Analyzing a Company’s Economic Moat

An economic moat protects a company from being over-run by competitors. It is not a guarantee against competitors capturing market share, but its strength can slow them down. A strong economic moat today does not mean it will last forever. In the early days of computers, IBM had a lock on most of the business. While it is still a strong company, the industry has evolved and is full of competitors. Great companies adapt to changes in technology and the market.

An economic moat is important in determining the company’s intrinsic value, because it gives you some idea of the potential long-term success of the company. As a long-term investor, you are looking for companies that can deliver value to stockholders for years to come. A strong economic moat is part of the answer to that question. Determining how a strong economic moat protects a company begins with a look at its financial health. The best way to find this information is to visit one of the websites discussed in Chapter 3, such as Morningstar, and find the following suggested indicators. The next step in analyzing a company’s economic moat is evaluating how deep and wide it is.

Strong History of Making Money

It is not enough for a company to be profitable today—you should be interested in companies that have been making money for years. Has the company been profitable in good economies and bad? Has the company grown revenue and earnings? Does the company generate a strong free cash stream? These are all signs of a company that is at the top of its market. Morningstar shows you five years on its free side and ten years on the subscription side. Ten years would be better, but five years will do.

Financial ratios are tools investors use to measure the health of a company. They are also good ways to compare one company to another and you can compare a company to its industry sector. Most ratios have some flaws, so you should never rely on a single metric.

Here are some markers of profitability:

Earnings growth. Look for companies that post year-to-year growth in earnings (an occasional hiccup during recessions is acceptable). Although this is not a perfect metric (remember accounting charges can reduce earnings), it is one you should look at. Make sure the target company is reporting earnings substantially higher than its sector (you can find these numbers in Yahoo! Finance in the stock research section). Also, compare it to major competitors.

Free cash flow. Great companies generate a lot of cash and, particularly, have a large flow of free cash. Free cash is what is left over after the company reinvests in itself to keep the business operating. Another way to think of this is how much cash you could pull out of the business without forcing a change in operations (closing plants, layoffs, and so on).

Return on assets (ROA). How efficient is the company in generating earnings? Great companies have a superior return on assets to their sector. This measure tells investors the company is using assets wisely and creating value for the owners. For example, two companies each have $100 in assets. One company uses those assets to create $5 in earnings, while the other company uses the same amount of assets to create $15 in earnings. Which would you choose to own? Compare companies in the same sector for a valid check.

Return on equity (ROE). Another way to look at a company’s profit-generating efficiency figures in how the company uses debt in addition to assets. Because most companies use some debt to run the business, it is important to take it into consideration. ROE considers how well the company uses investors’ capital and includes the debt. It is very important to compare companies in the same sector. If a company has a ROE that is much higher than its sector, be careful that something unusual isn’t boosting the number (recent acquisitions, buying back stock, and so on).

Net margin. A company’s net margin is simply net income divided by sales. What this tells you is how efficient the company is in wringing profits out of sales. Some industries (grocery stores, for example) have low net margins and must drive a lot of revenue to generate profits. Other industrial sectors have higher net margins thanks to the nature of the business (software, for example). Great companies beat sector averages and close competitors.

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Evaluating an Economic Moat’s Width and Depth

All economic moats are not created equal. Some look wide, but may be shallow, while others are narrow, but deep. Great companies have economic moats that are wide and deep, which provide the best protection and are an indication that a company has a long-term future. There are several key characteristics to look at in evaluating a moat. Admittedly, some of this is somewhat subjective. You can find comments on these topics on most of the websites I mentioned in Chapter 3 (some may use the term economic advantage instead of economic moat):

Strong products. Few companies produce anything that is unique in the market, at least not for long if there is money to be made by the product. As soon as patents expire, generic drug makers duplicate leading products. When Apple introduced the iPhone in 2007 and the iPad a few years later, it created a whole new industry. There were other similar products on the market, but these two raised the bar so high competitors could only produce wannabes for a number of years. Eventually, competitors will match Apple’s products, but in the meantime Apple is making money faster than it can count it. Apple has superior products and a hugely loyal customer base that is difficult to challenge. Great companies have products that competitors can’t match and customers keep coming back. Either one (or both) is a wide and deep moat.

Locks out competitors. A strong economic moat can lock out competitors by cutting prices to the bone, yet still provide a profit to the company. A classic example of this is Wal-Mart, which has such efficient operations and massive buying power it can, and does, prove fatal to less-efficient competitors. Another way to lock out competitors is a high cost of entering the market. It takes a tremendous amount of money to start an airline and compete with existing carriers.

Locks in customers. An economic moat can protect a company’s customer base by making it difficult or expensive for competitors to entice them away. One way to do this is make it difficult and/or expensive to switch. Cell phone providers are good at this by requiring most customers to sign a two-year agreement with a stiff penalty if they want out before two years. Banks and other financial companies want as much of your financial business (banking, loans, investing, insurance, and so on) as possible so moving your business would be difficult and inconvenient. Social media companies, such as Facebook, use networking to build a solid moat. You join because your friends and family joined and then a friend of yours joins, and so on. In early 2012, Facebook had 750 million users. Yes, a new social networking company may pop up (they do all the time), but it is hard to imagine one duplicating Facebook’s success. However, people once said the same was true of MySpace (once the dominant social media site), which has faded from relevance.

Durability of an Economic Moat

How long will an economic moat retain is protection? This is almost impossible to know for sure, but by looking at the industry where the company competes, you may be able to make a guess. We are unlikely to give up toilet paper, food, or energy anytime soon. However, moats built on cutting-edge technology may not be sustainable. Unless companies keep innovating, technology alone is not strong protection—someone is always looking for and finding a better solution. Microsoft became an economic giant on the back of its operating system, which is widely considered far from the best, but is installed on some 90 percent of personal computers. Microsoft built on this positioning by introducing a suite of office technology tools that only (at that time) ran on its operating system and are ubiquitous in businesses around the world. Other companies with durable brand names such as Coke, General Mills, and General Electric have years of consumer confidence filling their moats.

No moat exists forever or is beyond breaching. All companies, even those with the strongest brand, customer base, and financial strength must work to maintain their economic advantage. If competitors find a crack in the protection, they will exploit it.

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