The 5 Key Signs of an Economic Moat

In spite of a dozen years of sideways markets that have just about ground the philosophy of buy and hold into the dust, Warren Buffett's purchase decisions are still able to turn a thousand heads. Investors know that what really interests Buffett are companies with 'durable competitive advantages' which promise enduring high returns on capital and free cashflow in his pocket.

By upping his stake in Tesco (LON:TSCO) last week Buffett was signalling his confidence in the longevity of its advantage especially as the argument for Tesco's investment case on valuation grounds alone is perhaps only moderate.

So how can we as investors learn to spot companies with durable competitive advantages?

What is a durable competitive advantage?

Buffett likened businesses to castles at risk of siege from competitors and the marketplace. Great companies are able to dig deep economic moats around their castles that become increasingly impregnable to competition and market pressures. These moats bring either pricing power or cost reductions which help sustain very high returns on capital, leading to higher cashflows and returns for investors. Clearly everyone would like to own a business with a wide economic moat but Buffett has been most systematic in tracking them down.

How to think about Economic Moats

One of the best books on the subject is very small and easily digestable - "The Little Book that Builds Wealth" by Pat Dorsey of Morningstar - and comes extremely highly recommended. Morningstar have developed the concept of an economic moat into a structured framework. Essentially 'wide' moat businesses have one of 2 attributes - high pricing power or low cost advantages - which in turn lead to sustainably high margins and returns on capital investe. These advantages can be split into the following categories…

1. Intangible Assets

Intangibles are basically things you can't see - i.e. Brands, Patents and Regulatory approvals rather than tangible assets like factories or distribution systems. Intangible assets can be unique to companies and deliver fantastic pricing power.

• Brands - While Brands are a dime a dozen these days, not all give the owner the ability to price at a premium. While Coca Cola may be able to charge a fortune for sugared water, French Connection can't charge a premium for its bargain bucket fashions. Be careful and pick only premium brands.
• Patents - think Viagra while it lasted [sic]. Effective Patents of great products are a licence to print money as they provide monopoly conditions. But patent lawyers are not poor, and litigation can be rife… so be careful. Patents also expire, so watch out for single patent companies.
• Regulatory Approvals - excellent returns can be found in such eclectica as waste disposal sites, credit rating agencies or financial services firms. Look for big barriers to entry due to high regulatory hurdles which can lead to pricing power.

2. Switching Costs

Banks historically have been able to charge nosebleed fees to their customers because people just can't be bothered with the hassle of switching banks. Similarly costs of switching are high for companies or individuals that rely on integrated software - data processing, tax or accounting can be great businesses (e.g. Sage (LON:SGE) , Intuit).

3. Network Effects

This is a form of switching effect that is so powerful it deserves its own category. Think about Ebay and the fact that no other auction site can compete, or Facebook in the social graph. But its not just internet companies. Credit Card companies like Visa or Amex with millions of pay points benefit from massive network effects as does Microsoft with a virtual monopoly in office software due to the fact that everyone needs to open .doc and .xls files. But watch out - network effects can break down - witness falling margins in stock exchanges as new competition enters.

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4. Cost Advantages

When considering investing in an industry always consider whether there are easily available substitutes as a company's cost advantage can be small or temporary - witness the poor economics in Airlines, Autos or microchips. But cost advantages can be sustained for a long time in certain situations - Dorsey discusses four sources - cheap process, better location, unique assets and scale benefits…

•  Cheaper Processes  - While some companies (think Dell or Southwest Airlines) have been able to carve out unseemly profits due to a better process, Dorsey cautions that they are not as enduring as other moats. A company like ASOS (LON:ASC) may be winning with web savvy marketing at present, but it may not last!

• Location, Location, Location - Think quarries, waste haulage and local steel mills. Heavy, cheap products are best in local networks as competitors can't ship in products to compete economically - gravel can be a better business than liquid natural gas due to the low value to weight ratio.

• Unique Assets - If you can own commodity assets with lower extraction costs than any other competitor then obviously you'll have a great moat.

5. Greater Scale

Dorsey describes scale as the king of cost advantages and breaks it further down into distribution, manufacturing and niche markets.

• Distribution Networks - Industries with higher fixed costs relative to variable costs tend to be more consolidated - think Fedex vs Estate Agents. Any guy with a phone can be an estate agent but you can't easily compete with a national parcel distribution network! Half full vans cover fixed costs so additional parcels go straight to bottom line, difficult to compete with.

• Manufacturing Scale - Massive upstream oil refining scale at Exxon Mobil is an example. But its also evident in massive sales distribution networks - for example in marketing video games. Electronic Arts can spread the cost of developing a game over a massive sales network. British Sky Broadcasting (LON:BSY) in the UK can dominate its rivals with massive subscriber network and the satellite dish switching cost.

• Niche Markets - Small niche markets, like local cable networks, or school software can also be incredibly profitable niches.

How can you screen for economic moats?

We've been thinking hard about how to screen for economics moats as part of Stockopedia Pro. The most obvious financial sign of an economic moat is the ability to generate a higher rate of free cash flow. This is the cash generated by the business after all capital expenditures (factory improvements etc) have been paid off. Effectively, this is cash in the pocket of the firm which can either be reinvested or paid out in dividends. Valuation 101 shows that a company is only worth the present value of its future cashflow so the higher the rate of cashflow generation, the higher the value of the company. If free cashflow to sales is 5% or greater you may have found a company that can print money.

Warren Buffett also looks to companies that can generate high sustainable returns on capital and returns on equity compared with their peer group. Returns of 12% and higher on a long term basis may indicate a company with pricing power or cost advantages. The Dupont Formula shows that higher ROE can be due either high profit margins, high asset turnover or from high leverage - make sure a high ROE isn't just coming from high leverage!

Caution 1: False Moats

There are a few busines attributes that you should be aware of that are potentially false moats… beware of companies that promote their great management, great execution, great products and big market share. These attributes do not bring a sustainable advantage on their own. The history of business is littered with the wrecks of companies with false moats - RBS (Fred the Shred), Palm Pilots (Product), Kodak/Blackberry (Market Share) to name a few.

Caution 2: Steer clear of industries with bad economics

Investing is a game of odds, and investors should take another leaf out of Buffett's book by playing the game of the 'Snowball'. If you invest in an industry with good economics you are far more likely to end up a winner as the odds are more stacked in your favour.

Dorsey highlights that far wider economic moats are found in industries like Media, Healthcare, Business Services, Asset Management, Consumer Goods and Software than in industries with occasionally brutally awful economics like Hardware, Industrial Materials and Retail (switching costs too low!).

Bet rarely, bet heavily...

The stock market allows you to play any strategy you like from trying to pick growth stars to going after turnaround 'cigar butt' stocks. But many of these strategies only shine temporarily and year to year market stars have a tendency to burn out. Transaction costs will kill your returns. Buffett has shown that choosing only to invest in easily understood companies with durable moats at favourable prices is the best route to investment success, as the miracle of compounding does the rest of the hard work for you.

The trouble is these companies can be very rare and hard to find. Which companies do you know in the UK market that have the above attributes? And at what price are they bargains? Let me know in the comments below.