Process

Let’s face it, there is no simple way to screen for stocks with a moat. There is no line item on a financial statement that says moat. On the qualitative side, some companies that should have a moat but do not thanks to poor management. Then, there are companies with a moat but competitors are making quick work of breeching the moat. My process of finding solid moats starts with looking for clues.

My process for building my moat research universe is straightforward and starts with annual quantitative screening. I start with more than 27,000 stocks that show up in most research databases here for American investors.

Step 1

I screen out stocks with a market cap under $500 million.

Step 2

The next step is to remove companies from countries with poor rule of law like China and Russia.

Step 3

The third step is where things get interesting. Here, I start to focus on Return on Invested Capital (ROIC). I screen the most recent annually reported numbers for ROIC greater than 10%. The resulting list is roughly 2,500 stocks. Ideally, I want to see ROIC above 15% on a consistent basis. I set it at 10% to capture the small number of companies that might have had a subpar year in the most recent reporting.

Step 4

The next screen is a time series analysis where I look back at annual ROIC for ten years for each company. This is where I find the companies that stand out. I’m looking for companies that have consistent ROIC above 15% for the last ten years. The result is a list of about 200 stocks that meet this strict screen. These 200 stocks are not the final list. I’m not so strict and only look at companies with ROIC over 15% for ten years. Rather, I forgive a bad year or two. But, the years under 15% should not be successive or close in time.

I also look at companies that appear to be building a track record. Some examples might be recent listings where there is a short history but solid numbers above 15%. The fast start new listings are likely to be smaller investments as the risk is higher. Another example is a steady rise from below 15% per year to above. Again, proceed with caution with steady risers and start positions small.

Step 5

This is the point where things get qualitative. At this point I remove a good number of stocks due to their industry. Industries with poor long-term ROIC are banks, utilities, air transport, education, renewable energy and insurance to name a few. Companies in these aforementioned industries are removed. I also narrow in on best of breed stocks. For example, I think Pepsi is a better run company and has better numbers that Coke. Therefore, I only track Pepsi in my research universe.

This is also a point where some companies that did not appear in the screening, or showed poorly in the quantitative screening, are added back. Often these ‘add in’ companies are younger companies that have built a moat but the numbers are not reflecting it yet. These add in companies are higher risk investments but a moat is present.

Step 6

Each company is then analyzed for establishing the source(s) and durability of their moat. My goal is to maintain a list of no more than 80 high quality moat stocks as a stable to consider for investment. I do not recommend holding 80 stocks. Rather, it’s the universe I’m comfortable tracking for consideration. Keep in mind, this list is always changing as some companies come into the universe and others fade away.

Step 7

I create two lists.

  • The first is the +/- 80 company Research Universe that I actively follow and provide research reports and insight for.
  • The second list is about 400 companies deep and comprise the companies cut in the last few steps. These are all companies with moats of some sort. Once a year I run the numbers on these companies for consideration to be promoted to my research universe. This second list has the very technical name of ‘The Rest.’

End Goal

The goal is a list of best of breed in industries that have the ability to generate high ROIC. I will remove solid companies from the list that have have enviable moats but are lesser to their peers. Seeing that this is an ongoing process, a removed stock may show better down the road. Those lesser stocks go on to ‘The Rest’ list.

Why do I track more stocks then I’m looking to own? Because you never know when a stock might drop from the list or a stock show up in our screens. It’s always good to have a shopping list ready.