A fair business at a wonderful price is still a fair business. The first job, before you ever look at the price, is telling a great business from an ordinary one. Buy an ordinary one and time has to bail you out. Buy a great one and time does the work for you.
The moat
Source: Buffett & Clark
Some companies can keep earning high profits for years, even decades. Others cannot, because the moment they start making good money, competitors copy them and compete those profits away. The difference is whether a company has a lasting edge that keeps competitors out.
Investors borrow a word for that edge. They call it a moat, like the ring of water around a castle that keeps attackers from getting in. A moat can come from a strong brand people trust, a product that is painful to switch away from, a cost advantage rivals cannot match, or a network that gets more useful as more people join. Most companies do not have one. Buffett spends his time hunting for the rare ones that do.
A moat is the reason a good business keeps its profits after rivals arrive to take them.
You cannot see a moat directly, but it leaves marks in a company's financial reports. Mary Buffett and David Clark, who wrote a whole book on reading those reports the way Buffett does, list the clues to look for. No single clue proves anything on its own. What matters is seeing many of them hold up year after year:
- A high gross margin, usually above 40%. Gross margin is the share of each sales dollar left after paying the direct cost of making the product. A high one means customers will pay up and rivals cannot undercut the price.
- Low overhead. The cost of running the office and sales team eats up less than about 30% of the gross profit. The company runs lean.
- Small interest costs compared to operating profit, under about 15%. Borrowing is not swallowing the earnings.
- Modest wear-and-tear charges compared to gross profit. The company does not need heavy spending just to keep its equipment running.
- A high bottom-line profit, usually more than 20% of sales.
- A high and steady return on the owners' money, often above 20%, without piling on debt to get there.
- Profits the company keeps and reinvests growing every year. That is the engine that compounds your money.
- A steady habit of buying back its own shares, which leaves each remaining share owning a bigger slice of the company.
- Little or no long-term debt. The company does not need to borrow to fund its operations.
None of these are quick filters you run before you understand a company. They are confirmations you check after you already like how the business works. The next section turns this list into the exact checklist tenbagger runs on every stock.
The moat scorecard
Source: Mary Buffett & David Clark
Every ticker page on this site shows a moat scorecard. It is a checklist of 11 marks that Buffett and Clark tie to a lasting competitive edge. Each mark is a simple pass or fail. The point is to see many of them pass, and to see them keep passing for years, not to chase a perfect score on any one of them. A company that passes 9 or more for a decade tends to be the kind of name everyone knows, like Coca-Cola, Apple, or Moody's.
Here are the 11 marks. The chapter number after each one points to where Buffett and Clark explain it in their book.
- Gross margin of 40% or more, averaged over five years. Lasting pricing power. Ch. 4.
- Selling and admin costs of 30% or less of gross profit. The company runs lean. Ch. 6.
- Research spending of 30% or less of gross profit, or none at all. Buffett actually prefers low research spending, because a moat that needs constant reinventing is a weaker moat. Ch. 7.
- Wear-and-tear charges of 10% or less of gross profit. The company is not hungry for capital. Ch. 8.
- Interest costs of 15% or less of operating profit. The debt load is manageable. Ch. 11.
- A steady tax rate between 15% and 30%. A rate that jumps around hints at one-time items or aggressive tax games. Ch. 14.
- Bottom-line profit of 20% or more of sales, averaged over five years. Durable profitability. Ch. 17.
- Earnings per share rising year after year over the available history. The sign of compounding. Ch. 18.
- Total debt no more than four years of profit. The company could pay it off from earnings if it had to. Ch. 27.
- A growing pile of bought-back shares. Steady buybacks. Ch. 31.
- Kept profits growing. The compounding engine. Ch. 30.
We work out each mark from the most recent yearly statements, using multi-year averages where the list calls for them. The scorecard shows how many passed, and you can hover any mark to see the cutoff, the actual value, and why it matters.
One warning. The scorecard is a guide, not a verdict. Fast-growing tech companies often fail the research-spending mark and still turn out to be fine investments. Buffett bought Apple knowing this. Banks and insurers do not fit the checklist at all, because their financial reports follow different rules. Read the scorecard as a starting point, and see Chapter 8 for where it breaks down.