Superb Companies
An aid to business thinking
In this post I will look at what Warren Buffett calls moats and their link with a company’s return on invested capital (ROIC). Moats are identified through a qualitative business analysis. ROIC is a financial metric derived from financial statements.
This post is the first of two parts. The second is here: The awkward link between Buffett’s moats and ROIC – Part ll
A definition
What is a moat? Let me define it. An economic moat is a sustainable competitive advantage that allows a company to earn excess returns on capital for a long period of time that is also higher than that of its competitors.
Every word is important here. I have bolded the key ones. These bolded words are central to Warren Buffett’s investment philosophy.
Growth Buffett style
Buffett explains it this way: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. 1998) p93 (Emphasis added)
The rub is how one identifies such companies.
Growth in sales or growth in earnings
Let’s cut to the heart of it. It’s not just growth in sales.
Buffett tells us that “Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long- term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.” (Buffett, 1998) p86. (Emphasis added)
He adds: “…the best business to own is one that over an extended period of time can employ large amounts of incremental capital at very high rates of return.” (Emphasis added)
Philip Fisher
Before going further, we should credit Philip Fisher’s contribution to Warren Buffett thinking on this. Fisher wrote that what he was looking for in a company was: “the degree to which there does or does not exist within the nature of the business itself certain inherent characteristics that make possible an above-average profitability for as long as can be foreseen into the future.” (Fisher, Common Stocks and Uncommon Profits and Other Writings. 1958,1996) p198
Back to definition of a moat
If our business analysis concludes a company has an appropriate sustainable competitive advantage, does it currently have to earn an excess return on capital? In other words, does a company with a moat also have to show an ROIC substantially in excess of its weighted average cost of capital?
Let’s look at ten years of historic data for a U.S. public retailer. I’m going to call it Amazing Retail Inc. to disguise it.
Operating Performance
(Fiscal Year End 31 Dec 2024)
2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 09/2024 Fiscal (%)
-0.68 3.31 8.42 7.09 14.70 11.72 14.71 15.98 -0.60 9.82 13.56 Rtn on Invested Capital
I think you will agree the performance is not especially inspiring. In the interests of full disclosure, our family owns shares in this company.
Traditional accounting rules
We can leave the retailer for a moment and turn to software companies. Historically, software companies spent R & D dollars to create products which they sold to customers. The development costs were expensed in the same period as the associated revenue. The SaaS software came along and today dominates the industry.
Today, software companies typically expense their R&D annually, expense their sales and marketing expenses in the year they are incurred and also expense other intangible investments that create intangibles of lasting value, but they only recognize the revenue generated over the years of use of their products by their customers. Software companies love the recurring revenue and investors love it too. But, the mismatch between the expensing of costs and the recognition of revenue results in lower profitability expressed in ROIC on a current basis.
Typically, it takes several years for SaaS companies to earn back their software development costs and customer acquisition costs.
We can generalize
In the last fifty years the world has changed. Traditional accounting has not kept up with the massive shift of companies to investing in intangible assets rather than in tangible assets.
In his new book titled The Corporate Life Cycle – Business, Investment, and Management Implications published in 2024, Professor Damodaran writes: “When accountants misclassify expenses…as they continue to do with R&D expenses, a capital expense if you follow first principles but one that is treated as an operating expense – the accounting earnings can be skewed significantly.” (Damodaran, 2024) p.132 (Emphasis added)
The most important consequence is that reported earnings are distorted and that the book value of company equity is also distorted (because the investment in intangibles of lasting value are expensed rather than capitalized), both of which impact the calculation of ROIC.
I have written about this in earlier posts. These two may be useful for investors not familiar with the shift. The emergence of a new model of capitalism and Investment in intangibles has wreaked havoc on the meaning of multiples
Measuring the moat and high ROICs
Let’s think through the following two quotes from a report titled Measuring the Moat – Assessing the Magnitude and Sustainability of Value Creation, CONSILIENT OBSERVER | October 15, 2024 by Michael J. Mauboussin and Dan Callahan, the Consilient Research duo at Counterpoint Global Insights of Morgan Stanley.
