Some investing concepts hold a powerful allure, simply because they are so successful. Year in and year out, these investment approaches show their ability to meet or exceed the major market benchmarks. For example, we have been big believers in the power of buybacks and we know the approach works because the PowerShares Buyback Achievers ETF (Nasdaq: PKW) has delivered a 19.3% annualized return over the past five years. That beats the S&P 500 by around five percentage points, according to Morningstar.
The other virtue of wide-moat companies: they typically have superior financial management strategies. If you know how your business will fare each year, then you can make better strategic resource allocation strategies and boost returns in the process. That's why some market strategists suggest that the companies with the strongest moats also have the highest returns on equity, or ROE.
I took a look at the companies in the S&P 500 with the most robust ROEs and weeded out any companies that realistically face a stiff amount of competition. Here's the top 10 wide-moat firms with the highest ROE.
|Company||Return on Equity|
|Moody's Corp. (MCO)||248|
|Masco Corp. (MAS)||232|
|Pitney Bowes (PBI)||160|
|Mead Johnson Nutrition (MJN)||159|
|Verizon Comm. (VZ)||94|
|Tempur Sealy (TPX)||90|
|Corporate Executive Board (CEB)||70|
To be sure, ROE by itself can be misleading. The Clorox Co. (NYSE: CLX) for example, carries more than $1.5 billion in goodwill and intangibles on its balance sheet, which can distort ROE measurements. All of these companies possess impressive moats, but we need to broaden the financial assessment. In addition to companies with high ROE, it pays to take things a step further, looking at companies that also have strong free cash flow (as a percent of revenue). That generates a more accurate picture of the true financial strength.
|Company||FCF/Revenue||Return on Equity||Industry|
|WEX (WEX)||69.3%||29.5||Payment Solutions|
|Mastercard (MA)||47.4%||63.8||Credit Card Processing|
|Navient (NAVI)||38.9%||35.4||Student Loans|
|American Express (AXP)||36.5%||29.1||Credit Card Processing|
|Eaton Vance (EV)||33.6%||45.2||Asset Management|
|Alliance Data Systems (ADS)||26.0%||65.0||Marketing Programs|
|Fiserv (FISV)||24.9%||27.6||Payment Solutions|
|Moody's Corp. (MCO)||21.4%||248.0||Bond Rating|
|FactSet Research (FDS)||20.5%||43.3||Investment Analytics|
To be sure, these companies don't hold a monopoly on their sector. But they are typically one of just a few players in their niche -- an oligopoly. It's notable that almost all of them are in the financial services sphere, which is understandable when you consider that these are not capital-intensive businesses.
A Great Moat -- And A Growing Yield
How these companies parlay their wide moats into shareholder perks can vary. Moody's Corp. (NYSE: MCO), the debt-ratings agency, which took a lot of flak during the debt crisis of 2008, has emerged stronger than ever. Although regulators and investors angrily expressed concern that the company was simply asleep at the wheel, perhaps too close to the company's it was tasked to rate, the controversy didn't have much impact on business. That's the benefit of having minimal competition and high market share. Sales, which stood at $1.8 billion in 2008, are likely to exceed $3.5 billion this year. Equally impressive: profit margins are sky-high.
Much of Moody's recent growth has come from its international operations, where bond issuance has been stronger. Though revenue growth will likely only be in the upper single digits in coming years, that should still be enough to help generate ever-rising free cash flow.
And the impressive free cash flow is fueling a rising dividend, which has been boosted at least 20% for four straight years.
A Great Moat -- And Room For Improvement
Not all wide moat firms make the most of their market share prowess. Although auctioneer Sotheby's (NYSE: BID) turns 58% of revenue into free cash flow and generates an eye-popping 37% ROE, the company can do better, according to hedge fund manager Dan Loeb, who runs Third Point LLC. He has already succeeded in getting Sotheby's to pursue a share buyback, sell some real estate and deliver a one-time special dividend. Cost cuts largely explain why per share profits are expected to rise 25% next year, to around $2.50. (Though a costly legal defense this year against Loeb will dampen 2014 profits.)
In some respects, Sotheby's is the ultimate wide moat stock for the baby boomer generation. Many baby boomers are inheriting the estates left by their parents and need a cost-effective way to part with their most highly-valued heirlooms. Sotheby's is typically the first name that comes to mind for these baby boomers. The key for Sotheby's management, as Third Point's Loeb is surely suggesting, is to boost the company's business internationally as family wealth gets passed on to heirs around the world.
Risks To Consider: Not all moats last forever. Western Union (NYSE: WU) had a wide moat for decades, but is being obsoleted these days by companies such as PayPal, which make global money transfers a lot easier.
Action To Take --> These large companies are obvious wide moat examples. But you can find many examples among smaller and micro-cap stocks. These kinds of companies tend to fall through the cracks as analysts rarely follow companies that act as the lone player in an industry. As you conduct research into small companies, understanding their competitive operating environment is a crucial component. Companies that must deal with many competitors typically must sacrifice profit margins in order to retain market share. Yet as the wide moat examples above show, limited competition can lead to great returns on equity and robust free cash flow.
A wide moat is one of the hallmarks of a "Forever Stock" -- a company so great that you can buy shares and virtually own them forever. My colleague Dave Forest, the chief strategist behind Forever Stocks, just gave a presentation at St. Edward's University revealing the unique qualities that make a business worth holding for life. To watch the video of his latest groundbreaking research, click here.