Warren Buffett: How To Identify ‘Moat’ Stocks

Warren Buffett: How To Identify ‘Moat’ Stocks
By Mark Hirschey (Work of Mark Hirschey) [CC BY-SA 2.0], via Wikimedia Commons

Warren Buffett: How To Identify ‘Moat’ Stocks by Robert Tattersall, The Globe And Mail

A recent article in the ROB suggested that the defensive moat surrounding some of Warren Buffett’s core holdings may be eroding. In particular, Coca-Cola, International Business Machines, Procter & Gamble and Wells Fargo were singled out as candidates for a critical review due to declining revenue trends.

It is a bold investor who will challenge Warren Buffett’s track record, but maybe there is some truth to this allegation. So, how can the individual investor separate iconic names whose defensive moat remains impregnable from those such as Eastman Kodak and Polaroid, which were iconic names en route to oblivion?

My approach is to examine the marginal, or incremental return on equity (ROE), for the company. This is a calculation that I have suggested in the past for evaluating the value-added of management when shareholders are asked to approve the compensation package at the annual meeting. It is a handy tool in every investor’s work box.

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In simple terms, marginal return on equity answers the question: How much extra has management earned on the assets retained in the business over the past few years? A marginal return on equity less than the historical record of the company suggests that new opportunities are generating lower levels of profitability. This may indicate that the defensive moat is eroding and that margins are under pressure.

Although the concept sounds complicated, the calculation is relatively easy. Simply go back five years or more and calculate the increase in book value (net worth) per share for the company. This represents the per share amount of profits that management has chosen to retain in the business to generate future profitability. Now go back over the same time frame to see how much earnings per share have increased. Divide this number by the book value increase. The percentage result is the incremental return on incremental investment, or what I call the marginal return on equity.


See full article here by The Globe And Mail

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