At Marcellus, we like the idea of using a mixture of quantitative and qualitative methods for identifying firms with big moats. The author, an American fund manager, seems to be doing something similar in the US.

Whilst we use YOY revenue growth and ROCE as our filters, he uses: “A decade of earnings predictability: Our Buffett model looks at 10 years worth of earnings and rewards firms that have increasing earnings over that time period. Using 10 years should give a snapshot of corporate performance over various parts of the business cycle. Growing earnings in and of itself isn’t completely a sign of a competitive advantage, but a decade of growing earnings can give an investor confidence in future earnings of the company.
A decade of above average return on equity and return on total capital: It’s not enough for a company to just have consistent earnings, but the real determination of whether a moat exists comes in looking at 10 years of return on equity (ROE) and 10 years of return on capital (ROTC). ROE measures the profits a company is able to generate on its equity, or net assets, since equity equals assets minus liabilities. Since leverage can be used to magnify earnings, ROTC takes both equity and debt, or total capital, into consideration.”

Then even more interesting part of this paper is data from a book by the legendary Roger Ibbotson on whether these firms with wide moats outperform. “Research from the new book: Popularity: A Bridge between Classical and Behavioral Finance by Roger Ibbotson and three Morningstar investment researchers, Thomas Idzorek, CFA, Paul Kaplan, CFA, and James Xiong, CFA, counters the belief that wide moats equal superior stock returns. What these researchers found was that characteristics like a strong brand name, a defined competitive advantage, a wide moat, or a good reputation made stocks more popular, and therefore more expensive. For wide moat firms specifically, the authors measured the performance of those companies with the highest Morningstar Economic Moat ratings and compared the performance to firms with narrow moats or no moats. The data shows “wide moat” firms actually underperformed narrow moat or no moat firms from a raw performance perspective, but did generate superior risk-adjusted performance.”

The article gives a table from Ibbotson’s book that the Sharpe Ratio for firms with “wide moats” (quantitatively measured) is 0.82 whereas the Share Ratio for firms with “no moats” 0.73.

 

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