“To invest I look for a business to have an economic castle protected by an unbreachable moat.”

– W.Buffet

Economic moats are what defend companies from attack the bigger the moat- the company’s competitive advantage, essentially-the better. Find a well-protected firm at a decent price and the returns should roll in for years.

The Golden Ratio

The key trait that identifies a strong firm is that its “return on invested capital” is high “relative to its cost of capital” as Morningstar’s strategist Paul Larson puts it. In plain English this means that the return the business squeezes from its assets must be bigger than the cost of maintaining those assets. If a firm can only earn 5% a year (its return on invested capital, or ROIC) from assets that cost it 10% to finance (its cost of capital, or COC) via bank loans, it might as well shut up shop, sell its operating assets, and put the money in the bank.

If, however it can earn 20% a year, with the same financing cost of 10%, then it may be a long term winner- that is, as long as it can keep it up (this is known as the sustainability of returns). The bigger the gap- or “spread”- between ROIC and COC, the better. So how do you calculate these two key measures?

ROIC compares a firms net operating profit after tax (NOPAT) to its invested capital (IC) and expresses the result as a percentage. So if NOPAT is £100m and IC is £500m, ROIC is (100/500) x 100%) or 20%. To get NOPAT, you take the “profit before tax” figure from a profit-and-loss account, and add the interest expense back in. (This way the operational profit figure isn’t distorted by the firms decision about how it is financed – say, with lots of debt, rather than shares). You then deduct a tax charge.

To get IC, you usually look for ‘total assets deployed’ on the balance sheet, then take away the surplus cash and non-interest bearing short-term payables (aka, current liabilities). Surplus cash is left out, because it isn’t really deployed in earning a return. For example, many firms are currently holding cash in case a juicy acquisition comes up. As for short-term payables, this is usually the amount owed to trade suppliers for goods and services received.  You leave this out because it represents the suppliers’ capital being tied up in this firm, not the firm’s own capital.

COC is the weighted average cost of the debt and equity funds (WACC) that are deployed by external lenders and shareholders in the business. The calculation can be fiddly but boils down to this: if a firm has £400m of debt costing 6% and £800m of shares costing 8 %( a combination of the expected dividends and capital appreciation its shareholders demand) then the WACC is roughly ((400 x 6%)/1200) + ((800 x 8%)/1200), which equals 7.3%. The 8% cost of shares is often estimated using something called the capital asset pricing model (CAPM).

In short a firms ROIC must come in well above its WACC, and do so consistently. So what are the other four ingredients?

The Network Effect

This can be summarised as a product that sells itself, because the more people use it the more other people want to- or have to- use it too. A good example is the payment network provided by the likes of Mastercard or Visa. These companies created a virtuous commercial circle in that every time a customer signs up for a card, it forces more retailers to accept those cards, which in turn leads more customers to want the cards. Social networking sites such as Facebook are similar- as more and more people join, it becomes increasingly difficult for others who want to communicate with them to remain non-users.

Sticky Product

The best products commercially are often those where, as an economist would say, the cost of switching once a customer has committed are high. Bank accounts are a classic case. People can and should switch accounts, but the thought of the hassle involved stops them. Equally, firms that supply, say, complex IT systems to the government often prosper because it is expensive to bring in a rival once a project is underway.

Cost Advantage

This usually accrues to big firms. Either they can charge the same as rivals, but get a job done cheaper by leaning on suppliers and keeping overheads tight (think of Japanese car makers or British supermarket chains), or they can afford to undercut competitors to win business (a classic strategy in Tesco Metro stores, which can put pressure on local shops by cutting the prices of mainstream items, such as bread, milk and petrol).

Hidden Intangible Strength

This is a built-in advantage that confers pricing power. Big drugs companies have these through their patent rights. A “best-in-class” drug is a huge money-spinner, Coke and Pepsi have it via their secret recipes and the strength or their brands, which allow them to charge more for their drinks. In luxury good market, various labels are perceived as conferring exclusivity, enabling them to mark up prices for clothing or jewellery.

Or perhaps you are the first mover in a market that then becomes saturated so there’s no room for competition. As Larson puts it, “in Chicago we have a NASSCAR racetrack, and in Chicago market we can support exactly one NASCAR racetrack. So even if I had a billion dollars, why….build another?”

NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.