What Is An Economic Moat? And How Do You Hunt For It?

What is your investing style? Do you invest in undervalued companies, or do you look to hold companies for long periods of time. If you invest in companies that are just undervalued, you will have to sell them when they reach their fair value. Now that you have sold this company for a profit, you have another task at hand — finding another worthwhile opportunity to invest in. Quite a tough task, eh?

 

On the other hand, if you invest in companies that stay great for decades, you don’t have to put in the effort to search for another opportunity very soon. The advantage of this approach is two fold. First, you don’t have to sell that company when it reaches its fair value. Second, you reduce the amount of decisions that you have to take. It is proven that more amount of decision you take in the stock market, the more will it hamper your returns.

 

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

— Warren Buffett

 

Types of Moats

Let us first understand what exactly is a moat. This is what Warren Buffett has to say about it:

 

A good business is like a strong castle with a deep moat around it. I want sharks in the moat. I want it untouchable.

— Warren Buffett

 

1. Intangible Assets

The most common one that you’ll hear is patents. This is normally seen in pharmaceutical industries. Patents prevent competitors from entering in that segment. The tenure of a patent is usually around 10 years. Patents come under intangible assets.

 

Some of the other intangible assets which translate into competitive advantage are regulatory or license advantage. Utility companies like Power Grid have a huge advantage. Companies like these are virtual monopolies. Another intangible asset is brand loyalty. If a brand is great, it does NOT necessarily mean that the company has a moat. Brand translates into a moat ONLY if customers are relatively inelastic to price hikes. Sin stocks are good examples of this.

 

2. Access to Key Resources

This moat is normally seen in commodity companies. They have access to key resources that their competitors won’t be able to have. A company like Coal India has access to the biggest coal mines in India, from which it will be able to milk coal year after year.

 

Another example is the distribution network of Hindustan Unilever. They have almost twice as many touch-points as compared to the second best FMCG company. This would definitely mean that their products reach more number of people as compared to their competitors.

 

3. Network Effects

You might have heard this term a lot. Network effects become more and more powerful with the amount of users using it. Almost all technology companies are network effects — Facebook, Google, Amazon, Naukri.

Network effects form a vicious cycle for the competitors. Let’s take the example of Naukri. Employees will apply on a platform which has the highest number of jobs posted, and employers will post jobs on a platform which has highest number of employees. This has led to Naukri having 70 percent market share in the online recruitment space.

 

4. Economies of Scale

As a company sells more units, it becomes cheaper for them in terms of per unit cost. This leads to a higher margin as compared to their competitors. They can use this difference to either pass it on the customers and drive more volume, or they can invest that in their growth.

 

Let’s have a look a Wal-Mart. As they are huge in size, they can order their stock in bulk. This means they get a discount. This helps them maintain their EDLP (Everyday Low Price) strategy, which drives more customers in their stores.

 

 

Hunting For Moats

Now the big question is how do you hunt for such companies? What you know is that these moats prevent competitors from denting a company’s attractive cash generation ability. In reality, such castles aren’t visible directly. Still, there are some metrics you can look at to spot a potential moat.

 

First is high ROCE (Return on Capital Employed). The law of mean reversion states that if a company is earning extraordinarily high returns on capital employed, then it will attract competitors till the time that return is attractive enough. More competitor entering the industry will drive down the ROCE.

 

If you find that a company is consistently having a high ROCE, then it means that there is something that is protecting the company’s ROCE. Let’s take the case of Nestle India. Their ROCE has consistently been north of 70% — which is a extraordinarily high number. This alone should tell you that they have a moat.

 

You must dig deeper to understand why this moat exists in the first place, and whether or not it is sustainable in the future. Baby food contributes 50% to Nestle India’s topline and almost 80% to the free cash flow. Let us look at why this is the case. Nestle’s baby food products are high margin products. There is zero discounting required to sell the product. They have a dominant 97% market share in the infant food market.

No new entrant will be able to enter this market as the government has stopped issuing new licenses. Also, the government has banned advertising of baby food products — this means no competitor of Nestle India can promote their product. There is little incentive for mother to try new products for her newborn child and it is most likely that a mother will turn towards Nestle’s products.

 

Final Thoughts

There are many different types of moats — some are easily visible, some are a little difficult to figure out. Whenever you come across a company that you think has a moat, just check that company with the types of moats listed here. This will help you stay away from fake moats.

 

Till next time.

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