8min read
PREVIOUS ARTICLE Top dividend paying stocks - h... NEXT ARTICLE 2009 is the perfect year to bu...

These companies are rare, but when you find them – hold on for the ride – as this could be the stock of a lifetime.

We are talking about companies with wide economic moats, generally regarded as the best companies to invest in. But before we sift through the Australian investing landscape in search of wide-moat stocks, let’s take a moment to understand the concept a little better.

Just like a castle in medieval times that was protected from the onslaught of invaders by its surrounding moat, superstar companies also sport a moat of sorts, protecting their wares and market position from competitors; these companies hold particular advantages that keep predators at bay.

So what sort of advantages are characteristic of an economic moat? Well, just as the image of a moat implies, significant barriers to entry are the hallmarks of an economic moat – and this may include a hefty market share generating significant economies of scale (low costs compared to competitors), high switching costs (it’s costly, inconvenient or just darn difficult for customers to ditch this company in favour of its competitor); legal protection via patents, copyright and licenses, a reputable and strong brand name inspiring customer loyalty; and an established network, such as being an important intermediary between buyers and sellers.

An economic moat means that a company has more power to raise prices to boost earnings without losing its share of the market to a cheaper rival.

But beware: the presence of an economic moat doesn’t make a superstar company. Most importantly, does this company throw off above-average returns on capital? If a company doesn’t use its competitive advantage to generate attractive returns to shareholders, then its economic moat is useless. Roll out the drawbridge.

Airlines are a good example of companies with significant barriers to entry – competitors can hardly establish a fleet of planes overnight and land a spot on the runway – but struggle to remain profitable. Constant price pressure (when booking flights, most people just head for the cheapest) and volatile fuel costs make the airline industry a bugbear of an investment. Biotechnology companies are another good example. While a patent for a new-beaut drug might protect a biotech company for a number of years, once that patent lapses, a host of cut-price competitors flood into the market – severing shareholder returns.

The difficulty for companies basking in the fruits of an economic moat is that before long, competitors will be sniffing – seeking every opportunity to get a piece of the action. For this reason, economic moats can be hard to sustain over the long haul; a company with a dominant market share becomes fat and lazy and its market share contracts, competitors put pressure on Governments for changes to regulation, ora brand becomes tarnished and customer loyalty suffers.

Therefore it’s worthwhile investigating the historical returns on capital achieved by a company. If the stock has a track record of generating material returns above the cost of capital for a sustained period of time, then there’s a fair chance that this trend will continue.

Return on capital employed (ROCE) measures how efficiently a company utilises its capital to generate revenue for shareholders. Is it taking out hefty loans to buy equipment that sits in the corner and rusts, or is it using its capital (debt and equity funding) wisely? The best companies are those that use capital sparingly to boost revenue dramatically. For those who like to see ratios in all their glory, here is the formula:

ROCE =

Operating Revenue – Operating Expenses (Pre-Tax operating profit)

Total Assets – Current Liabilities (Capital Employed)

If a company sporting an economic moat exhibits rising returns on capital employed, then this company is worthy of closer scrutiny. It could hold the secret to a superstar stock.

Now legendary investor Warren Buffett, who coined the phrase economic moats, likes to make the distinction between wide and deep moats. It’s widely agreed that wide moats are better than deep moats, or in other words, it’s preferable for a company to hold a range of competitive advantages rather than one advantage in particular. If a company has competitive advantages across a number of its product lines, it’s more likely to withstand competitive threats.

Should it hit a roadblock in one area of its business, other areas can easily pick up the slack – hence, explaining the reason why a popular home loan company will sensibly branch into credit cards, commercial borrowing, financial planning services and so on. The wider the moat, the more likely excess returns on capital can be sustained over the long term.

But lastly, it’s important to acknowledge the effect that structural changes can have on a company’s economic moat. Take the invention of the Internet as an example. The pricing power once enjoyed by many Australian companies – across myriad industries – is quickly eroding due to the onslaught of rival companies setting up on the Internet.

Below we throw up some companies in Australia worthy of further investigation.

