Picking winners with 'enduring moats'

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When I began studying the strategies of history's greatest investors more than a dozen years ago, one thing that struck me was how much these gurus relied on "the numbers." Investors such as Warren Buffett, Peter Lynch, and Benjamin Graham focused their analyses not on hunch-playing, macroeconomic factors, or some sort of investing "sixth sense." Instead, they keyed in on the numbers on a company's balance sheet and in its stock's fundamentals - numbers such as debt levels, returns on equity, and a variety of valuation metrics.

That's not to say that the gurus didn't also look at non-quantitative factors, too. One of the best examples may be the "durable competitive advantage," or "enduring moat," that Mr. Buffett is known to seek. "A truly great business must have an enduring 'moat' that protects excellent returns on invested capital," he wrote in his 2007 letter to Berkshire Hathaway shareholders. "The dynamics of capitalism guarantee that competitors will repeatedly assault any business 'castle' that is earning high returns."

What is an enduring moat? It can come in several shapes and forms. One that Mr. Buffett has cited, for example, is a powerful brand name. Take Coca-Cola. The company is one of the (if not the) best-known brands in the world, and its famed cola has become enmeshed in our culture and lexicon.

Other types of moats include being the low-cost producer in an industry. Berkshire investments such as Geico and Costco fit that bill. And in some cases a moat can be built by exceptional product quality, as is the case with FlightSafety, a pilot training program Berkshire owns. Mr. Buffett says FlightSafety is known for being the best at what it does - and when you're learning to fly a plane, quality comes above all else.

These various types of "moats" all have a similar effect: They make it difficult, if not impossible, for other companies to move in on a firm's business turf. A new startup could have unlimited funds and one of the best managers in the world, and it still likely couldn't supplant Coca-Cola as one of the world's leading beverage companies; the Coke brand's tentacles are simply spread too deeply into the global consumer psyche.

While Mr. Buffett (upon whom I base one of my Guru Strategies) has popularized the "moat" concept, he isn't the only guru who targeted moat-encircled companies. Kenneth Fisher, whose book Super Stocks is the basis for another of my strategies, wrote that the "super companies" he looked for needed to have an "unfair advantage" - that is, "a competitive superiority over all current or potential competitors," which can come from a powerful brand name, status as the industry's low-cost producer, or a patent on a particular product or technology.

Hedge fund guru Joel Greenblatt, whose Little Book that Beats the Market is the basis for another of my models, similarly talks about a "special advantage," one that keeps competitors from destroying a firm's ability to earn strong profits. Examples of such advantages, he says, are strong brand names, excellent competitive position, or a new top-notch product.

Numbers in the Water

Finding firms with an enduring/unfair/special advantage may seem to have little to do with quantitative analysis, and more to do with a very subjective assessment of products and services and consumers' mindsets. But according to Messrs. Buffett, Fisher, and Greenblatt, that's not entirely true. Each has said this sort of business advantage often manifests itself in metrics that you can find on a balance sheet, income statement, or a stock's fundamentals.

Mr. Buffett, for example, sees high returns on equity (those over 15 per cent) as a sign of a durable competitive advantage, his former daughter-in-law Mary Buffett wrote in her book Buffettology. Mr. Fisher said profit margins are a key sign that a firm has an "unfair advantage" and said "super companies" average net three-year profit margins of at least 5 per cent. And Mr. Greenblatt says high returns on capital are a sign a company enjoys a "special advantage" over its peers.

What that means is that, despite the title of Mr. Greenblatt's book, good quantitative stock-picking strategies are anything but magic. The numbers work not because of some mathematical hocus-pocus, but instead because they measure very real business concepts. And, as all the gurus I follow knew, a good business is at the heart of a winning stock.

Stocks to watch

Here are a few companies that pass muster with my Guru Strategies - and have the high profit margins and returns on equity and capital that Messrs. Buffett, Fisher, and Greenblatt found were signs of a "durable" advantage.

Coca-Cola Co.: The beverage giant gets approval from my Buffett-based model, in part because of its 29.4-per-cent 10-year average ROE. It also passes my James O'Shaughnessy-based strategy, and has a return on capital of close to 40 per cent and average three-year net profit margins of more than 20 per cent.

Tupperware Brands Corp.: Many people refer to dark colas as "Coke" regardless of what brand they are; so too do people refer to any plastic food storage container as "Tupperware." The firm's strong brand name is borne out in its 7.2-per-cent average three-year net profit margins, 24-per-cent return on capital, and 28.8-per-cent 10-year average ROE. It gets approval from my Peter Lynch- and O'Shaughnessy-based models.

TJX Companies: This discount clothing titan's advantage seems to come in part from its size (more than $20-billion U.S. in sales in the past year), pricing power, and strong brand name (it owns the TJ Maxx and Marshalls chains). It has a 10-year average ROE of 37.2 per cent, a 48.1-per-cent return on capital, and average three-year net margins around 5 per cent. It gets approval from my Buffett-, Lynch- and O'Shaughnessy-based models.

Disclosure: I'm long Coke, Tupperware and TJX.