A moat is a trench, usually filled with water, surrounding a building, fort or town as a defence against invasion.
Economic moats are companies with a strong competitive advantage, likely to generate good returns on investments over a period of time.
Warren Buffet (who else?) introduced the concept to the investing community.
Morningstar based its investing strategies on identifying economic moats. It popularized the theory by putting it into practice and delivering results.
HOW DOES ONE IDENTIFY ECONOMIC MOATS?
Let’s discuss the factors that often mislead investors into thinking that a company is invincible.
- Great products
- Strong market share
- Immaculate execution
- Great management
Great products may disrupt the market, but may not be able to retain the benefit.
Maggi noodles captured the imagination of all those who wanted a quick meal with less effort. Many other companies entered the market showing health benefits along with speed of cooking, but could not replicate the success. They failed to add any substantial benefit for consumers. The public sees through a ‘me too’ product. Nestle stands tall, despite regulatory issues being raised at a point of time.
On the other hand, Kellog popularized breakfast cereals with aggressive advertising, but local companies reaped the benefits. It is because they understood muesli suits local taste better than cornflakes.
You see how tough or easy it is for competitors to make a dent in the market share.
Great CEOs sometimes fail when asked to head a bad business. The impact of an individual on a deeply entrenched structure and culture is limited.
The above-mentioned factors are good to have, but not fool proof.
WHAT HELPS A BUSINESS TO SUSTAIN IN THE LONG RUN?
Pat Dorsey of Morning star sums up the four factors as
- Customer switching costs
- Network effect
- Cost Advantage
- Intangible assets
I can open a savings account online easily. But switching all the linkages to the existing savings account takes time.
Rahul thinks of moving house every time the rent increases by 15%. But the transportation and settling down cost in a new place is higher than the increased rent he pays in a year.
A good product is one that ensures stickability makes switching expensive and difficult.
Mergers and acquisitions often look at the network enhancing factor to get a strategic advantage. Geographical presence, client base all matters.
Why did Microsoft pay 26 billion dollars to acquire LinkedIn? They calculated the price per user. Till then users did not know what they are worth, and that they are the product being sold. But other social media platforms took the cue to change strategies.
Large banks team up with microfinance companies to make a dent in areas where they hold no expertise.
A cost advantage is achieved by backward or forward integration. An orthopaedic hospital chain manufacturing implants, or a coffee shop chain owning plantations are examples of backward integration. A chain of NEET coaching classes investing in schools show an attempt to ensure a steady supply of students. It reduces acquisition cost. Some corporates wield political influence and manage to get import duties waived.
A layperson probably cannot differentiate between a Tanishq diamond and the one sold by a local jeweller. But they happily pay double the price for the brand they buy. The prestige and trust associated with Tata enterprises is their intangible asset.
HOW DO COMPANIES CREATE MOATS?
They need to restrict competition.
1. Government regulations
A number of small regulations rather than one big one which can be changed.
2. Willingness to pay for lifestyles
Popularity that compels one to pay – like car manufacturers or fashion designers selling prestige.
3. Geographical advantage
Ananda Health Spa spawned many imitation luxury spas, but it retains the benefit of being located on a mountain top. Everything else is just an add-on.
4. Financial capacity
Retail and telecom companies find it difficult to beat the deep pockets of Reliance.
Funded start ups capture market share by selling at a loss, with the investor backing they have. But the market has burnt its figures on their IPOs. Losses cannot be an acceptable norm, because nobody is making profits.
Due caution needs to be exercised.
Find a list of economic moat companies in India here. Get some more ideas on this blog.
PARAMETERS TO BE CHECKED TO IDENTIFY ECONOMIC MOATS
1. Return on capital
It indicates the efficiency of using employed capital to generate revenue.
2. Price to cash flow ratio
A high cash flow often means the company has not provided for replacement of fixed assets with a certain life span. Hence, a low ratio is not good.
3. Price to sales ratio
This is often used to evaluate start ups. Consistent sales and revenues matter, but not if they fail to make profits for a long time.
4. Price to book value ratio
Book value raises questions on actual tangible worth of a company, compared to price favoured by stock market trends.
5. Yield-based valuations
These help you make direct comparisons with bonds.
6. Price-to-earnings ratio
Look at your own earnings here to make a sensible decision.
Benchmarking matters. So does your performance against your own financial goals.