Replicating Buffett’s Wide Moat Investing Method

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di Max Malandra 23 Aprile 2019 | 13:00

A cura di Justin Carbonneau, Validea Capital Management

Warren Buffett and others have long advocated buying companies with moats around their businesses. Strong brand loyalty (Disney), economies of scale (Walmart), innovation (Google), location (Starbucks) and other sources of competitive advantage play an important role in in the success of companies over time. The reason companies with moats appeal as attractive investments is that a moat, which is a function of a firm’s competitive advantage, protects the business and overall profitability from competitors. One may argue the very largest companies in the market today — Amazon, Apple, Microsoft, Facebook — all have competitive advantages.

But how might an investor systematically identify companies with moats and does it translate into strong investment returns over time for most investors?

Source: https://www.stratechi.com/competitive-advantage-strategy/

Identify a Moat Advantage Quantitatively

To answer the first part of the question above, we don’t need to drift too far away from Buffett himself. On the surface, one could look at the very top stocks in the market or even at Buffett’s own holdings at Berkshire and come up with a list of companies that exhibit moat-like attributes — big, profitable and dominant in their industries. There may be some merit in that type of thinking, but it’s certainly not systematic or scalable, and any subjective analysis automatically means there are decision-making biases baked into the decision and as quantitative investors we want to avoid situations like that.

What if there was a way to quantitatively analyze a company’s financials and fundamentals to help us determine if a company has a competitive advantage. That is exactly what we’ve tried to do in the replication of the Warren Buffett algorithm on Validea. Extracted from the book, Buffettology, Validea’s Buffett model has a few distinctive quantitative criteria that can help us determine if a company has a competitive advantage and moat around its business.

They are the following:

A decade of earnings predictability: Our Buffett model looks at 10 years worth of earnings and rewards firms that have increasing earnings over that time period. Using 10 years should give a snapshot of corporate performance over various parts of the business cycle. Growing earnings in and of itself isn’t completely a sign of a competitive advantage, but a decade of growing earnings can give an investor confidence in future earnings of the company.

A decade of above average return on equity and return on total capital: It’s not enough for a company to just have consistent earnings, but the real determination of whether a moat exists comes in looking at 10 years of return on equity (ROE) and 10 years of return on capital (ROTC). ROE measures the profits a company is able to generate on its equity, or net assets, since equity equals assets minus liabilities. Since leverage can be used to magnify earnings, ROTC takes both equity and debt, or total capital, into consideration. If a firm consistently produces a 25% ROE then this means that for every $100 in equity the firm is generating $25 dollars in profits. U.S. companies have had an average ROE of about 12% over the last 30 years, so any company with consistently higher returns on equity and total capital over a long period of time are protecting their profits from competitors and demonstrate a moat.

Let’s take a look at a concrete example using Costco, the membership-only warehouse retailer.

In the table below you’ll see 10 years of earnings per share, ROE and ROTC for Costco. Year 1 is the most recent fiscal year and prior years follow in the table. As you will see, earnings have been steadily increasing each year, starting at $2.47 earnings per share 10 years ago and ending at $7.14 in the latest year. ROE and ROTC have been steadily increasing as well, but our Buffett based model requires a consistent ROTC through the entire period and the company has some early years below the 12% hurdle, resulting in a failure of that specific criteria in the Buffett model.

The point of showing you the data is not to focus on Costco, but instead to show competitive advantage can express itself in the mosaic of company fundamentals over time. The trend in Costco’s earnings, ROE and ROTC are all trending in a way that implies a competitive advantage.

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