[Updated: 08-May-2021] What is the economic moat in business? A more heard term for it, in the context of stock investing, is competitive advantage. What is it? It is an expression to describe the edge that a company has over its competitors. [Check a list here…]
If Warren Buffett will look for stocks in India, which Indian companies will attract his attention? He will invest in stocks having a wide economic moat. In simple words, a company with a wide moat operates as if it has a monopoly in the market.
What is the benefit of a monopoly business? They have considerable pricing power. As a result, they operate with higher margins as compared to companies with a lower moat.
List of MOAT Companies in India (Warren Buffett Type Stocks)
|SL||Name||ROE (%)||ROE-5Y (%)||RoCE-5Y (%)||PEG||GMR Score|
|6||The New India Assuran||8.73||8.44||9.99||1.3||70|
- What is a Moat?
- What is an economic moat?
- Why economic moat is necessary?
- Factors that build an economic moat.
- Economic moat converts into more profits.
- How to identify moat companies?
Before we understand the economic moat, let’s first understand what is a “moat”.
What is a Moat?
Moat is a hole dug all-around a castle, which is later filled with water. It was a “safety arrangement” built around the castles in ancient times. The wider and deeper is the moat, the more protected is the castle.
The moat acts like an obstruction for the attackers to get access to the castle. How the moat around the castle helps us in stock investing?
If we will treat a company like a castle, then its competitors are the attacker. If a company has a moat (competitive advantage), it can hold its competitors from taking-over their business (or profits).
|The Castle||The Company|
|Water Body (Moat / Protection)||Competitive Advantage|
What is an Economic Moat?
An economic moat is also referred to as a “competitive advantage“ that a company enjoys for a certain time period. No company can enjoy the advantage forever. Some enjoy it for a shorter period, while others may enjoy it for a longer time horizon.
The concept of the economic moat in business (competitive advantage) is an exceptionally important concept for stock investors. But we discuss more stock price, P/E ratio, latest news, etc. What is the reason? Because we do not hear experts talk more about the “economic moat.”
In this article, we will try to discuss the concept of the moat in stocks. We will also use this knowledge to screen a few moat companies in India. These are great companies, among the plethora of average ones, whose stocks we can buy and hold for the long term.
Why economic moat is necessary for a company?
Companies must build a moat for themselves. A wide moat is what is desired. Generally speaking, a company cannot divulge its business’s or product’s know-how with its competitor. It is like giving up the moat.
Britannia (a biscuit manufacturer) cannot divulge its secret recipe to its competitors like Nestle, ITC, Parle, etc. The stronger they will ensure the secrecy, the wider will be their moat.
In a free market, any product or service will eventually get duplicated. With this fact in mind, all companies operate their business. Hence, as important it is to develop and deliver products and services, building a moat in business is equally crucial.
No matter if the company is very big or profitable, if there is no moat, it will not remain competitive. Eventually, the rivals will build similar or duplicate products, and the profits will begin to go their way.
No company can prevent duplication of their products and services forever. Even global corporate giants like Coca-Cola, Pepsi Co, Apple, Microsoft, Nestle cannot ignore the threat of reproduction by its competitors.
Patents, copyrights, and trademarks can provide temporary protection. But long-term competitive advantage (economic moat) needs to be built (gradually, over time).
Companies with a narrow moat are better than companies with no moat (no competitive advantage). But for a business to continue to remain profitable time after time, must build a wide moat. Such companies remain investors’ favorites because they remain in a position to earn high profits for the long term.
Factors That Build An Economic Moat
A thing that provides the widest moat (competitive advantage) to a company is customers’ preference for their products. No matter what the competitors are doing, if customers will not look-away, the company will continue to enjoy the sales, profits, and margins.
Market restrictions can also give the business its moat. An example of such restrictions can be the Car Industry of the 1980s. Back then, 90% of people in India had Hindustan Motors (HM), Maruti & Fiat as their cars. The Indian economy was closed and Giants like Ford, VW, Toyota could not enter India. The restriction in the Indian economy gave HM, Maruti, etc its economic moat. But such a moat is often short-lived.
