According to Bloomberg, there are over 7,000 stocks trading on the major U.S. exchanges with over 200 initial public offerings (IPOs) last year alone. In order to be effective, investors need to develop powerful filters in order to narrow those numbers down to the most promising names. That's all the more true for individual investors, who can't afford to devote all of their time to this pursuit!

In that context, I'm going to show you a powerful filter -- the "no-moat" filter -- inspired by legendary investor Warren Buffett. With a single question and two quick steps, you'll be able to eliminate more than 90% of companies out there from your universe of possible investments. Together, we'll apply that filter to the IPO of Dropbox, Inc., a company that provides online storage and is increasingly a collaboration platform. Dropbox shares are expected to begin trading on Friday.

Depiction of a siege to a medieval castle.

Image source: Getty Images.

In Sept. 1999, with the NASDAQ Composite (NASDAQINDEX:^IXIC) index up by more than half over the prior 12 months, Buffett gave an informal talk to a group of friends on the long-term future for stocks, during which he 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. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

The following year, at Berkshire Hathaway Inc.'s annual meeting in Omaha, Neb., he expounded [emphasis is mine]:

We like to own castles with large moats filled with sharks and crocodiles that can fend off marauders -- the millions of people with capital that want to take our capital. We think in terms of moats that are impossible to cross, and tell our managers to widen their moat every year, even if profits do not increase every year.

The fundamental question for an investor (not a speculator) in analyzing Dropbox's imminent IPO is: Does Dropbox have a competitive advantage or, failing that, is there a realistic prospect that it will develop one?

Where does one find the answer to that question? A good place to start is the company's offering prospectus for the initial public offering (otherwise known as form S-1), which contains the most comprehensive description of the business and its results available to prospective investors.

Dropbox company logo, with a representation of an open box next to the company's name.

Image source: Dropbox, Inc.

Step 1: Search for "competitive advantage" in the offering document (or the latest annual report)

In searching for "competitive advantage," we're trying to ascertain management's degree of awareness and understanding of this critical concept and, ultimately, whether or not the company question has been blessed with one.

Dropbox's prospectus contains a single mention of "competitive advantage," in the section on risk factors (emphasis is mine):

With the introduction of new technologies and market entrants, we expect competition to intensify in the future. Many of our actual and potential competitors benefit from competitive advantages over us, such as greater name recognition, longer operating histories [...] Some of our competitors may make acquisitions or enter into strategic relationships to offer a broader range of products and services than we do. These combinations may make it more difficult for us to compete effectively. We expect these trends to continue as competitors attempt to strengthen or maintain their market positions.

It's not promising that the only mention of a competitive advantage is in reference to Dropbox's competitors! In fact, if you put a gun to my head and asked me to make a choice on that basis alone, I'd bet on Dropbox's "actual and potential competitors" before betting on Dropbox. Sure enough, in the same section, Dropbox lists those competitors -- and they are formidable:

The market for content collaboration platforms is competitive and rapidly changing. Certain features of our platform compete in the cloud storage market with products offered by Amazon, Apple, Google, and Microsoft, and in the content collaboration market with products offered by Atlassian, Google, and Microsoft.

I'm not familiar with Atlassian, but Inc., Apple Inc., Google parent Alphabet Inc, and Microsoft Corporation is a veritable murderers' row of corporate America.

Step 2: Search for "competition" and/or "pricing" in the offering prospectus

That a company does not refer explicitly to the concept of competitive advantage in discussing its business does not automatically preclude its existence. Still, it's not an encouraging sign because it suggests several possibilities, none of which are palatable from an investor's point of view:

  • Management understands the concept but is unwilling to discuss it because they know full well that their business does not possess a competitive advantage.
  • The business does have some form of competitive advantage, but management doesn't discuss it explicitly. The unfortunate implication here is that they don't understand the enormous value of this asset and the need to continue developing it.

Nevertheless, investors will want to continue probing for a competitive advantage -- even if it turns out that the company's own management hasn't fully grasped they are sitting on the business equivalent of a golden goose.

Let's dig deeper into the competitive environment -- something every offering prospectus will discuss in the section on risk factors, or under a section that may be titled (appropriately) "Competition" (or both). Sure enough, a search for the word "competition" quickly yields the following paragraph:

Demand for our platform is also sensitive to price. Many factors, including our marketing, user acquisition and technology costs, and our current and future competitors' pricing and marketing strategies, can significantly affect our pricing strategies. Certain of our competitors offer, or may in the future offer, lower-priced or free products or services that compete with our platform or may bundle and offer a broader range of products and services. Similarly, certain competitors may use marketing strategies that enable them to acquire users at a lower cost than us.

An offering prospectus is a formal legal document that is drafted with the help of lawyers. As such, the discussion of the business and risk factors is couched in conservative terms. Nevertheless, the above paragraph suggests that Dropbox has limited, if any, pricing power, which suggests that its competitive advantage -- if it has one -- is limited and/or nascent.

"No-moat" filter verdict on Dropbox: pass

My recommendation, based purely on the above quick-and-dirty exercise would be to pass on Dropbox. Our "no-moat" filter simply didn't produce convincing evidence that Dropbox has or can develop a competitive advantage.

Beyond the 5-minute analysis

Is it possible that our filter produced a false negative (i.e., a company that our filter indicates has no competitive advantage when it actually has one)? Yes, it's certainly possible -- consider the following elements:

  • There are switching costs involved in changing from one provider of storage and collaboration software to another, and this is particularly true for corporate customers (personally, I have switched, over the years, from i-Drive to Microsoft OneDrive to Google Drive).
  • Although only 2.2% of them are paying users, Dropbox had over 500 million registered users at the end of 2017. That growing user base is a valuable asset, particularly in light of its "very attractive cohort economics." Dropbox defines a "cohort" as all registered users that signed up within a given time period; the company has observed that "each cohort of new users typically generates higher subscription amounts over time."
  • Dropbox is profitable on a free cash flow basis, and its 15% free cash flow to equity margin last year is nothing to sneeze at (in other words, for every dollar in revenue, the company made $0.15 in cash profit on shareholders' behalf).  

If Dropbox could be a false negative, what use is our "no-moat" filter, you ask? For individual investors who have limited time, the greater risk is betting on a false positive (a company that you believe has a competitive advantage when it doesn't), not passing on a false negative. The "no-moat" filter, which is a blunt instrument, is draconian when it comes to avoiding false positives.

For professional investors (or individual investors with unusual amounts of experience, time, and interest), it may be worth digging further into Dropbox's business to get a better grasp on whether or not it has or is developing a legitimate moat; nevertheless, given the company's competition, I think one ought to be skeptical regarding one's ability to estimate the durability of any potential competitive advantage that transpires.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.