsey & Company on the growth rate of publicly-traded American businesses.
Source: Valuation by McKinsey & Company.
Screening
In order to screen for stocks with moats, we set the following filters based on the qualitative approach discussed above:
- Return on Equity: consistently above 20% for the past 10 years;
- Return on Invested Capital: consistently above 15% for the past 10 years;
- Cash Return on Invested Capital: currently above 10%;
- Return on Tangible Equity: currently above 20%;
- Operating Margin: consistently above 12% for the past 10 years;
- Net Margin: consistently above 5% for the past 10 years;
- Gross Margin: consistently above 15% for the past 10 years;
- Earnings Growth: earnings growth at -5% or less happened at most once during the past 10 years;
- Capital Intensity: used at most 50% on average of operating cash flow for CapEx for the past three years.
The screening results in the following list of 10 picks:
| 1-yr Performance | 5-yr Performance | |
| NetEase (NTES) | 2.67% | 425.86% |
| Tencent (OTCPK:TCEHY) (OTCPK:TCTZF) | 82.44% | 732.66% |
| Novo Nordisk (NVO) | 36.62% | 46.58% |
| FactSet Research (FDS) | 22.83% | 116.22% |
| Clorox (CLX) | -1.2% | 49.97% |
| Novozymes (OTCPK:NVZMY) (OTCPK:NVZMF) | 32.58% | 45.68% |
| Mettler-Toledo International (MTD) | 20.66% | 171.91% |
| Infosys (INFY) | 15.98% | 65.58% |
| AutoZone (AZO) | -6.89% | 64.82% |
| IDEXX Laboratories (IDXX) | 23.38% | 331.84% |
Source: Google Finance; data as of 4/1/2018; performance excluding dividends.
If we create an equally-weighted index of all the above stocks, the index would outperform S&P 500 on the 1-year, 3-year and 5-year basis by wide margins (see below).
Source: Finbox.io; data as of 4/1/2018.
Summary
Studies show quantitative strategies often works better than qualitative methodologies when it comes to stock picking. In terms of analyzing economic moats, a quantitative approach could be easy to implement, more efficient, more objective, and hence, less error-prone, or at least as a sanity check on the top of traditional fundamental analysis. Investors can examine company's return metrics, margins, capital intensity and growth history in order to screen for wide-moat candidates.
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.
This article was written by
Analyst’s Disclosure: I am/we are long NTES, TCEHY, NVO, FDS, CLX, NVZMY, INFY. 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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