Out of the two, it is the customer’s preference-driven economic moat that lasts the longest. So which are the factors that can tend people to lean more towards a particular brand or product. Let’s read more about it.
Economic Moat in Business and Customer Preference
A company must do everything to create a preference for its products and services. Thus it creates value for its customers. The higher is the value creation, the more it will restrict customers from switching to other brands or products.
This cycle of customer preference, value creation, and restriction to switching can build a wide economic moat for a company.
But what a company must do to create customer preference (value creation or discourage switching)? Following four actions can create great value for the customer:
- Superior Quality Product: It all starts with the quality of goods and services offered by the company. No matter if the company is small, if customers like its offerings, sales/profit will grow. It is one reason why good companies spend considerable resources in the research and development of their products.
- Low Cost: A good company keeps a balance between quality and cost. A customer may reject even the best quality product if they perceive its price as expensive. Cost is a critical ingredient of value creation. It is one reason why a low-cost producer beats its competition in the market.
- Brand Value: It gives customers a sense of pride to own its products. There are certain brands whose products are considered more reliable than others. Some brands become a status symbol for people. It takes time and effort to build a brand name, but it’s worth an effort. It can give a huge competitive advantage to the company by ensuring value for all stakeholders.
- After Sales Service: In the last few decades, it has gained more traction in value creation for existing customers. There will always be some customers who will face problems with the products or services of the company. How a company handles such customers is very crucial. Making happy a dissatisfied customer is great. Such customers spread goodwill by word of mouth. It, in turn, can bring new customers to the company.
What is the point?
Customers who are using a branded quality product, bought at a low price, getting good after-sales service builds an experience. Such customers are least likely to switch to other competitors. Moreover, they also bring in new customers.
So you can see what the company is trying to achieve by creating value for its customer. All the actions ultimately discourage people from switching to other brands.
A company with a wide economic moat are the one whose customers simply do not want, or cannot, switch to other products. As an investor, we should always be on the look-out for such companies.
Having said that, it is also true that there are not many companies who can boast of a wide economic moat. This is the reason why such companies always trade at overvalued price levels.
So what can we do? The first step is to identify such companies. Prepare your list of moat companies in India. Second, wait patiently for the price correction. Every time the stock price of such companies falls by 4-5% or more, go ahead and grab it and hold for the long term. Read: Effect of Bonus Shares and Share Splits on long-term returns.
How Economic Moat Converts into More Profits?
Economic moat gives pricing power to companies. What is pricing power? No matter if the company increases the price of its goods or services, there will be no fall in demand.
Examples: BMW, Bose, Rolex, Gucci, Harley Davidson, etc. These few companies (brands) enjoy the widest moats. They have attained a cult status among their customers. People will buy them no matter what. Owning products of such brands gives a sense of price to its customer.
The desire for the products from these brands is so fierce that people often stretch their spending powers to buy them. It in turn gives the pricing power to the company – which ultimately leads to more profits (growing EBIT, PAT, and EPS).
How to identify Moat Companies?
This is a subject on its own. People who do this research spend months identifying such companies. But we need not delve so deep into it. Our screening criteria will be the sustained profitability and size of the company.
What is the logic? The moat companies are necessarily ones that operate with high profitability (margins). But it is also essential to check the sustainability of the margins. Hence, only one-year margin numbers are not enough. Consistency of the number in the last 5-10 years and high average numbers is what we should look for.
We can use the ROE and RoCE numbers as the financial metric for profitability.
Once we have a list of highly profitable companies, we will apply the filter of the size. The size can be in terms of sales revenue or market capitalization. I personally prefer the market cap as a second filter.
Companies shortlisted based on these two criteria are the ones which we can call Warren Buffett-type stocks.
For value investors, there is nothing better than investing in a company that has a wide moat. But a “wide moat” is not a financial metric or ratio which can be easily measured. A researcher must conclude it based on self-study (four actions that are shown above). Beyond the financial of the company, it is also advisable to observe the overall market in general. We can try to locate brands that are gaining recognition due to high-quality products and services.
Thanks for reading and have a happy investing.