Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Note: The table below has been corrected with accurate data since this article was first published.
Investing is a tough game: Opportunities are rare and uncertainties are bountiful. This ambivalent environment can tempt investors to believe that some sort of action needs to be taken. But a common solution in times of uncertainty is to simply do nothing.
As usual, Buffett eloquently brings this concept down to earth for us: "You do things when the opportunities come along. I've had periods in my life when I've had a bundle of ideas come along, and I've had long dry spells. If I get an idea next week, I'll do something. If not, I won't do a damn thing."
How can Buffett sit back so calmly as Mr. Market continues with his moody fluctuations? Simple: Buffett buys companies with durable competitive advantages that he can count on for the long haul, through thick and thin. In this article we'll take a look at five great companies that exemplify these characteristics.
The Economic Moat
Buffett once said, "In business, I look for economic castles protected by unbreachable 'moats.'" Thus were the humble beginnings of the now commonly used investment term, economic moat. An economic moat is simply a durable competitive advantage -- the key word being durable. According to the Foolsaurus, the five sources of economic moats are economies of scale, intellectual property, relationships, network effects, and switching costs.
Identifying companies with economic moats first takes a bit of common sense and business savvy to pair a business with one of the five sources of economic moats outlined above. From there we can narrow our search with some fundamental analysis. I personally like to start with the balance sheet. Mary Buffett & David Clark, authors of Buffettology, claim that "Warren has found that a company with [a] durable competitive advantage spins off a lot of cash and has little or no need for debt." In other words, a good indicator of an economic moat is a balance sheet relatively free of long-term debt.
Why the Debt-to-Equity Ratio Falls Short
The commonly used debt-to-equity ratio is, unfortunately, not always a useful measure of financial health -- especially when examining wide-moat stocks. The debt-to-equity ratio measures debt relative to assets. But if the wide-moat stock will not be liquidating assets any time soon, it is better to focus on the business' ability to service its debt. As Mary Buffett and David Clark emphasize, "the ability of a company to use its cash flow to service and pay off the loan is far more important than the assets backing it up."
So, to assess financial health, we will divide long-term debt by TTM earnings to find out how many years it would take the company to pay off its long-term debt with its current earnings. This ratio is referred to as the long-term debt burden. Companies with durable competitive advantages can typically pay off their long-term debt with three years of current earnings or less. Hence, wide-moat companies should have a long-term debt burden ratio of three or less.
5 Wide-Moat Stocks with Envious Balance Sheets
The following five companies are each representative of at least one of the sources of economic moats outlined in the Foolsauras. Even better, these five wide-moat stocks possess enviable balances sheets, with minimal long-term debt.
A quick observation of the above chart reveals that every one of these companies could potentially pay off their long-term debt in less than 2.25 years. Apple, of course, has no long term debt at all, Google, Nike, and Microsoft's long term debt is practically insubstantial.
Though there are very few opportunities to buy wide-moat companies at a bargain price, valuation still matters. Take a look at the chart below that shows their free cash flow (FCF) yields over the last 5 year. FCF shows you what percentage of a company's share price is represented by the cold, hard cash it's churning out. The higher this percentage, the better.
Microsoft is the clear winner in the chart above, with a FCF yield of 12.32%. Based on Microsoft's FCF yield, the assumed growth rate of FCF is -2.53%. If you are an investor who gets uncomfortable dealing with future growth projections, Microsoft could make a great core holding for your portfolio.
Apple, by far the fastest growing company of the bunch, is surprisingly the second cheapest in terms of FCF yield. With many new products in the market and 20% estimated growth by analysts, Apple appears to offer the greatest value, in my opinion.
Finally, Google, Disney, and Nike can only be bought at a hefty valuation. But if you follow the chart back 5 years you'll realize that these companies are rarely available for a FCF yield of 7.5% or higher. This is because the market has great confidence in their economic moats and predicts many more years of success and growth. I would agree with the market that Google, Disney, and Nike probably do have the most certain moats of the five companies. These three companies, therefore, make great investments for investors who want less volatility and uncertainty in their portfolio.
The Bottom Line
Wide economic moats and envious balance sheets make up a powerful combination. Using the long-term debt burden ratio as opposed to debt-to-equity is an effective way to measure the financial power of wide-moat stocks. Unfortunately, it's difficult to find companies with both a wide economic moat and an envious balance sheet available at a bargain price. But when you do, take advantage of it. Then you can sit back, relax, and do nothing while you wait for the next incredible opportunity.