Published September 20th, 2016 by Ben Reynolds
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”
– Warren Buffett
Warren Buffett says the key to investing is determining if a company has a durable competitive advantage.
Unfortunately, “durable competitive advantage score” is not something you can find on financial statements or stocks screeners.
If it were, investing would be much easier.
Fortunately there are ways to identify businesses with durable competitive advantages.
This article shows you how to find businesses with durable competitive advantages; the ‘key’ to investing (according to Warren Buffett).
Before going any further, it is important to note that this article shows a few ways to quickly identify businesses with strong and durable competitive advantages.
But there is no ‘one size fits all’ system. Most businesses using the methods in this article will have competitive advantages, but they could be waning or have already lost them.
Additionally, there are businesses with competitive advantages that won’t be picked up by the methods in this article.
The stocks identified by the methods in this article have a high probability of having a strong and durable competitive advantage. You will be right most of the time, but not all of the time. This is different from saying only stocks using the methods below have competitive advantages; that is simply not true.
Method 1: Copy from Other Great Investors
The quickest way to find potential businesses with strong and durable competitive advantages is to look at the portfolios of famous investors who follow the same investment methodology.
The most obvious example is Warren Buffett. You can see Warren Buffett’s top 20 stocks here.
When analyzing Buffett’s portfolio, one must make the distinction between true Buffett buys, and companies that Buffett’s investment managers have bought into.
Buffett plans to turns the investing reins over to Ted Weschler and Todd Combs. While great investors in their own right, Buffett’s stock picks are what we are after.
You can see all of Buffett’s holdings sorted by the percentage total of his portfolio here. Berkshire Hathaway (and many other businesses and hedge funds) are legally required to disclose their holdings periodically. These disclosures are known as ‘13F Filings’.
Buffett’s 6 largest holdings make up a whopping 75% of his stock investment portfolio. These are all certainly true Buffett stocks, and not Weschler/Combs picks. Buffett’s Top 6 holdings are below:
- Kraft-Heinz (KHC) at 22.2% of Buffett’s portfolio
- Wells Fargo (WFC) at 17.5% of Buffett’s portfolio
- Coca-Cola (KO) at 14.0% of Buffett’s portfolio
- IBM (IBM) at 9.5% of Buffett’s portfolio
- American Express (AXP) at 7.1% of Buffett’s portfolio
- Phillips 66 (PSX) at 4.8% of Buffett’s portfolio
These businesses are all high quality blue chip stocks. They all have strong and durable competitive advantages.
Another data source to mine for businesses with strong and durable competitive advantages is the VanEck Morningstar Wide Moat ETF (MOAT). The fund seeks to find: “attractively priced companies with sustainable competitive advantages”.
The MOAT ETF currently has 44 holdings. You can export an Excel sheet of all holdings at this link.
Method 2: Low Volatility
Businesses with strong and durable competitive advantages will be able to (on average) grow their earnings year-after-year.
Additionally, their earnings will be more stable than weaker peers. Earnings will not decline as much during recessions.
Lower earnings volatility translates into lower stock price volatility. In fact, lower stock price volatility might be a better way to determine earnings volatility than actual earnings volatility. Stock price volatility is a ‘crowd sourced’ measure of what investors are expecting out of a business.
As an example, if a company has a 1 time 50% earnings hair cut from a change in accounting policy, the market might not penalize the stock price much, whereas earnings would have fallen 50% in that year, greatly increasing volatility.
You can quickly identify low volatility stocks by downloading the constituents list of the PowerShares Low Volatility ETF (SPLV). The ETF invests in the 100 S&P 500 stocks with the lowest stock price volatilities. Here’s how:
- Go to the PowerShares Low Volatility ETF Fund Holdings page.
- Click the ‘Excel Download’ button (as shown in the picture below>
What immediately stands out about low volatility stocks is that they are not distributed evenly by industry. The number of constituents (out of 100) in the low volatility index by industry are shown below (using GICS classifications)
- Energy: 0
- Materials: 1
- Telecommunications Services: 2
- Information Technology: 3
- Consumer Discretionary: 6
- Health Care: 11
- Industrials: 15
- Financials: 19
- Consumer Staples: 20
- Utilities: 23
As you can see, commodity businesses in the energy and materials sectors have very little weighting.
