Building a portfolio of quality companies

Investing is not easy. It is also not as difficult as some might have you think. To be sure, it takes time to understand companies and the sources of their profits. That’s what we do for you. The question is how do we go about finding companies with established moats?

Unfortunately, there is no line item on a company financial statement declaring a moat let alone it’s width or depth. Rather, company results leave clues that a moat may be present. In our process, we start by screening out companies that don’t meet our standards for financial health which slims the investable universe. From there, we screen for positive factors on key metrics and look for consistency in those metrics over time. With a much smaller list, we dig into finding the source of potential moats and analyze how durable the moats may be.

Now let’s talk about a few of those clues that a moat might be present.

1 – Return on Invested Capital (ROIC)

Return on Invested Capital (ROIC) is a powerful and popular datapoint. It is also the most complicated data point I’ll discuss here. Understanding this point is important because it’s a big one for me. ROIC simplifies in some ways and complicates in others relative to ROA and ROE. The most important note on the difference between ROIC, ROA and ROE is that ROIC puts debt and equity financing on equal footing, which removes the boost that levered (companies that use debt to grow) companies might see in ROE. Have no fear, ROIC is more often than not easily found by investment research providers like Morningstar. So, you will not have to calculate it but, you should understand what it means.

Generally speaking, I look for ROIC consistently above 15%. In reality, I look to compare ROIC to the market as a whole and to other companies in the same industry and sector. The higher and more consistent the better and more likely there is a moat or growing moat happening.

2 – Free Cash Flow

Keep in mind, that some metrics are not meaningful for some industries. What follows are key items we compare across companies in the same industry to find the cream of the crop. Before I get into some of the other metrics, I want to spend a minute on one very important metric – Free Cash Flow (FcF). 

FcF is the cash generated by a business that is available for distribution among its stakeholders which includes equity, debt, preferred stock, and convertible security holders. FcF is used to:

  • Pay dividends
  • Make acquisitions
  • Research & Development
  • Invest in new plants and/or equipment
  • Pay interest expenses
  • Reduce debt 

In my opinion, free cash flow is the best indication of a company’s ability to generate cash. The higher and more consistent a company generates free cash flow the better. We’re not going into the weeds with the formula. But, very simply free cash flow is the money left after covering all the costs of doing business. That’s why it’s called free cash flow; the business is free to do as it wishes with the money.

3 – Cash Return

Cash return shows how much FcF a company is generating as a percentage of enterprise value. Enterprise value (EV) is a very common term to find for a company.  Simply, it’s the total value of the business. EV measures what the market believes the company is worth and is the total value of the business including equity and debt. EV is considered to be the takeover price of a business. This is due to the fact that the purchaser will take on the debts, keep the cash and have a right to all earnings down the road.

I want to see cash returns above the 10-year US Treasury yield. You can find the 10-year yield with a quick search on the internet. Do not use cash return to evaluate financial companies or other companies that earn money from assets on their balance sheet – i.e. banks, insurance companies etc. Honestly, I have never had interest in investing in banks or insurance companies.

4 – Net Margin

Net margin is net income as a percentage of sales (revenue). Very simply, it tells us how much profit the company generates per dollar in sales. The higher the better, period. At this point you are getting the picture that net income is an important number for many ratios. 

Generally speaking, I look for net margins consistently above 15%. In reality, I look to compare companies to other companies in the same industry and sector.

5 – Brand as a verb

The name of this one alone tells you that we are departing from the quantitative part of finding moat stocks to the qualitative side. The reality is, moat’s are more often derived from qualitative aspects. The quantitative data points are the evidence of the economic moat’s impact. 

One of the most obvious clues that a company may have carved a moat is when the company, product or service becomes a verb. At the point of verb utilization, there is entrenchment in a massive amount of psyche. A few examples in (2023) are Google, Uber, Photoshop, Instagram, Venmo, and many more.

6 – Not commoditized

This is a departure from the rest of the hints in that it refers to what a company is not. More often than not, commoditized items or businesses have a hard time establishing a moat or maintaining a moat. But, what do I mean by commoditized business or products. Commoditized, in this sense, means that a product is deemed the same across the board. Simply put, the items become indistinguishable across competitors.

Some prime examples of commoditized businesses are airlines, trucking companies, railroads, utilities, and phone carriers. To be sure, some businesses within the above mentioned industries have found ways to carve out moats. For example, well run trucking companies that play in a particular area like less-than-a-truckload could have a moat.

As you think through a company, question if the business or service is commoditized to the point where pricing is impaired because other companies do the same thing at a same price.  If so, move on to your next idea.

This website and associated newsletter along with its content/links are not financial advice. Nothing in this newsletter is an investment recommendation. All content is created for entertainment, educational, or informational purposes only. My strong buy, accumulate, hold, reduce or sell opinions are exactly that – opinions. Be sure to do your own research for your own particular circumstances or higher a professional advisor.

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