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Warren Buffett once said, “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” (Nati Harnik/The Associated Press)
Warren Buffett once said, “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” (Nati Harnik/The Associated Press)

STRATEGY

Buffett's key to investing: Four stocks that show a durable competitive advantage Add to ...

John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.

Some investors seem to have a formula for finding bargains regardless of the current market and economic climate.

The billionaire Warren Buffett, known as the Oracle of Omaha, looks for companies that have a durable competitive advantage to others in their industry, another way of saying he looks for a cash cow, or a company that performs year in and year out regardless of the state of the economy or what’s going on in the world.

This idea is supported by the research of the Harvard economist Michael Porter, the author of a 1985 book Competitive Advantage, which quickly became a business thinker’s bible. He examined the competitiveness of companies relative to their industries and identified five forces at work: the threat of substitutes, the bargaining power of buyers and suppliers, the threat of new competitors and industry rivalry.

Over the long run, he found that companies that had a competitive advantage either achieved it by getting things done more cheaply than others or by being different enough to command a premium price. The winners had above-average profitability.

Some companies are driven by strong brands, such as Coca-Cola, so they have a strong grip on the purse strings of consumers who loyally buy their products. Others sell goods or services that are vital to the daily functioning of consumers or other businesses.

Breaking down the concept further, a company that has a competitive advantage sells things that are basic needs and don’t change much. They exist in industries with few competitors, or provide a unique product or service that can’t easily be copied. They do not spend a lot of money on research and development relative to the amount of sales they generate.

As Mr. Buffett once explained in Fortune Magazine, “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”

Companies that have a competitive advantage have the sort of long-term, predictable profits that patient investors such as Mr. Buffett prefer, creating what he has called an “economic moat” that allows them to continue to grow and prosper.

Using my Buffett-inspired stock picking model, which looks for stocks that have 10 years of increasing earnings and higher than average returns on invested capital and equity, I’ve identified four stocks (two in the United States and two in Canada) that have a durable competitive advantage and that score highly based on a number of financial and valuation factors.

Apple Inc. (AAPL): The Cupertino, Calif., tech giant attracted a $1-billion (U.S.) investment from Berkshire Hathaway earlier this year even though Mr. Buffett has famously said in the past he doesn’t like to invest in tech companies. But it would be hard to argue Apple hasn’t developed products that are so ubiquitous they can sell them at a premium price with plenty of excess demand. One of its attractive attributes: predictable earnings over a long period of time. Earnings have declined just once in the past seven years and that one time was three years ago. The company boosts an impressive ROE of 29 per cent, on average, over the past 10 years. This is one of a handful of stocks that gets a top score of 100 per cent, based on the Buffett approach.

Nike Inc. (NKE): another iconic consumer brand, Nike is practically synonymous with sport and active living. It also lives up to Mr. Buffett’s metrics. It’s average return on equity for the past decade is 17.8 per cent, above Mr. Buffett’s threshold of 15 per cent, and the average ROE over the past three years is 20.7 per cent, growing steadily higher for the past five years. The Nike swoosh logo is one of the most recognized brands in the world.

Alimentation Couche-Tard Inc. (ATD.B): The company has generated $8.49 (Canadian) in retained earnings over the past 10 years compared to a gain of $1.78 in earnings per share over the same period. This shows that Couche-Tard's management has generated a 21 per cent return on the earnings kept by the company. The firm’s decade earnings stream and profitability indicated a solid moat around this company’s business model.

Ritchie Bros. Auctioneers Inc. (RBA): The world’s largest auctioneer of industrial equipment recently agreed to acquire IronPlanet, which is an industrial-world version of eBay for heavy equipment sales. Aside from this more than $700-million (U.S.) deal, Ritchie Brothers doesn’t spend a lot of money on major plant upgrades or research and development, something Mr. Buffett likes to see. Its free cash flow is $1.60 (Canadian) a share, which means it’s generating more cash than it is using. Overall, the stock gets an 85 per cent score based on the Buffett investment criteria.

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