Identifying Companies With Economic Moats

When we consider any search of stocks for the long-term, we quickly encounter a ‘Buffettism’ – the concept of Economic Moats. So what exactly are Moats? The answer is hard to define, and is seemingly individual to an investor and custom for each company. Here is a typically accepted definition: The wider the moat, the larger and more [glossary_exclude]sustainable[/glossary_exclude] the competitive advantage. By having a well-known brand name, pricing power and a large portion of market demand, a company with a wide moat possesses characteristics that act as barriers against other companies wanting to enter into the industry.

All well and good, but how exactly, as an investor pressed for time, does one identify [glossary_exclude]sustainable[/glossary_exclude] competitive advantages? Not that easy. Here is another ‘that looks good on paper but how do I work this in practice’ breakdown of the factors to help identify Economic Moats:

Intangible assets: Fanatically loyal customers. Successful companies with high priced, quality products or services for decades, supported by their brand strength. E.g. Coca Cola (NYSE:KO)
Customer Switching Costs: Products and services that are not easily abandoned for a substitute or for a competitor’s product. E.g. Gillette
Cost advantage: Meaningful economies of scale. E.g. Wal-Mart (NYSE:WMT)
Networks Effect: Services that become more useful as more people join. E.g. eBay(NYSE:EBAY)
Efficient Scale: Monopolies that exist for the purpose of efficiency; E.g. Airports

The examples listed make sense, certainly for large companies, but again: how does one identify these characteristics? In a nutshell, Economic Moats appear to be a bit like pornography – hard to define, but you are expected to recognize it when you encounter it.

Identifying Stocks with Economic Moats

For an investor, the answer then seems to be able to translate some of the characteristics into financial or business terms that are ‘screenable’. Here is one way to think of the issues:

Intangible assets: If companies have this, they should be able to charge a premium for their products. Translation: profit margins or returns on invested capital that consistently exceed the industry average or those of their competitors, i.e. Dominant Operating Model
Customer Switching Costs: If companies are able to lock-in their customers, then their returns, over time, should be consistently higher than the competition i.e. Sustainable Returns
Cost advantage: A trend of healthy operating and profitability ratios i.e. Differentiated; Low-cost products
Network effects: Harder to quantify, but points to high margins as well i.e. Differentiated; Low-cost products
Efficient Scale: Bit of a catch-all – points to a low cost base as well as high returns. And towards good cash flow generation.

There you have it – at least the beginnings of a decent screen. The key here is to recognize that all of these criteria are RELATIVE in nature i.e. vis-à-vis the competition. This is normally a tough search using existing screeners – all of whom give you search criteria and data on a single company at a time. Fortunately the CapitalCube screeners are designed precisely to address this shortcoming – since we have a large set of criteria that are relative to a company’s peer set. An added bonus: we already crunch the numbers and label the criteria. So the screening is more intuitive for you.

And of course as investors, since one would like to fish where nobody else is yet, one option is to apply these criteria to the small-cap space. With this in mind, we searched for stocks using the following criteria: North American stocks that have (i) dominant operating models, (ii) differentiated products (to reflect brand premiums), (iii) low costs, and (iv) superior operating returns that are sustainable!

A highly complex search. But one easily accomplished in a couple of seconds with ourscreener!

For better investing prospects, we restricted the market cap to $500million to $2billion and screened for high fundamental analysis scores (66 or better out of 100). The result is a list of 23 companies. Naturally most of them do trade at close to their 52 week highs – as one would expect of quality companies. But this should matter less if you are looking for the long-term!

A couple that all of us can relate to (an important criteria if we remind ourselves once more of the pornography definition!) really stood out.

Stock Screener Results

Download a Free report for Select Comfort Corp. (NASDAQ:SCSS) and Vistaprint N.V. (NASDAQ:VPRT) below:

Download a Free report for these two companies!

Select Comfort Corp.

Select Comfort Corp. (NASDAQ:SCSS): Designs, manufactures, markets, and distributes beds and proprietary beds and other sleep-related accessory products. It offers beds under the brand name Sleep Number.

The company generates a healthy amount of cash (Operating Cash Flow is about 11% of Revenues) with lower working capital needs than most of its peers. Interestingly, the company is better than its peers on a variety of other cash management indicators likecash conversions cycles and cash float days (view the Free report). And its margins, both gross and operating, are higher than the competition suggesting both brand premium as well as cost controls. The company trades at around 20x trailing earnings and shows a 3 year revenue growth rate of about 20%.

Vistaprint N.V.

Vistaprint (NASDAQ:VPRT): Provides customized marketing products and services including business cards, brochures and post cards to customized apparel, invitations and announcements, direct mail services, promotional gifts, signage, website design and hosting services, and online marketing and creative services.

The company generates a fair amount of cash as well – Operating Cash Flow is a good 10% of revenues, and working capital is actually negative! The company appears to have a lock on the market with brand recognition (what other business card company do you know that advertises on national TV?). Our earnings analysis did not throw up any flags at present.

The company trades at a high earnings multiple (PE of 58x), but the top line growth (3 year revenue growth of 25%) and margins go a long way to create comfort in the valuations.