S&P Global — 10 June 2024
Daily Update: June 10, 2024
Measuring Metrics for Moats
By Nathan Hunt
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When building a fortification, a moat has the practical benefit of making defensive walls higher and therefore more challenging to attack. Although moats are often associated with medieval European castles, there is evidence that they were used in ancient Egypt, Babylon and Assyria. These days, a company is considered to have an economic moat when it can sustain competitive advantage, preserve market share and generate high profits over the long term. An economic moat — an idea the investor Warren Buffett has helped to popularize — prevents competitors from replicating a company’s offering or challenging its position in the market. Earlier this year, S&P Dow Jones Indices launched the S&P 500 Economic Moat Index, which seeks to identify companies with lasting competitive advantages.
Selecting a list of companies with a strong economic moat is methodologically challenging. Moats can be determined by a host of factors, including network effects, economies of scale, brand recognition and high switching costs. Determining a list of companies to include in a moat index based upon these individual characteristics would require a series of value judgements: How strong is the brand recognition? What is the value of network effects in this sector? Could a well-funded competitor achieve similar economies of scale?
However, the performance of a certain set of financial metrics serves as a strong historical indicator of an economic moat. Regardless of the conditions that lead to companies having strong moats, those companies share common financial advantages.
The quantitative metrics that the team at S&P Dow Jones Indices used to identify an economic moat include a sustained high return on invested capital, sustained high gross margins and high market share. While the three metrics each showed promise in identifying economic moats, the best historical performance emerged when they were combined into a multifactor score.
Of the three metrics, sustained high return on invested capital was the strongest single indicator of a moat since companies with a higher return on invested capital averaged over five years are using capital more efficiently. High gross margins alone aren’t an indicator of an economic moat, unless they are sustained over time versus a company’s competitors. The S&P Dow Jones Indices team used two metrics to determine whether high gross margins were maintained over time: Gross margin over the past 12 months and gross margin stability over the past five years. The ability to maintain premium pricing with a lower cost of production over many years is a strong indicator of an economic moat. Finally, the team included a metric for high market share. On its own, that doesn’t necessarily indicate a moat; the company might just have attained a temporary advantage in a sector with high switching. But combined with the other metrics, high market share may indicate a strong moat resulting from economies of scale, network effects and brand power.
Reviewing the historical performance of the S&P 500 Economic Moat Index since June 30, 2013, it outperformed the S&P 500 by 2.63% annualized with reduced volatility and low turnover.
Today is Monday, June 10, 2024, and here is today’s essential intelligence.
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