In our previous blog, we introduced the newly launched S&P 500^® Economic Moat Index by reviewing its methodology, index characteristics and historical performance. In this blog, we will examine the specific quantitative metrics used to identify the companies with the widest economic moats. Furthermore, we will discuss the complementary nature of the metrics, which has historically led to strong performance when combining the metrics into a multi-factor score.

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Quintile Analysis

In addition to having a solid economic rationale, we believe that metric selection should also be based on empirical research. For Exhibits 2-4, we tested each metric on a standalone basis by dividing S&P 500 constituents into quintiles based on their metric z-score and equal weighting them, with quintiles 1 and 5 being the lowest and highest ranked quintiles, respectively. Exhibit 5 shows the results after combining the three metrics into a multi-factor score. Like the S&P 500 Economic Moat Index, the quintiles are rebalanced semiannually in June and December. Performance is calculated using daily returns from June 21, 2013, to March 31, 2024.

Sustained High Return on Invested Capital

Sustained high return on invested capital (ROIC) is a strong indicator of business quality since it measures how efficiently capital is utilized. This is arguably the strongest single indicator of a moat since companies with wide moats tend to have higher ROIC than those with narrow or no moats.

Exhibit 2 shows that long-term annualized returns steadily increase for each quintile, with quintile 5 providing an annualized return of 14.38% versus 10.56% for quintile 1. Conceptually, this makes sense as companies that can sustainably earn higher ROICs should grow their earnings and intrinsic value at a faster rate over the long term. Moreover, volatility tends to also decrease for higher ranking quintiles, with quintile 5 exhibiting a 15.81% annualized volatility versus 18.51% for quintile 1.

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Sustained High Gross Margin

Two metrics are used to assess sustained high gross margin: gross margin over the past 12 months and gross margin stability over the last 5 years. These metrics are used to assess pricing power, i.e. those companies able to charge a premium price over the cost of production, which may indicate the presence of an economic moat.

Like Exhibit 2, Exhibit 3 shows that long-term annualized returns steadily increase based on companies’ gross margin. Furthermore, due to volatility diminishing for companies with higher sustained gross margins, the risk-adjusted return significantly improved from 0.48 to 0.91 for quintiles 1 and 5, respectively, representing a substantial 90% improvement.

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High Market Share

A high market share may indicate a strong moat resulting from economies of scale, network effects and brand power. This metric is most useful when combined with other metrics since high market share may not indicate high profitability or sustainable competitive advantages. This metric is calculated using Syntax’s Market Share Score.

Although Exhibit 4 does not show perfect sequential improvement in quintile performance like Exhibits 2 and 3, the trend remains evident that companies with high market share significantly outperform those with low market share. In addition to posting the highest absolute return of 14.64%, quintile 5 also exhibited the lowest annualized volatility (15.00%), translating to an impressive 0.98 risk-adjusted return.

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Complementary Metrics

Although each selection metric shows efficacy on a standalone basis, the metrics may not always accurately identify an economic moat if used in isolation. One way to enhance the effectiveness of identifying an economic moat is to use the three metrics in combination, since it mitigates the risk of distortion when relying on a single indicator. For example, software companies may have high gross margins simply due to their structurally lower cost of goods sold (COGS) and in certain industries such as airlines, high market share has not historically translated to the presence of an economic moat.

Another benefit of using multi-factor selection is strong risk-adjusted performance. As Exhibit 5 shows, quintile 5 provided the highest annualized return and the lowest volatility at 15.43% and 14.48%, respectively. This impressive set of results translates to a risk-adjusted ratio of 1.07. It is quite challenging to achieve a risk-adjusted ratio above 1, and even more uncommon when accompanied by a long-term annualized return in the mid-teens.

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Conclusion

Due to the financial reward typically associated with identifying a company with a wide economic moat, there is a great deal of investor attention directed toward this concept. We posit that the strong back-tested performance in this blog supports the notion that financial statement metrics can be used to identify a wide economic moat and that a purely quantitative approach helps overcome the limitations of a subjective selection process.

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