- “Generating excess returns by investing in the stock market is difficult. But a sound and thorough analysis of competitive advantage—measuring the moat—can help long-term investors understand why specific companies are unique and capable of sustaining high ROICs.”(Emphasis added)
- “We can quantify the drivers of sustainable value creation. One measures the magnitude of the positive spread between return on invested capital (ROIC) and the weighted average cost of capital (WACC) as well as how much the company can invest at that spread. The other reflects how long a company can earn that positive spread. Modeling aggregate value creation for a company requires considering both dimensions.”(Emphasis added)
The analysis depends on measuring the ROIC to WACC spread. But there are problems with the measurement, interpretation and use of these metrics.
Amazing Retail Inc.
As noted, Warren Buffett’s insight is that “Growth benefits investors only when the business in point can invest at incremental returns that are enticing.” The ROIC to WACC spread is supposed to do the trick.
It seems that in the last several decades accounting has let us down. And anyway, even if the accounting wasn’t so messed up, we have to be careful. As Warren Buffett put it in his 1986 Chairman’s letter: “…accounting is but an aid to business thinking, never a substitute for it.”
The results set out above were actually for Amazon.com Inc AMZN. Let’s look at them again.
Operating Performance
(Fiscal Year End 31 Dec 2024)
2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 09/2024 Fiscal (%)
-0.68 3.31 8.42 7.09 14.70 11.72 14.71 15.98 -0.60 9.82 13.56 Rtn on Invested Capital
Half the time Amazon is not even earning its cost of capital. At least, that is the case if you rely on traditional accounting.
And yet the company has a serious moat. And the company is creating lots of long-term substantial shareholder value. It truly is making oodles of money. Here is Morningstar’s moat rating for the company.
“We assign a wide moat rating to Amazon based on network effects, cost advantages, intangible assets, and switching costs. Amazon has been disrupting the traditional retail industry for more than two decades while also emerging as the leading infrastructure-as-a-service provider via Amazon Web Services.
We also believe AWS is a wide-moat business, thanks to high customer switching costs; a cost advantage associated with economies of scale where few competitors can keep up with Amazon’s investment pace; intangible assets arising from semiconductor and facility development; and a network effect associated with a marketplace for software created to make AWS work better.
We also would assign Amazon’s burgeoning advertising business a narrow moat based on intangible assets from its proprietary data on hundreds of millions of users and a network effect again focusing on buyers and sellers meeting in the largest available venues.
We believe that the wide moat for Amazon’s entire business is greater than the sum of its parts; we prefer to analyze Amazon’s moat on the whole, as the company’s segments reinforce one another and returns result in an unrivaled consumer experience.”
Four problems
It seems there are companies with substantial moats that are creating sustainable long term shareholder value but not showing it in accounting-based calculations of ROIC to WACC spreads.
There are also some companies that are showing substantial ROIC to WACC spreads simply because the book value shareholders’ equity is substantially understated. They may not in fact enjoy sustainable economic moats.
There are serious issues around the calculation ROIC. See my post: Problems with the most popular indicator of superb companies
Finally, there are companies that show long term sustainable ROIC in excess of WACC that enjoy moats but where the business in point cannot, to use Buffett’s expression, “employ large amounts of incremental capital at very high rates of return.”
Oligopolies
Let me give you an example of the last of these four problems. As I have written, the main problem with companies in an oligopoly is that the market share pie has already been divided. It is difficult for any one company to increase its market share. Growth is hard to come by. The companies may generate significant free cash flow but they may not be able to deploy this excess capital at high rates of return, which is one of my requirements for superb companies. Superficially they appear to enjoy moats but their returns on capital while highish, are not higher than those of their competitors. And the main problem is that they have little opportunity to invest their excess capital in growth. As a result, there is a tendency toward what Peter Lynch calls ‘diworseification’. See my post: The danger of investing in companies in an oligopoly
That post deals primarily with the U.S. economy. Canada faces the same problem. Oligopolies exist in Canada in airlines, telecoms, eye glasses, streaming, movie theatres, app stores, concert tickets, grocers, banks, hotels, transportation, minerals, grains, pork, turkeys and more. I imagine all countries around the world face the same problem. They are simply not be able to deploy this excess capital at high rates of return, so it is squandered on ‘diworseification’ or CEO empire building or vanity projects or worse.
Conclusion
Moats are an integral part of Warren Buffett’s style of investing. Looking for companies that will be able to generate very high returns on their excess capital is at the heart of it. We have to use a company’s financial statements to calculate the ROIC to WACC spread. There are problems with the measurement. And, we must always keep in mind, they are merely an aid to our work. The mindless application of formulas will not get us there.
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