I started with wide moat ratings of morningstar and selected 10 companies randomly as below

Asian Paints Bajaj Auto Colgate India Dabur Cummins HUL Infosys ITC Nestle Lupin

Then I collected 10 year data on above companies from 2005 to 2014, collecting 10 year data will ensure that you can avoid sampling errors although I want to clearly point that selecting 10 companies and trying to interpret patterns in itself will have sampling errors

If you have gone through our previous posts on competitive analysis , ROE dissection or Earnings framework you know I like to understand a concept through key metrics and examples , I have selected 3 important metrics and plotted on how have they performed for 10 companies in last 10 years

Lets take them one by one

Understand this first  you get rated as improved if a particular company is able to beat its own average over last 10 years in year 2014. So if year 2014 was extremely bad/good year for the company than data interpretation below could be erroneous

Gross Margin – My reason to select – this indicates pricing power

8 out 10 companies were able to improve their gross margins

Cash Conversion Cycle – My reason to select – CCC indicates dominant or passive position in industry set up

8 out of 9 companies were able to improve their cash conversion cycles indicating a dominant standing in their respective industries

Fixed Turnover – Provides an insight to how is company milking its assets also is it using operating lever to optimum

6 out 10 companies improved their fixed turnover in last 10 years indicating efficient use of assets by them

Taking these three factors only and focussing companies on who have improved on all three parameters, Can we conclude that ROIC for these companies would also improve  ?

Lets put that to test, the four companies which improved on all three parameters were Bajaj Auto Dabur ITC & Lupin

See what happened to their ROIC (Return on invested capital)

3 out of 4 companies improved their ROIC when they improved on three parameters. Quite a good strike rate (75%) however I would have loved to have a 100% strike rate (this now pushes me to analyse Dabur in detail which I might do in a later post)

Now as a reader you might say this is nice – whatever you have told is fairly basic if a company improves on gross margins , cash conversion cycles and fixed asset turnover it is bound to improve it’s ROIC

Hold your thoughts, knowing something works and seeing it actually work is a different thing altogether.

Let me throw few more interesting observations for you to take away

Myth 1 – For company to have wide moat it’s gross margins have to be in high 30’s or 40

Fact 1 – Bajaj Auto’ s gross margins in 2004 was 28%

Myth 2 – Screen for negative cash conversion cycle to find wide moat companies
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Fact 2 – Lupin’s CCC was 206 days in 2004

Myth 3 – Look for companies with massive fixed turnover to find wide moat companies

Fact 3 – ITC’s fixed asset turnover was mere 1.92 in 2004 and even in 2014 it is 2.59 (since the base is huge a minor improvement like this adds millions to their bottom line)

The above facts tells us that we should not be fixated on a number or  percentage / ratio when we want to identify companies with moat, if we do, we can and will miss amazing companies like Lupin or Bajaj Auto (in 2004)

Now, how to use this analysis ?

Approach -1 (Enterprising approach)

1. Select an industry or a sub segment you understand (Say IT – Products , Auto spare parts)

2. Download financial information for last 10 years of all prominent companies in that industry or sub segment, you can use tools like this as well

3. Run these ratios to see which companies are improving on at least 2 of 3 parameters ( or more if you want to)

4. Don’t be bothered by low margins / low turnovers / high CCC or debt on books – Focus on improvements

5. Select few companies which have passed above test

6.  Value companies

7. SIT – When the valuations come on your side – Pull the trigger

8.  Continue to monitor performance on yearly basis

Approach -2 (Sitting on the bum)

1. Accumulate cash in good short term funds

2. Wait for equity markets to crash ( 2008,2009,2011)

3. Buy these wide moat companies

Remember if it’s was only maths,accounting or spreadsheets that would have made us great investors than academicians would have been the richest people on earth. Always look beyond numbers ! Make them your starting point not end point in investment analysis

 

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