Finding a Framework for Analysis: Moats

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Finding a Framework for Analysis: Moats

It’s a bit strange to think that an image typically associated with England and the Middle Ages might offer a framework for stock analysis. As we’ve already seen, in order to really think like an analyst, it’s important to consider factors beyond just the numbers. After all, our quest is to find exceptional companies delivering outstanding performance, in which case we may need to put forth extra effort to find that "Holy Grail."

One helpful concept is that of an "economic moat." And while you may not hear it used as often as terms such as P/E ratio or operating profit, the concept of an economic moat should be one guiding principle in stock analysis and valuation. Eventually the idea may gain more of a following since it is a foundation for identifying companies that create shareholder value over the long term. In the meantime, we’ll just consider ourselves lucky to have a framework that can separate really great companies from the merely good ones.

What is an economic moat?

Quite simply, an economic moat is a long-term competitive advantage that allows a company to earn oversized profits over time. The term was coined by one of our favorite investors of all time, Warren Buffett, who realized that companies that reward investors over the long term have a durable competitive advantage. Assessing that advantage involves understanding what kind of defense, or competitive barrier, the company has been able to build for itself in its industry.

Moats are important from an investment perspective because any time a company develops a useful product or service, it isn’t long before other firms try to capitalize on that opportunity by producing a similar—if not better—product. Basic economic theory says that in a perfectly competitive market, rivals will eventually eat up any excess profits earned by a successful business. In other words, competition makes it difficult for most firms to generate strong growth and profits over an extended period of time since any advantage is always at risk of imitation.

The strength and sustainability of a company’s economic moat will determine whether the firm will be able to prevent a competitor from taking business away or eroding its earnings. In many analysts’ view, companies with wide economic moats are best positioned to keep competitors at bay over the long term, but we also use the terms "narrow" and "none" to describe a company’s moat. We don’t often talk about the depth of a moat, yet it’s a good way of thinking about how much money a company can make with its advantage.

How do I tell?

To determine whether or not a company has an economic moat, follow these four steps:

1. Evaluate the firm’s historical profitability. Has the firm been able to generate a solid return on its assets and on shareholder equity? This is probably the most important component to identifying whether or not a company has a moat. While much about assessing a moat is qualitative, the bedrock of analyzing a company still relies on solid financial metrics.
2. Assuming that the firm has solid returns on its capital and is consistently profitable, try to identify the source of those profits. Is the source an advantage that only this company has, or is it one that other companies can easily imitate? The harder it is for a rival to imitate an advantage, the more likely the company has a barrier in its industry and a source of economic profit.
3. Estimate how long the company will be able to keep competitors at bay. We refer to this time period as the company’s competitive advantage period, and it can be as short as several months or as long as several decades. The longer the competitive advantage period, the wider the economic moat.
4. Think about the industry’s competitive structure. Does it have many profitable firms or is it hypercompetitive with only a few companies scrounging for the last dollar? Highly competitive industries will likely offer less attractive profit growth over the long haul.