Warren Buffett often talks about the business ‘moat’ and how important it is for companies to have one to succeed. While Buffett has never precisely defined what he believes a moat is, most understand it is a business that has a strong competitive advantage.
Companies with such a competitive advantage make the best investments because they offer a specialist service customers cannot find elsewhere, giving them scope to charge whatever they please.
Hard to replicate
Breedon (LSE: BREE) is an excellent example of a moat business. The company makes products for the construction industry, namely aggregate, asphalt and concrete. Its operations include approximately 60 quarries and over 30 asphalt plants These businesses are extremely capital intensive and starting a mine for these products is no easy task. For this reason, Breedon is almost one of a kind. Quarries and production facilities are difficult to replicate while the company’s size means it can achieve economies of scale peers cannot. These competitive advantages give Breedon a Buffett-style moat, which indicates that the group’s growth will not slow any time soon.
Over the past five years, Breedon’s pre-tax profit has surged from £5.8m to £47m, and in the year ending 31 December 2017, a pre-tax profit of £17.8m is expected. Earnings per share are projected to have grown by 470%. For 2017 and 2018 City analysts have pencilled-in earnings per share growth of 13% and 16% respectively.
Unfortunately, this kind of growth doesn’t come cheap. Shares in Breedon currently trade at a forward P/E of 18.7, but this is significantly below the company’s five-year average valuation multiple of 28.1. And if it can continue to grow earnings at a mid-teens rate it’s certainly worth paying a premium to buy into the growth.
Customers come first
Like Breedon, Restore (LSE: RST) also has a unique competitive advantage. It is one of the leading UK records management companies providing document management, records storage and archive storage. This is a sensitive business where only the most reputable companies will attract customers, and it seems Restore has built a great rapport with its clients. Indeed, if the firm hits City estimates for growth this year, pre-tax profit will have risen at a compound annual rate of 65% over the past six years. Analysts have pencilled-in earnings per share growth of 17% for the calendar year 2017 followed by 13% for 2018.
Just like Breedon, shares in Restore do not come cheap, however. Based on current estimates, shares in the firm trade at a forward P/E of 18.6. Yet considering Restore’s historic growth rate, this premium valuation multiple actually seems cheap. If earnings per share continue to grow at their current rate, and the shares continued to trade at a multiple of 18.6 times earnings, by 2023 the stock could be worth 766p, up nearly 100% from current levels.
