No. of Recommendations: 20
possessing a competitive advantage or "moat."
Not exactly mechanical....
There is one quick test to get you firms that are a little more bemoated than others: high ROE.
It's dangerous to invest in firms with high ROE solely because they are overgeared, so best to first eliminate firms with seemingly dangerous levels of debt. e.g., total debt ought to be less than 5-10 times net earnings.
But, other than that, a consistently high ROE is a pretty good sign. Not all high ROE firms are great businesses, but almost all great businesses have high ROE.
The reason is relatively simple: book value is a shortcut proxy for the cost of a competitor to set up in competition with you with the same assets you have. If you are earning a lot on your assets, then a would-be competitor is strongly motivated to raise the money to compete against you, undercutting just a bit to steal some business. To the extent his cost of competitive entry is approximated by your book value, he'll earn outsize returns on his investment.
If your ROE has been very high for many years and is not falling (and your debt burden isn't rising), then there is some reason the competitors are NOT going up against you. The simplest one is that you have some very high cost of competitive entry or barrier to competitive entry (not quite the same thing), both of which might be called a business moat.
I like the ft.com global equity screener, which has a great field "five year average ROE".
But even most-recent-fiscal isn't so bad. Compare the performance of the highest ROE firms versus the lowest.
For example, in the VL universe 2000-2023
top 25% by ROE, CAGR 12.4%
S&P 500, CAGR 7.0%
bottom 5% by ROE, CAGR 3.8%
It isn't perfect, but it's a quick way to find a group highly correlated with the moated crowd.
Jim
