SWOT analysis & economic moats

SWOT Analysis and Economic Moats

 So you have examined the list of candidates for your portfolio and undertaken some research of the companies.  This should have included as a minimum, reading their annual report, all their major announcements since release of those annual results and any recent presentations on the company’s web-site.  You should pay particular attention to the last three years of cash flow and how this compares to their declared profits over this period.

If this research confirms the attraction of the share as a long-term investment, then you should look to produce a SWOT analysis and also determine whether the company has an economic moat.  I will cover each in turn.

A SWOT analysis will seek to define a company’s strengths (S), weaknesses (W), opportunities (O) and threats (T).  This will take some time and I suggest you don’t try to complete it in one sitting.  If you cannot think of at least three items in each category, it is possible that you do not fully understand the business, which is a good enough reason not to invest in the company.  A SWOT analysis is best understood by an example, below I have shown a SWOT analysis, produced using PowerPoint, for GlaxoSmithkline (GSK):

Click on picture to enlarge

Once developed this should be updated after all major announcements to determine whether all comments still apply.  Bear in mind that some of these comments are subjective and another investor may view them differently, the most important part is the thought process that will assist you in determining whether a share is worthy of investment.

Having produced your SWOT analysis on your target company, the next process is to determine whether the business in question has an Economic Moat.  It is worth bearing in mind that the majority of companies on the stock exchange do not have any economic moat. The description of an economic moat was made popular by Warren Buffett, he looks for companies to own that have a competitive and durable advantage.  He describes those companies as like a castle that have an “economic moat” that create difficulties for other companies to compete against it. In his own words “…Wonderful castles, surrounded by deep, dangerous moats where the leader inside is an honest and decent person. Preferably, the castle gets its strength from the genius inside; the moat is permanent and acts as a powerful deterrent to those considering an attack; and inside, the leader makes gold but doesn't keep it all for himself.  Roughly translated, we like great companies with dominant positions, whose franchise is hard to duplicate and has tremendous staying power or some permanence to it…” (Berkshire Hathaway Annual meeting, 1995)

Economic moats usually consist of at least one of the following criteria:

Intangible Assets – Includes brands, patents, regulatory approvals or corporate culture.  Examples would be Unilever, Arm, GlaxoSmithkline etc.

Switching Costs – Where the cost of switching to a competitor is prohibitive, or problematic in the amount of time or bureaucracy involved.  Examples would be Sage, BAE, retail banks etc.

Network Effects – Where the value of a service increases as more people use it.  Examples would be ebay, Facebook, Visa etc.

Cost Advantage – Where a company has low cost processes, a unique asset or low cost location.  Examples are Ryanair, Pan African Resources etc.

Scale – Where a company has scale of manufacture or distribution within its market.  Examples are Tesco, Shell, Fedex etc.

A company may have no economic moat, a narrow one (2 or less from the criteria above) or a wide economic moat (3 or more from the criteria above).  This is best displayed for companies that you own in the form of a matrix:

Click on picture to enlarge

 

Economic moats can be eroded over time, not least by government legislation/regulation (ie switching procedures for bank accounts and mobile phone contracts), so should be checked at least once a year to confirm they still exist.

Companies that have economic moats, usually have in common - a durable competitive advantage that will produce good cash generation, high returns on equity and profit margins over a prolonged period of time.  Every investor should be seeking out these types of companies, adding them to their portfolio when they become available at an attractive value.

As an example, I judge GlaxoSmithkline (GSK) to have wide economic moat, as they pass the test of three of the criteria - Intangible Assets (patents, regulatory approvals and consumer brands), Network Effects (As the efficacy of a drug becomes proven, the knowledge is networked by physicians and patients) and Scale (GSK has one of the largest manufacturing and distribution networks for medicines in the world).