The introducing guide to invest in economic moats stocks (Part 1 of 2)

FINDING MOATS 101

What you will learn in this post:

– What to look for when investigating economic moats businesses.

– Where to find that information.

– How to process it to find economic moats businesses.

– Get a free Excel spreadsheet to compile data and find out if the considered business has moats.


I have this friend, Mike.

He told me “Well, the moats thing you’re talking about is kinda cool! But how am I supposed to find them?”

I’m happy to write this post to answer his question.

Today, I’m going to show you basic steps to filter companies from the whole market that are great performers over the past ten years and that likely possess competitive advantages or so-called “economic moats” to enjoy long term high returns on your investments.

In other terms, you will discover how to potentially find potential businesses with moats.

This is what this first post of a two-posts series is about.

It will make you able to dig into the stock market and separate businesses that can supposedly have “economic moats” from ones that don’t.

This will help you getting rid of the long term losers stocks you don’t want to waste your time on.

Here’s a glance at what you will learn in this post:

1) What information do you have to look for to find great economic moats-likely businesses

2) Where to find that information

3) How to calculate the ROE (Return On Equity)

4) What are the used criterias to value this calculated ROE to find out if a company is likely to possess a competitive advantage

5) Get a free Excel spreadsheet to use all that information contained in this post and practice finding moats-businesses

Let’s tackle the first part of this guide to get better investment opportunities.

1) What do you have to look for to find supposedly businesses with moats.

Let’s put ourselves into context.

Your good friend John has a little business he’s been running for years now: He cleans swimming pools.

Now, to clean them and to actually operate, John needs some cash to buy equipment, tools and products. Eventually, John pays himself a long overdue salary. He’s got to reward himself too, right.

Because John is a well-known and appreciated kid in his neighborhood, he managed to develop his customer database to clean 25 swimming pools each month. This leaves him with considerable cash.

And John has high ambition. He wants to expand his business around and needs capital to invest its expenditure.

Guess what!

You happen to be the two years younger best friend of John, and you’re interested entering in this growing business.

John knows that and approaches you to lure you into his business.

As the son of an investment banker, you ask yourself these questions:

– What am I supposed to expect from this business?

– How much will I gain?, or

– What’s the return I shall get giving John my money?

man-thinking

As an investor giving your capital to John to expand his business, you shall expect an expansion of the business according to John’s ambition.

You shall also expect to gain not only at least what the businesses has allowed in its past recent history, but also a considerable excess return on the money since he’s planning to invest in growth assets to sustain the business’ expansion.

Although there must be verified concordance between John’s plans and his actions, what’s more important here is the accuracy of future operations and income with John’s predictions, and the consistency of high passed returns realized with the owner’s capital.

To put it clearly, here’s a closer look at what you look for.

You find John’s business very appealing and you invest, let’s say, $10,000 in it.

If John is right (and the shrewd investor you are made his research to get along with him), the business should be able to generate net income over the next 10 years of at least 21% of the invested equity.

This would mean that John’s business is able to take someone’s money, use it for its operations, pay whatever it needs to operate, including his taxes, and still manage to get a net income delivered right in your pocket of 21% of your invested equity.

Concretely, you should then get 21% of your $10,000 each year.

$2,100 each year! Promised according to John’s plans of expansion and past business return’s history.

That’s what you shall expect from this opportunity.

Sounds pretty awesome, right!

Well, this is how you can find out businesses that can better use your money invested as business equity.

You need to find the businesses that have over the past 10 years the highest return on equity (ROE) with consistency.

The more the business is able to generate with consistency high net income relative to invested equity (ROE) and the more often those returns are the highest, the luckier you get to dig up likely-moats businesses.

2) Where to find that information

The information you need is two-fold.

You need to know what is the amount of equity invested in a business.

And you need to know what is the net income of that same business.

Plus, this information needs to be available for the past ten years, because only over the past ten years can you be sure that a company has something special that allows it to be among the best businesses in the world able to reward your investment with great returns.

That information is found generally in the financial statements of the company.

Since these searched businesses are public, this information is available legally and controlled by the S.E.C (Security and Exchange Commission), so the public and individual investor (you and I) can use it to do research.

The financial statements of any public company can be found on its website. And I suggest to get this information only there so you can be sure this is a safe source.

In the financial statements, you need two of them: The “balance sheet“, and “the income statement“.

In the balance sheet, search for the line “total equity“. This is the equity invested in the business and used by the management of the business to generate money. That’s your first ingredient.

In the income statement, search for the line “net income“. This is the money left in the business after all charges and fees taken in account. That’s the money you get after operation and paying everything due. The management decides then what to do about it. That amount of money is what is important to you and that is the second ingredient.

3) How to calculate the ROE (Return On Equity)

Once you get to that step reporting over the past ten years these two ingredients you need (the equity of the business and its net income), you are ready for the next part.

That part is what you are looking for.

You can now calculate the Return on Equity (called ROE).

This tells you how efficient is a business at taking your money as invested equity and use it to generate money supposedly destined to you.

Getting that number is easy. At this stage, it’s only a matter of plugging.

You need to divide the output of the business (the net income) by the input of the business (the equity).

This is the formula:

ROE = Net Income / Business Equity

You need to calculate it for the past ten years to value the likeliness of your studied business to have economic moats.

