Stockopedia: how to find companies with the strongest ‘moats’

Warren Buffett’s idea of spotting firms with a durable competitive edge still holds water.

It’s that time of year when the eyes of the investment industry - and savers with money to invest - begin turning to ISA season.

Early April is the moment when the tax-free savings allowance for the current year expires, and next-year’s allowance kicks off. But the run-up this year comes at an uncertain time for the UK’s economic outlook.

The UK stock markets have got off to a decent start in 2021, but there is little doubt that the Covid-19 pandemic will continue to affect many companies for some time yet. So how should investors position themselves?

A theme we often cover in this column is the idea of focusing on quality in both good times and bad. And one way of doing that is to consider the idea of ‘economic moats’, and how companies with durable competitive advantages can not just protect themselves but deliver bumper returns to boot.

Recognising what makes a moat

The legendary billionaire investor Warren Buffett, is credited for the concept of competitive economic moats. In the past, he has often mentioned the idea of finding and holding good quality firms that generate high returns on capital and are well-protected from competition.

This idea is captured by the fund manager and former Morningstar analyst Pat Dorsey, in his publication The Little Book that Builds Wealth: “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 cashflows 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.”

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There are a handful of characteristics that can be clues to companies with durable competitive advantages. They may be able to operate at low cost and pass those savings on to customers. They may also have powerful brands (or patents) that consumers recognise and identify with.

Alternatively, companies that enjoy huge 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.

Screening for durable companies

In practice, there are a lot of qualitative assessments in deciding whether a firm has a moat. It’s not quite so easy to see one just through the lens of a set of accounts. Even so, there are aspects of company moats that can be seen 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).

This screen takes those principles and uses a set of rules that could be useful in the hunt for company moats in market conditions that are far from normal. The rules include:

• Companies in the top 20% 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.

Here are some of the results:

You can see from the list that this approach captures shares right across the market-cap range - from small-caps such as Best of the Best, Bioventix and Sylvania Platinum to much larger companies such as Rightmove, Games Workshop and Auto Trader.

In common, these stocks have strong average profitability over the medium term, supported by solid margins and high levels of free cash flow. The trade-off is that their valuations can become high in places.

If you are planning to be investing in the market in and around the forthcoming ISA season, thinking in terms of moats could be helpful.

A look at company financials can offer a pretty good idea of which companies have signs of durable financial and business quality. It’s important to be wary of moats that might be a mirage, but a strategy that looks for firms with a track record of generating strong, sustainable returns is a solid start.