Now, just to quickly recap, these companies flaunt impressive competitive advantages, which Warren Buffett has coined an ‘economic moat’. Strong barriers to entry, high switching costs, legal protection via patents, copyright and licenses, a reputable and strong brand name and an established network of distribution partners are typical characteristics of an economic moat.

Just as a moat around a castle keeps enemies at a distance, these competitive advantages prevent competitors from eating into the company’s market share and profits. Such companies are known to throw off excess returns to shareholders over the long term.

So let’s sift through the Australian investing landscape for some notable examples.

Hardly surprising, a great chunk of these companies reside in the S&P/ASX50, the index of Australia’s biggest and most powerful companies. Arguably, an economic moat is an intrinsic characteristic of some of the most powerful companies in Australia, enabling them to dominate the markets in which they operate (keeping profits high).

We could therefore surmise that the powerful companies of the future – those currently residing outside the top 50 companies – are those that establish an economic moat early on in their growth trajectory. We’ve highlighted a couple of these stocks to keep on your radar.

But before we jump into learning more about these companies, it’s worthwhile touching on the risks. Since these companies are on many investors’ radars – fund managers, stockbrokers, private client advisers and financial planners – they are often priced for perfection. In other words, it’s unlikely that you will pick up these stocks for a bargain.

So if you think that these stocks will make you a fortune overnight, think again.

Another point worth mentioning is that companies enjoying significant market share can become lazy. And if they lose control over costs, profits fall, and competitors can make up lost ground easily.

Lastly, although a company might sport an economic moat, that isn’t the end of the story. Indeed, you have to do your homework before you launch into purchasing a stake. Has this company generated increasing returns on capital over time? And are you paying a fair price for this company, or is it currently over-valued?

Below is a list of companies boasting characteristics indicative of an economic moat. Clearly, there are other companies not mentioned below such as BHP Billiton in the resources sector, the Australian Wheat Board, Fosters in beer manufacturing, Telstra and Telecom NZ, MYOB in business administrative software and Tabcorp and Tattersals in gaming.

ASX Limited (ASX)

When you buy and sell shares you don’t have any alternative except to trade through the Australian Securities Exchange, which derives revenue from equity, derivatives and fixed interest trades put through the market as well as offering listing and clearing facilities. This monopoly position puts the ASX is an enviable position, and its recent merger with the Sydney Futures Exchange only builds on this overwhelming market dominance.

Woolworths (WOW)

The largest retailer in Australia, Woolworths’ strong market position in food and liquor is an insurmountable economic moat that even Coles Myer and discount chain Aldi struggle to compete with.

Woolworths operates under the brand names of Safeway, Caltex/Woolworths Petrol, Dick Smith Electronics, Tandy, Dan Murphy’s, BIG W and Foodtown to name a few – comprising over 2000 supermarkets and over 200 hotels. Woolworths has even ventured into India via a joint venture with consumer electronic retailer Tata.

Cochlear (COH)

Hearing implant maker Cochlear is the clear market leader in its category. Its revolutionary Cochlear implants – world-renowned for their reliability compared to its competitors – are sold in over 100 countries around the world. In this market, Cochlear enjoys Microsoft-like dominance.

Cochlear’s unique product offers up pricing power (Cochlear implants can cost tens of thousands of dollars). And as the great bulk of baby boomers age, demand for Cochlear’s hearing-loss products should only increase.

The only roadblock on the horizon could be the emergence of low-cost rivals from stgeloping nations coming up with a substitute product.

Cabcharge (CAB)

Cabcharge, which is now offered in 98% of all taxis in Australia, offers a way for taxis to deal with non-cash payments. The vast majority of office workers pay for taxi rides with a Cabcharge account. Unsurprisingly, Cabcharge is the clear market leader in this category.

In January 2002, Cabcharge snapped up the largest taxi company in Australia, Taxi Combined Services. Today, Cabcharge is looking to replicate its success in other markets around the world such as the UK.

Computershare (CPU)

The world’s largest share registry Computershare manages shareholder registers and communications with 100 million investors, with a presence in countries such as UK, Canada, Hong Kong, Germany and South Africa. This dominant market position gives it huge pricing power.

Its recent acquisition of Equiserve in the US makes Computershare one of the largest share registry providers in the US.