[Updated: 09-Nov-2019] If Warren Buffett will look for investments in India, which Indian companies will attract his attention? [Check a list here…]
Warren Buffett will look for Moat companies in India.
Let’s know more about the moat and how it helps in value investing:
- 1. What is moat?
- 2. What is economic moat?
- 3. Moat and customer’s preference.
- 4. Concept of widening moat.
- 5. How economic moat converts into more profits.
- 6. How to identify wide moat stocks?
- 7. Explanation of RoCE.
- 8. Indian companies with moat.
- 9. How to buy moat stocks?
- 10. Excellent resource for moat companies.
Before we understand economic moat, let’s first understand what is a “moat”.
1. What is a moat?
It is a hole is dig all around the castle, which is later filled with water.
Moat is a “safety arrangement” built around the castles in ancient times.
The wider and deeper is the moat, more protected is the castle.
Such an arrangement makes it tough for the attackers to access the castle.
What is the analogy with stocks (companies)?
|The Castle||The Company|
|Water Body (Moat)||Protection|
When a castle is protected by a moat, attackers access to the castle is restricted.
Similarly when a company is protected by a moat, competitors will find it difficult to dethrone the company from its current position.
What is the current position of the company? High market share, high profits, high margins etc.
Now lets get slightly deeper into the financial side of “moat” (economic moat)…
2. What is Economic Moat?
Economic moat is also called as “competitive advantage“.
As the name suggests, a company with economic moat has an advantage over its competitors.
What is the advantage?
The company’s market share, profit etc is not in danger from its competitors.
What gives the competitive advantage (economic moat) to a company?
There can be several factors. Two of them which are more evident and are also logical are these:
- Customer’s preference.
- Market’s Limitation.
- Customers preference: This has a dominant role in building moat. If a customer is convinced that a particular product is good, no matter how much the competitors might try, customers will buy their preferable product. Example: Brand “Patanjali”. Recently, this brand has given competition to giants like HUL, P&G etc. What gives such a conviction to customers in favour of a brand? Again there can be several reasons, but what looks more logical to me are these:
- Product is useful & unique.
- Product is value for money.
- Product is trending.
- Brand is valuable.
- No alternative (R&D, patents etc).
- Market Limitations: Restrictions in the market can also give a company its competitive advantage. Example: Hindustan Motors (HM), Maruti & Fiat in 1980’s. Those days, 90% people in India had these cars only. Indian economy was closed and Giants like Ford, VW, Toyota could not enter India. The restriction in Indian economy gave HM, Maruti etc its economic moat.
Economic moat can only be built in long term. For any company, it might take decades to reach the stage of having a moat.
Building moat by influencing customer’s preference is a challenge, which only great companies can achieve.
3. Moat and Customer’s Preference
Let’s take names of few companies whose products we love. We will continue to buy their products no matter what. Why?
Because literally there are no comparable alternatives for them in the market…
- Maggie, Nescafe (Nestle India).
- Good Day Biscuits (Britannia).
- Chawanprash (Dabur).
- Paints (Asian Paints, Berger).
- Pizza (Dominoes – Jubilant Foodworks).
In many ways they have transformed themselves from “mere products” to “necessity” for its customers. How this happened?
This credit must go to the company.
They have used their money to invest in the following, thereby building the customers preference for their product and brand.
- Product development (R&D).
- Distribution and sales.
4. Concept of Widening Moat
As important it is for the company to build its moat, it is equally important to make it wider with time.
How to understand this?
What is a moat? Hole dug around the castle which is later filled with water.
As important it is to dig a moat in first place, it is equally important to keep widening the moat.
What needs to be done for the widening? Make the hole deeper and wider.
This eventually gives more safety to the castle. Moreover, it also ensures that, in future, if a bigger enemy-attack happens – the castle will be still safe.
When a company grow in size – it must invest sufficiently for “moat widening”.
How to do it?
By continuing to invest predominantly on the following:
- Product development (R&D).
- Distribution and sales.
5. 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 Car, Bose’s music system, Rolex’s Watch, Gucci’s clothing line etc.
These few companies (brands) enjoy the widest moats.
The have attained a cult status among its customers. People buy them to maintain their status symbol.
The desire for the products from these brands are so fierce that people often stretch their spending powers to buy them.
This in turn gives the pricing power to the company – which ultimately leads to more profits (growing EBIT, PAT and EPS).
6. How to Identify wide Moat Stocks?
Let’s ask a very basic question about moat.
What is the economic benefit to a company which enjoys a wide moat?
- They enjoy a high market share.
- They can operate at high profitability levels.
- They can even improve their profitability with time.
Which is the best way to measure profitability?
By using a financial ratio called Return on Capital Employed (RoCE).
A combination of high RoCE, RoCE growth and high Market Capitalisation can help us identify wide moat stocks.
But screening stocks based on long term RoCE growth may not be simple for many. Hence I’ve used an alternative screening criteria to identify moat companies.
