Lesson 4 of 7
Economic moats, checked in the accounts
A moat is whatever stops rivals earning what this business earns, and it is only a story until a return holds through a difficult year.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A durable high return on capital is the observation. A moat is one possible explanation, never the only one.
- Capital moves towards high returns, so an unexplained excess return is one competition is expected to wear down.
- The average return is a stock; the return on new capital added is a flow, and the flow moves first.
A high return on capital that lasts for years is worth explaining, because capital normally moves towards it and competes it away. A moat is a name for whatever stops that from happening here. Naming it is the easy part; the useful work is checking whether the filed numbers are consistent with a barrier at all.
Average return against the return on capital added, five years
- Average return on invested capital
- Return on the capital added that year
Show the numbers
| Average return on invested capital | Return on the capital added that year | |
|---|---|---|
| Year 1 | 18.3% | 8.0% |
| Year 2 | 17.1% | 8.0% |
| Year 3 | 16.1% | 8.0% |
| Year 4 | 15.3% | 8.0% |
| Year 5 | 14.7% | 8.0% |
Where a moat comes from
Berkshire's 2007 shareholder letter names two of these directly: an enduring moat can rest on being the low-cost producer, as it names GEICO and Costco, or on a powerful brand. Mauboussin, Callahan and Majd group the same sources into three kinds. Production advantages come from a low-cost process or scale. Consumer advantages come from habit or switching costs. The third kind comes from outside the business entirely, such as a licence.
Four traces a real moat leaves behind
A return on invested capital above the cost of capital, sustained across a run of years that includes a difficult one, not one good year.
A gross margin that does not erode while the industry grows, for a brand or a switching-cost moat. Competition arrives first as price, and price shows up first in gross margin. For a low-cost producer the trace is different: a lower gross margin than rivals, paired with a higher asset turnover.
Consistency, not just level. A company earning an excellent return in seven years out of ten and a poor one in three has a cyclical business, not necessarily a barrier.
Share held without a price concession. Revenue growing at or above the market rate while gross margin holds; growth funded by discounting is the opposite finding wearing the same shape.
Average is a stock, incremental is a flow
The figure starts from $500 of invested capital earning $100, a 20 percent return, the year before the chart begins. Each year the company adds $80 of capital that earns 8 percent, or $6.40, so by year five it has $900 earning $132. The average falls from 18.3 percent to 14.7 percent even though every new dollar earned exactly 8.0 percent, the assumed cost of capital. The average is dominated by capital committed years ago. The incremental return is where a competitor arrives first, and it can signal that a barrier has already given way while the headline average still looks comfortable.
Four things that can fake the pattern
A cyclical peak, where the run of years never included a downturn. Underinvestment, where a shrinking capital base raises the return ratio without a barrier doing anything. An accounting effect can also move the denominator for reasons unrelated to competition. Goodwill from an acquisition can sit there indefinitely while an organically built rival carries none. ASC 842 also brought leases onto the balance sheet, for fiscal years beginning after 15 December 2018. And regulation about to change, where a licence-based barrier holds only until the licence regime does not.
Check yourself
A company's average return on invested capital is 15 percent, but the return on capital it added last year was 8 percent, equal to its cost of capital. What does that suggest?
- The moat is getting stronger
- New capital earns only its cost, a sign the barrier may be fading
- The company made an accounting error
Show the answer
Answer: B.
The average return is a stock built from capital committed over many years. The incremental return on new capital is where a competitive threat shows up first.Why does a ten-year record of high returns that never includes a downturn need extra caution?
- It does not, ten years is always enough
- It cannot distinguish a real barrier from a temporarily favourable market
- It means the company is committing fraud
Show the answer
Answer: B.
High demand alone can raise margins and returns for years. Only a period that includes a difficult year can separate a barrier from good conditions.What does Greenwald's franchise test compare?
- Revenue growth against the industry average
- Earnings power value against the cost to reproduce the assets
- Book value against market value
Show the answer
Answer: B.
The test capitalises normalised profit at the cost of capital and compares it with reproduction cost. A gap between the two is the value a barrier is protecting.Sources
- Greenwald, Kahn, Sonkin and van Biema, Value Investing: From Graham to Buffett and Beyond, 2001, on earnings power value, asset reproduction cost and the franchise test.
- Berkshire Hathaway shareholder letter, 2007, on the enduring moat, the low-cost producer and a powerful brand as its two examples of a durable barrier.
- Mauboussin, Callahan and Majd, "Measuring the Moat," Credit Suisse, 2016, on production, consumer and external advantages.
- ASC 350, Intangibles, Goodwill and Other, and ASC 842, Leases, effective for public business entities in fiscal years beginning after 15 December 2018.
What this leaves out
- Every test here is retrospective. It measures what already happened to returns and margins, never what will happen next.
- The five sources of a moat are a vocabulary in general use, not a finding on their own; a company's story fitting one of them is not evidence.
- The franchise test and the average-against-incremental figure are both shown on round invented inputs and model no company.
- Measure the incremental return over three to five years; one year is noise, from lumpy capital spending, a lag before new capital earns, or an acquisition.
- Nothing here is advice about any security.