Value Investing

5 Ways to Identify Strong Economic Moats

By Daniel Sparks

I don’t know about you, but I never get tired of hearing about Warren Buffett. He’s central to the value investor community, and there’s good reason for that. He merged Fisher’s growth investing with Graham’s margin of safety. Also from Graham, he adopted the “Mr. Market” approach to thinking about the stock market. Finally, Munger brought the final touches to Buffett’s investing: a resolute determination to invest in only wonderful companies even if they have to be bought at fair prices.

But there was a Buffett original that emerged from all this: the economic moat. This criterion is what allows Buffett to rephrase Fisher: “Our favorite holding period is forever.” An economic moat represents some sort of protection of business cash flows. In other words, businesses with economic moats have sustainability.

A Competitive Advantage is Different from an Economic Moat

There is a great distinction between the typical competitive advantage and a wide economic moat.

A competitive advantage is any advantage that currently allows a company to earn premium margins over its competitors. But an economic moat is a sustainable competitive advantage–a competitive advantage that will last.

You can also refer to a previous article on how Buffett Interprets financial statements to identify sustainable competitive advantages.

Why are Economic Moats so Important?

Economic moats are incredibly important simply because it is impossible to estimate future cash flows without an economic moat. Sure, you can give it a shot. But there is generally too much risk associated with estimating cash flows that are not protected by a moat.

So, I follow a simple rule of thumb: If there is no economic moat, I require a significant discount to liquid-able assets. And based on this rule of thumb I can quickly throw out many of the stocks I analyze after only a few minutes. Even Buffett threw out companies without doing a full analysis:

When I started, I went through the manuals page by page. I went through 20,000 pages in the Moody’s industrial, transportation, banks and finance manuals — twice. I actually looked at every business — although I didn’t look very hard at some. – Warren Buffett (2001 Annual Letter to Shareholders).

All of this is why wide moats have become central to my entire approach to investing, from searching to researching to investing.

How to Identify Economic Moats?

Here is a list of the 5 economic moats discussed by Morningstar’s Paul Larson and some related “symptoms” to help us identify them:

1. Intangible assets: Fanatically loyal customers. Profit margins or cash returns on invested capital (CROIC) that consistently exceed the industry average or those of their competitors ($KO). Successful companies with high priced, quality products or services for decades, supported by their brand strength ($AAPL, $COH).

2. Customer Switching Costs: Products and services that are not easily abandoned for a substitute or for a competitor’s product ($ZMH).

3. Cost advantage: Meaningful economies of scale and over a decade of healthy operating and profitability ratios ($WMT, $JNJ, $MCD).

4. Networks Effect: Networks that become more useful as more people join ($EBAY).

5. Efficient Scale: Monopolies that exist for the purpose of efficiency; consistent positive free cash flow and dividend payouts ($XEL).

Also, refer to the book review on The Little Book That Builds Wealth that discusses these economic moats.

Quick, easy, and straight forward. Any of these could mean there is a moat at hand. A combination of these is even better and might mean you’ve found yourself a wide moat.

Using free cash flow (FCF) yield to to find reasonably priced, wide-moat companies

There is one crucial criteria to finding great, wide-moat investments that we have left out: Price.

Keeping an eye on free cash flow (FCF) yield or owner earnings yield is one great way to initially identify wide-moat companies that are trading relatively inexpensively. Companies that have a wide moat and trade at a FCF yield that is approaching 10% are generally in a great price range for a potential purchase.

Here is an example of 5 companies that I feel have wide moats and trade at reasonable prices:

Company Free Cash Flow Yield
Apple ($AAPL) 7.54%
Microsoft ($MSFT) 11.3%
Oracle ($ORCL) 8.17%
Abbott Laboratories ($ABT) 6.89%
Johnson & Johnson ($JNJ) 7.81%

What about you? Do you know of any great, wide-moat companies trading at decent prices?