7. Explanation of RoCE
There are two companies ABC and XYZ (makes same type of product). The financials of these companies are like this:
- Cost of doing business: Rs.100
- Profit: Rs.10.
- Cost of doing business: Rs.100
What is shown by the above numbers?
For every Rs.100 put in the business, ABC is generating Rs.10 and XYZ is generating Rs.12.
Which company is more profitable? XYZ.
This is simplified example of Return on Capital Employed (RoCE).
8. Indian companies with moat
How to identify companies with moat? This can be done using this excellent screening tool.
Allow me to explain how to screen wide moat stocks using this tool. One can use the below screening parameter.
- Market Capitalisation: Wide moat stocks are dominant companies of the market. Hence I’ve used “high” market capitalisation one of the screening criteria (Market Cap more than Rs.50,000 Crore).
- High RoCE: Another key parameter to screen wide moat stocks is RoCE. Why? Because high RoCE represents such business which are inherently profitable.
- Profitability Growth (ROE): Wide moat stocks improve its profitability with time. How to judge it? By looking at their ROE history.
- A company hose ROE is higher than its rivals is one good indicator (ROE more than the sector’s ROE).
- A company whose current ROE is higher than its last 5 years average ROE is also a good indicator. It says that the profitability of the company is increasing.
A combination of the above mentioned parameters can identify few good stocks with reasonable “moat”.
- MCap: Market Capitalisation in Rs.Cr.
- RoCE: Return on Capital Employed (%).
- ROE.S: ROE of the Sector.
- ROE5Y: Average ROE of Stock in Last 5 Years (%).
9. How to Buy Stocks with Moat?
Hence it is essential take care while buying these stocks.
What is the logic?
No matter how good is the stock (blue chip or wide moat), if it is not bought at a fair price, returns will be small (or even negative).
So, how to buy moat stocks?
- Prepare a list of moat stocks based on the above screening criteria.
- Start tracking the price of shortlisted stocks.
- Once the price falls below its fair price, go for it.
How to measure stock’s fair price? You can use stock analysis tool for this purpose.
10. Excellent Resource for Moat Companies
One of the best resource related to moat companies in India is Morningstar.
According to morningstar, the factors which gives economic moat to a business are the following:
- Cost Advantage: What is cost advantage? Example: two companies A & B sell a similar product at same price. But A’s margin is better than B’s. In this case A can said to have a cost advantage over B. In other words we can say that A has a wider moat than B.
- Switching Cost: It is a cost on customers. Suppose there is a company which is using SAP as its ERP system. Now the company decides to switch from SAP to a Cloud based ERP (like Workday). To do this, the company will have to make a large investment (switching cost). When switching cost is high, customers might prefer to stay with the existing product. This choice of customer gives a moat to company’s like SAP.
- Intangible Assets: Suppose you like a company whose main line of operation is machining. If you want, you can duplicate and establish a similar workshop of your own. But suppose, instead of a machine shop – it is a company which has a huge “Brand Name”. It will be very difficult to create a parallel of such a company. Strong brand recognition gives moat to companies.
- Market Limitation: Suppose there is an island country whose population is 1 million only. There are already 3 automobile companies which operates profitably in the place. A new company wants to enter the market. What will happen? First, as it is an Auto company – cost of capital will be huge. Second, as the market is limited, a new entry will only reduce the profitability of every competitor. Company’s do not prefer to set up operations in such a market. Hence, such a market allows moat build-up for existing companies.
- Network Effect: Recently we have seen Auto companies like KIA and MG, etc entering Indian market. Do you know what is their biggest entry hurdle? Not product – but building a network. Companies like Maruti, Tata, Honda, Toyota, VW, Skoda etc already has a dealer-service network. Considering India being a big country, establishing a wide network is a huge cost for the company. They may opt for the franchisee model, but that too will take time as their brands are not as established. This network effect gives moat to existing auto companies like Maruti, Tata etc.
Based on these parameter of Morningstar they also publish a list of stock which has a wide moat.
Top moat stocks as per Morningstar are these:
List of Moat Companies in India
|2||Kotak Mahindra Bank||1,581.00||Wide||Overvalued||Strong|
|5||HDFC Bank||1,259.75||Wide||Fairly Valued||Strong|
For value investors there is nothing better than a wide moat stock trading at undervalued price levels.
“Wide moat” is a not a financial metric or ratio which can be easily measured. A researcher must conclude it based on self-study.
What must be studied to establish moat of a company? It financial reports (of say last 5 years).
In the financial reports what is more important for moat finders will be the following:
- Sales growth.
- Profit growth.
- Reinvestment (back to operations, R&D, marketing, sales and distribution etc).
- Profitability enhancement (ROE, RoCE).
Beyond the financial reports, it is also advisable to observe the overall market in general.
Try to locate brands which is gaining more recognition due to high quality product, services coupled with marketing.
These are my few tips on locating moat companies in India. I hope it is useful for you.
In case you have any feedback/requests please feel free to ask it in the comment section below.
Thanks and have a happy investing.