Then you can calculate a average of the ROEs to estimate the average level of the returns you have been allowed to get over the past as an investor in one’s business and shall be able to at least get in the coming years.

But that’s not it.

4) What are the used criterias to value this calculated ROE to find out if a company is likely to possess a competitive advantage

The average ROE you get is a certain amount in percentage.

But let me ask you a question. How will you know your business is a great business, meaning one business that performs really well?

Actually, at this stage, before you might suspect a moat presence in one’s business, you need to make sure the business you consider is in itself a great business for the investor you are.

This can be done by comparing the levels of ROE you calculated with other returns that we will call benchmarks.

If the business’ average ROE you calculated over the past years is higher than those benchmarks’, then you are sure the business you put under your scope is a great business and has been worth of investment in the past ten years.

Remember, you want to select the best businesses.

So as comparisons and benchmarks, I suggest you get the following:

The average Gross USA Economic Growth over the past ten years.

If your business can’t get you a ROE that’s a better return than the gross revenue of USA economy, then you should pass it on.

The average Inflation over the past ten years.

Inflation has the power to erode your return. You definitely want to make sure the ROE generated by your business is higher than inflation. Otherwise, you just lose money.

– The average Net USA Economic growth over the past ten years.

If your average ROE isn’t higher than the growth generated in USA with inflation deducted, then your decision to invest your money in the business isn’t a wise choice.

The average Dow Jones Growth over the past ten years.

This is the index of all the legendary and most important stocks of public USA companies. If this index, that represents a consensus of many great companies, have a growth rate that is higher than your business and its ROE, then this same business isn’t called to be better than the average. You should then drop it as well.

If your average ROE is better than all of these benchmarks, then you can be pretty sure you have a good business between hands, and that business maybe has economic moats.

Congratulations!

Using these steps, you are now able to pre-filter businesses to get an output of businesses that sure are great businesses, but also are likely to have economic moats that have allowed them to generate that high and sustainable returns over the past few years … and hopefully will in the future.

Now is the next step.

You need now to make sure that these great returns rewarding investors over the past ten years are the consequence of the existence of a moat.

Sometimes, companies can just have luck and generate spectacular returns to the investor when they don’t have a proven situation nor structure that lets economic moats to preserve those returns.

The second part of this free guide will be exclusively about that.

5) Get a FREE Excel spreadsheet to use all that information contained in this post and practice finding moats-business

In the meanwhile, please enjoy this FREE Excel spreadsheet I created for you summarizing all those steps above.

You have 3 sheets allowing you to calculate everything (“ROE”, “Equity”, and “Net Income”) I’ve been talking about above.

Here is the cherry on the pie.

I have put some extra information such as the “total liabilities” you can complete searching for that same named line on the balance sheet of one’s company.

This is an interesting number, as it can let you know if the company investigated has debt, and if it has, what’s its weight relative to the financial structure of the company.

You really want to know if your company has too much debt. This has taken many companies down in the past.

The file is already plugged in with APPLE Inc. financial data, so you can enjoy the process and get to know APPLE Inc. in a more financial way.

I have also provided the files with hyperlinks to all information I have been searching for, as explained above in the process.

Interesting fact, the average net USA economic growth over the past ten years is worth -0.80%, meaning money invested in early 2005 in the US economy and taken back in the end of 2014 would have been reduced by 0.80%. You lost money in that period.

With inflation taken in account, between 2005 and 2014, the US economy was not a good pitch.

See the power of inflation?

You will see that the ROE’s generated by APPLE Inc. are really big over the past 10 years and shall be considered by an investor.

Now let’s not get lured. You need proof that these returns can be pursued in the next 10 years to put your money in the Palo Alto’s firm.

You will get that part in the next and final post of this ultimate free guide to finding moat businesses.

Here is for you the brand new and FREE file content with its user guide (info-graphic):

I.V.MOATS FREE Ultimate Guide to Finding Moats Businesses for Beginners (Part 1 of 2)

                                                                      Moats Guide Infographic (1-2)

I have also put some indications within cells and data. Please refer to comments and information cells before use.

Don’t hesitate. Download it and have fun.

Your long term wealth creation begins now.

I wish you lots of enjoyments with this great content I wish you will like and use for your research of moats stocks.

Here’s to your better investments,

Thank you for your loyalty and interest,

Samir Kaba

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5 thoughts on “The introducing guide to invest in economic moats stocks (Part 1 of 2)

  1. Nice pedagogical approach to company evaluation. The ROE is a good indicator of a company doing well, but is a lousy predictor for companies that might do very well in the future. Therefore, the ROE is good for bargain hunting (value) but not so good for growth investors.

    A good topic to explore could be Buffet’s Return on Retained Earnings metric.

    Regards,

    Like

    1. Thank you for this comment.

      I also think this indicator is a good tool to get real bargains about companies doing well now and the past recent years.

      My approach is to find those bargains because they maybe have an economic moat. The second step is to find out if they have actually one, and if this economic moat is narrow or wide, letting the investor taking advantage for great returns over the next years.

      I think the approach of growth investors in that step is a real source of alpha. I certainly will talk about that in the next posts I plan.

      Thank you again for your comment,

      Samir

      Like

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