Warren Buffett has made many meaningful contributions to the world of investment strategy throughout his long, illustrious career. But the greatest may be his development of the “enduring moat” (or “durable competitive advantage”) concept. “The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns,” he wrote while discussing the idea in his 2007 letter to Berkshire Hathaway (NYSE:BRK.A) shareholders. “A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.”
Just what did Buffett mean? Well, a moat — which can come in several shapes and forms — is an advantage that makes it difficult, if not impossible, for other companies to move in on a firm’s business turf. One type of moat that Buffett has cited, for example, is a powerful brand name. Take Coca-Cola. The company is one of the (if not the) best-known brands in the world, and its famed cola has become enmeshed in our culture and lexicon. A new startup could have unlimited funds and one of the best managers in the world, and it still likely couldn’t supplant Coca-Cola as one of the world’s leading beverage companies; the Coke brand’s tentacles are simply spread too deeply into the global consumer psyche.
Other types of moats include being the low-cost producer in an industry. Berkshire investments such as Geico fit that bill. And in some cases a moat can be built by exceptional product quality, as is the case with FlightSafety, a pilot training program Berkshire owns. Buffett says FlightSafety is known for being the best at what it does – and when you’re learning to fly a plane, quality comes above all else.
While Buffett (upon whom I base one of my Guru Strategies) has popularized the “moat” concept, he isn’t the only guru who targeted moat-encircled companies. Kenneth Fisher, whose book Super Stocks is the basis for another of my strategies, wrote that the “super companies” he looked for needed to have an “unfair advantage” – that is, “a competitive superiority over all current or potential competitors,” which can come from a powerful brand name, status as the industry’s low-cost producer, or a patent on a particular product or technology.
Hedge fund guru Joel Greenblatt, whose Little Book that Beats the Market is the basis for another of my models, similarly talks about a “special advantage,” one that keeps competitors from destroying a firm’s ability to earn strong profits. Examples of such advantages, he says, are strong brand names, excellent competitive position, or a new top-notch product.
Finding firms with an enduring/unfair/special advantage may seem to have little to do with quantitative analysis, and more to do with a very subjective assessment of products and services and consumers’ mindsets. But according to Buffett, Fisher, and Greenblatt, that’s not entirely true. Each has said this sort of business advantage often manifests itself in metrics that you can find on a balance sheet, income statement, or a stock’s fundamentals.
Buffett, for example, sees high returns on equity (those over 15%) as a sign of a durable competitive advantage, his former daughter-in-law and colleague Mary Buffett wrote in her book Buffettology. Fisher said profit margins are a key sign that a firm has an “unfair advantage” and said “super companies” average net three-year profit margins of at least 5%. And Greenblatt says high returns on capital are a sign a company enjoys a “special advantage” over its peers.
What that means is that, despite the title of Greenblatt’s book, good quantitative stock-picking strategies are anything but magic. The numbers work not because of some mathematical hocus-pocus, but instead because they measure very real business concepts. And, as all the gurus I follow knew, a good business is at the heart of a winning stock.
So what companies currently have the numbers that indicate they have economic moats? Here are a handful that my Guru Strategies think look good.
Winnebago Industries, Inc. (NYSE:WGO): This Iowa-based manufacturer of recreation vehicles makes motor homes, travel trailers and fifth wheel products. Its motor home and towable dealer organization in the U.S. and Canada include approximately 269 and 216 dealer locations, respectively.
Winnebago has a powerful brand name — in fact, just as many people refer to any dark-colored cola as a “Coke”, people sometimes refer to any mobile home as a “Winnebago”, regardless of who makes it. Its competitive advantage shows up in its fundamentals. The firm has averaged three-year net profit margins of 5.5%, impressing the Fisher-based model. The strategy also likes Winnebago’s 50.25% long-term inflation-adjusted earnings per share growth rate, lack of any long-term debt, and 0.66 price/sales ratio.
Winnebago also has a 24.6% return on capital using the Greenblatt method, which ranks among the top 10% of stocks in the market.
Gap Inc. (NYSE:GPS): This clothing retailer operates worldwide under the Gap, Banana Republic, Old Navy, Piperlime, Athleta and Intermix brands. Those strong brand names help give it an economic moat, as do cost efficiencies that come from economies of scale, according to Morningstar analysts. The stock gets strong interest from the Greenblatt-based model, in part because of its 41% return on capital (determined by dividing earnings before interest and taxes by enterprise value), and in part because of its 12.5% earnings yield (using EBIT/enterprise value). It has also averaged a 25% return on equity over the past decade, and net profit margins of 7% over the past 3 years.
Kellogg Company (NYSE:K): This Michigan-based food giant counts among its well-known brands and products the likes of Rice Krispies, Cheez-It, Keebler, Eggo, and Pringles. Those brands have helped it average a 43.2% ROE over the past decade, part of the reason it gets strong interest from my Buffett-inspired model. The strategy also likes that Kellogg has upped earnings per share in all but one year of the past decade and has a reasonable level of debt — $6 billion versus $1.7 billion in annual earnings. Kellogg also has a stellar 75% return on capital using the Greenblatt method, and average three-year net profit margins of 8.5%.
C.R. Bard (NYSE:BCR): New Jersey-based Bard is a multinational manufacturer of medical technologies, focusing on the fields of vascular, urology, oncology and surgical specialty products. Bard ($12 billion market cap) “has dug a narrow moat through its diverse portfolio of differentiated products and the patents that protect its innovations”, according to Morningstar analysts. The numbers reflect that. It has a 67% return on capital using the Greenblatt method (which also likes the stock’s 12.1% earnings yield and has strong interest in Bard). My Buffett-inspired model has some interest in the stock, thanks in part to its 22.5% average return on equity over the past decade. In addition, Bard has three-year average net profit margins of more than 17%.
Coach, Inc. (NYSE:COH): Another big-name retailer, this handbag and luxury goods specialist’s shares have struggled in 2014. But it still has an economic moat because of its “brand history and the extensive, directly operated, and wholesale distribution network”, according to Morningstar. And again, the numbers back it up. Coach’s three-year average net profit margins are nearly 20%, for example. It gets some interest from my Buffett-based model, in part because it has averaged a return on equity of more than 38% over the past decade. And it gets strong interest from the Greenblatt-based model, in part because of its stellar 39% return on capital.
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