When your prices are dictated by market forces (like the price of oil) rather than by brand strength, your earnings (and share price) are going to be more volatile. The Warren Buffett quote below expands on the difficulty of commodity businesses to generate wealth.
“Stocks of companies selling commodity-like products should come with a warning label: ‘Competition may prove hazardous to human wealth.’”
– Warren Buffett
There are also very few companies from the telecom and IT sectors. These sectors change quickly do to constant technological advancements. The only two IT sector companies are AT&T (T) and Verizon (VZ) – which dominate the industry. The 3 IT companies are all payroll/business services companies – Fiserv (FISV), Paychex (PAYX), and Automatic Data Processing (ADP).
The financial, consumer staples, and utilities sectors are all heavily weighted.
It’s interesting to see what kind of financials are heavily represented. The fall into two categories:
- Conservatively run insurance companies
- Conservatively run REITs
REITs like Realty Income (O) and Kimco (KIM) make up a portion of the low volatility financial sector. These are high quality REITs that have proven their success over long periods of time.
There are also several well-known insurance companies in the low volatility index. These include Berkshire Hathaway (BRK.A) (BRK.B), Aflac (AFL), Progressive (PGR), and Chubb (CB). The insurance industry is one of the best industries to invest in for wealth compounding over long periods. The amazing returns of Shelby Davis are an example of this.
Method 3: Dividend History
Businesses with long histories of consecutive dividend increases have historically outperformed the market. The performance of the Dividend Aristocrats Index is shown below:
Source: S&P Dividend Aristocrats Index
Dividend Aristocrats are stocks with 25+ consecutive years of dividend increases that are also in the S&P 500 Index. You can see a list of all 50 Dividend Aristocrats here.
For a business to grow its dividends for 25+ consecutive years it must have a strong and durable competitive advantage. This does not guarantee the company’s competitive advantage will remain strong or that it will exist in the future.
The next step up from the Dividend Aristocrats is the Dividend Kings. The Dividend Kings List is comprised of just 18 businesses that have increased their dividend payments for 50+ consecutive years. These are the ‘best of the best’ in terms of dividend longevity.
Businesses with long dividend histories have proven they can consistently grow year-after-year for long periods of time. This is clear evidence of a strong and durable competitive advantage.
Method 4: Higher Profit Margin Peers
Businesses with strong and durable competitive advantages will likely be more profitable than their peers.
If you have a competitive advantage that allows you to either:
- Have lower costs
- Sell goods for a higher price
This will reflect in net profit margin. All other things being equal, a higher profit margin is better.
Profit margin is not a particularly useful metric to compare businesses in different industries. A discount retailer like Wal-Mart (WMT) will always have a lower profit margin than a software business like Microsoft (MSFT). That’s the nature of their businesses.
Note: Microsoft’s net profit margin is 19.7%. Wal-Mart’s is 3.0%.
Profit margin can be useful to compare businesses in the same industry. Profit margins can change significantly from year-to-year. When comparing margins, it is important to compare average margin over a period of several years to account for fluctuating profit margins.
Of the methods described in this article, examining profit margins within industries are probably the least useful. Finding businesses with consistently high profit margins within an industry is still a good starting point for further research into finding businesses with a strong and durable competitive advantage.
Here’s how to quickly examine an industry’s profit margins.
Step 1: Go to Finviz
Step 2: Click on ‘Screener’
Step 3: Select the Industry you want
Step 4: Click on the ‘Financial’ tab
Step 5: Click on ‘Profit M’ twice to sort by Profit margin (highest to lowest)
This will quickly give you a view of current profit margins within an industry. In general, the businesses with stronger competitive advantages will be near the top.
There is no exact science to perfectly identifying businesses with strong and durable competitive advantages. It’s something you generally recognize when you see it.
The 4 approaches outlined in this article will help you to quickly identify businesses that are likely to possess strong and durable competitive advantages. Many of the criteria in this article (long dividend histories, low volatility) are metrics used in The 8 Rules of Dividend Investing to identify high quality dividend growth stocks trading at fair or better prices.