Economic moats are what defend companies from attack: the bigger the moat the company's competitive advantage, essentially the better. Find a well-protected firm at a decent price and the returns should roll in for years. But what's the best way to measure a moat? Investment research firm Morningstar thinks it has the answer: you need to look for five main strengths.
1. The golden ratio
The key trait that identifies a strong firm is that its "return on invested capital" is high "relative to its cost of capital", as Morningstar's strategist Paul Larson puts it. In plain English this means that the return the business squeezes from its assets must be bigger than the cost of maintaining those assets. If a firm can only earn 5% a year (its return on invested capital, or ROIC) from assets that cost it 10% to finance (its cost of capital, or COC) via bank loans, it might as well shut up shop, sell its operating assets, and put the money in the bank.
If, however, it can earn 20% a year, with the same financing cost of 10%, then it may be a long-term winner that is, as long as it can keep it up (this is known as the sustainability of returns). The bigger the gap or "spread" between ROIC and COC, the better. So how do you calculate these two key measures?
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ROIC compares a firm's net operating profit after tax (NOPAT) to its invested capital (IC) and expresses the result as a percentage. So if NOPAT is £100m and IC is £500m, ROIC is ((100/500) x 100%) or 20%. To get NOPAT, you take the "profit before tax" figure from a profit-and-loss account, and add the interest expense back in. (This way the operational profit figure isn't distorted by the firm's decision about how it is financed say, with lots of debt, rather than shares). You then deduct a tax charge.
To get IC, you usually look for total assets deployed' on the balance sheet, then take away surplus cash and non-interest-bearing short-term payables (aka, current liabilities). Surplus cash is left out, because it isn't really deployed in earning a return. For example, many firms are currently holding cash in case a juicy acquisition comes up. As for short-term payables, this is usually the amount owed to trade suppliers for goods and services received. You leave this out because it represents the suppliers' capital being tied up in this firm, not the firm's own capital.
COC is the weighted average cost of the debt and equity funds (WACC) that are deployed by external lenders and shareholders in the business. The calculation can be fiddly but boils down to this: if a firm has £400m of debt costing 6% and £800m of shares costing 8% (a combination of the expected dividends and capital appreciation its shareholders demand) then the WACC is roughly ((400 x 6%)/1200) + ((800 x 8%)/1200), which equals 7.3%. The 8% cost of shares is often estimated using something called the CAPM (see page 37).
In short, a firm's ROIC must come in well above its WACC, and do so consistently. So what are the other four ingredients?
2. The network effect
This can be summarised as a product that sells itself, because the more people use it, the more other people want to or have to use it too. A good example is the payment network provided by the likes of Mastercard or Visa. These companies created a virtuous commercial circle in that every time a customer signs up for a card, it forces more and more retailers to accept those cards, which in turn leads more customers to want the cards. Social networking sites such as Facebook are similar as more and more people join, it becomes increasingly difficult for others who want to communicate with them to remain non-users.
3. A sticky product
The best products commercially are often those where, as an economist would say, the cost of switching once a customer has committed are high. Bank accounts are a classic case. People can and should switch accounts, but the thought of the hassle involved stops them. Equally, firms that supply, say, complex IT systems to the government often prosper because it is expensive to bring in a rival once a project is underway.
4. Cost advantage
This usually accrues to big firms. Either they can charge the same as rivals, but get a job done cheaper by leaning on suppliers and keeping overheads tight (think of Japanese car makers or British supermarket chains), or they can afford to undercut competitors to win business (a classic strategy in Tesco's Metro stores, which can put pressure on local shops by cutting the prices of mainstay items, such as bread, milk and petrol).
5. Hidden intangible strength
This is a built-in advantage that confers pricing power. Big drugs companies have these through their patent rights. A "best-in-class" drug is a huge money-spinner. Coke and Pepsi have it via their secret recipes and the strength of their brands, which allow them to charge more for their drinks. In the luxury goods market, various labels are perceived as conferring exclusivity, enabling them to mark up prices for clothing or jewellery. Or perhaps you are the first mover in a market that then becomes saturated so there's no room for competition. As Larson puts it, "in Chicago we have a NASCAR racetrack, and in the Chicago market we can support exactly one NASCAR racetrack. So even if I had a billion dollars, why...build another?"
How to find a decent moat
The stocks that Morningstar screens for wide moats are all US-listed and include big names such as consumer goods giant Procter & Gamble (NYSE: PG) and technology group Microsoft (NASDAQ: MSFT). There is also a US-listed exchange-traded fund that tracks the 20 companies that Morningstar deems to have the widest moats.
