In business, I look for economic castles protected by unbreachable ‘moats’.” Warren Buffet
Remember big investors talking about moats in equity context. Apple's moat of high switching cost or in Indian context, ITC's moat of extensive distribution network. This time, I thought of providing a synopsis on what exactly are the economic moats and how to spot them.
The term is an analogy to moats which were developed in the ancient
times around the castles. These were primarily the holes dug around the
castle and filled with water so that enemies cannot breach their
territory.
Similarly, an economic moat is a competitive advantage that gives a company a superior hand over its
competitors. Such advantages can arise in the several different forms which are primarily:
- Intangible assets: These are majorly "brands" or "patents" owned by the corporations which dis-incentivize other companies to enter the same industry. For eg.,if I am running a packaging firm, the competition can easily enter and replicate me. On the other hand, if I am operating a brand called "Maggi", it would be very difficult for the rival to enter and dominate the same industry
- Low cost production: These are majorly the companies which, owing to their access to different resources at a much cheaper price, are able to produce the same product at a much less cost than their competitors and able to pass their savings to the customers. These can be due to the economies of scale enjoyed by the company or the inherent location advantage. The example can be the IT industry in India which can produce the same end product at a less cost due to labor arbitrage
- Network Effects: This is the strongest moat which the company can exhibit. In short, the value of the company's network grows with each stakeholder being added in the network. A lot has been written about the network effects in the tech industry, network effects can also be exhibited in the non-tech world. For eg., let us take an example of cigarettes. Why do people buy cigarettes from ITC or VST (Parent of Charms)? It is because of their easy availability. Why do retailers keep only ITC or VST? It is because more people are buying ITC or VST. This virtuous cycle keeps on reinforcing.
- High switching cost: This makes it tough for the customers to use the competitor's products. Take for example CRM industry. A customer who has bought a CRM X would be highly unlikely to switch to CRM Y due to heavy integration costs, behavioral changes required and other factors
The metrics, which can lead to preliminary analysis of the stocks with moat, are ROCE and ROE. The company with moat, consistently has
- ROCE greater than the cost of capital
- ROCE greater than competitors
- Large ROE with optimal debt
Company B's ROE is better on this account since the denominator is much less. But since it has taken a sizeable debt, it might not be wise to consider it better than A.
Fulfilling all the three listed criteria does not guarantee multibagger returns. There are a lot of other factors at play. The investor has to zero down on what makes the company's ROCE so great. Is it due to its pricing power or is there any other factor at play. Will the company able to maintain and widen its moat in the future. Is the company trading at attractive valuation.
There are a lot of companies with moats which can be named from Indian context: Asian Paints, Havells, Page industries, Avenue Supermarts, Kotak, Marico etc.
But wait!! No need to get tempted as they already trade at a very high multiple (EV/EBIDTA, P/B, P/E). Investing is more art than science
What I am reading this week?
Comments
I completely adhere to what you have said and the way you have approached the things. I will also say the most important line of your write up is the last line. "Investing is more art than science". I am still to understand how do you recognize these attributes early. Let's take the case of Safari industry. Kind of return and brand it has built-in last 5 yrs is amazing. Now, for sure this is going to huge in India. Its competitor is VIP industries which itself has every single component of high moat business. Safari created a niche for itself in the backpack business. We also had burgeoning middle class, aviation etc tailwind. Sudhir Jatia ex VIP is credited with the turnaround of Safari Industry. There are two points which I am trying to make one. Quality of mgmt and promoter is for sure the best thing but it is never included in moat literature. Second, how do we catch this train early? What are those signals which can help us check turn around at an early stage.