What is Economic Moat and 5 Ways to Spot Companies with Moat

You can crunch all the numbers, but numbers will always represent history. Ironically, you are buying Stocks for future gains. And history can never guarantee future. Fortunately, MOAT is one of the factors that tries to defend the historical numbers - in the future.

Background

If numbers only represent history, and we are investing in Stocks for future gains, then what are the tools that help us make our historical numbers more predictable in future. 

If you have read the book The Autobiography Of A Stock, then you would remember Round-1, where we do look for Earnings stability as one of the factors for a predictable future. 

But that alone may not be enough. 

We need to look for other factors that reduces our future risk of buying companies with a great past. 

MOAT is one such factor that you must look out for. Let us understand all about Moat.

What is a Moat?

As per English dictionary, Moat is a deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defense against external attack. Take a look at the picture above. The surrounding water body prevents land attack to the buildings.

Presence of Moat

The first thing that the fort or town must have, is a moat - a defense mechanism to prevent itself from the attacks of its enemies.

Sustainability of a Moat

Having a moat is just one part of the story, and perhaps the less important one. Taking the same example of a moat, what use is the moat if the water dries out over a period of time. The moat becomes redundant, and the entire effort and cost in constructing that moat goes down the drain. The sustainability of a moat is even more important than the presence of a moat. 

From Moat to Economic Moat

The concept of 'Moats' for stock selection, was popularised by none other than Warren Buffett. He defined a term called as Economic Moat.

What is an Economic Moat?

The term economic moat, refers to a business' ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms. Just like a medieval castle, the moat serves to protect those inside the fortress and their riches from outsiders.

Sustainability of Economic Moat

Sustainability of Economic Moat is far more important that the Moat itself. While some companies may look like companies with moats in the short term, their competitive advantages can be eroded in the future. When this happens, the company and investors both suffer. How do you know whether a moat is sustainable? For that, you have to study what business the company does. and how it does it. 

A Very Simple Life Example of an Economic Moat

Let us assume that you run a lemonade stand business. 

You realize that if you buy your lemons in bulk once a week instead of every morning, you can reduce your expenses by 30%, allowing you to undercut the prices of competing lemonade stands. 

Your low prices lead to an increase in the number of customers buying lemonade from you (and not from your competitors). 

As a result, you see an increase in profits. You just found out a Moat - the technique of buying cheaper lemons.

However, it probably wouldn't take very long for your competitors to notice your method and employ it themselves. 

Therefore, in a short period of time, your large profits would erode, and the local lemonade industry would return to normal conditions again. 

So, your Moat was NOT sustainable enough.

However, suppose you develop and patent a juicing technology that allows you to get 30% more juice out of the average lemon. 

This technical moat would have the same effect of reducing your average cost per glass of lemonade. 

And this time, your competitors will have no way of duplicating your methods, as your competitive advantage is protected by your patent. 

In this example, your economic moat is the patent that you hold on your proprietary technology. And if your lemonade company was a public firm, your common stock would probably outperform that of your competition in the long run. 

You have a sustainable moat in your hands.

A Wide Moat

A wide moat gives a company a clear financial edge over other competing companies. 

When it comes to the stock market, a wide moat is desirable as it means the company has enough financial advantage over its competitors that it is very likely to keep growing while its competitors need to work harder to keep their profits up. 

In effect, a wide moat is like a wider water canal to protect the fort. The wider the canal, the more difficult it is for the enemies to break in.

A Narrow Moat

A narrow moat gives a company a smaller competitive edge over its competitors. This is usually very brief and lasts only until the competition catches up.

This type of moat is still desirable and still benefits the company, but it is usually short-lived.

The size of a company's moat (wide to narrow and vice versa) can change over time. 

If the company works hard to create something that becomes meaningful to its consumers, then it can make its economic moat wider.

Spotting Companies with Moats

Identifying companies with moats requires you to have a lot of experience in investing. 

Not just experience, it requires one to be patient and rigorous in your approach. 

Sometimes moats may not be easily visible. Many times they aren't sustainable. 

Still, the following pointers may help:

1/ Strong Brand

A strong brand that cannot be replaced from its position in consumers' minds is a moat. 

This is why companies are willing to spend enormous amounts on brand-building activities. 

Their aim is to deliver the message to their target audience that their products or services are better than those of their competitors. 

Example 1:

Maggi is a strong brand from Nestle. 

After running into trouble in 2015, when it was declared unsafe for consumption, Maggi has bounced back and regained its lost market. 

Such is the brand strength of Maggi that it has become eponymous for the noodles category itself.

Example 2:

Thums Up is a powerful brand too. 

When Coca Cola bought Thums Up, it underestimated the power of this brand and tried to push Coke instead. 

It was only when Coke failed to make quick inroads into the Indian market that it realised its mistake. 

For once it made an exception to its global rule and decided to have two brands within the cola segment.

Do you know other brands as strong as this?

However, branding does not work in all industries. 

Especially in high-tech industries (electronics, computers, etc) customers are guided more by technical specifications and product features than by branding. 

For instance, Sony has a powerful brand and it was also the inventor of the Walkman (the first individualised music player). 

But today's youngster covets an Apple iPod. 

Tomorrow if another company comes out with a better product that offers superior value, customers will switch loyalty at the drop of a hat.

2/ Great Distribution

Companies require many years to spread its distribution. 

Hence, companies with a widespread distribution are in a prime position. 

Pepsi's Kurkure is a product that looks omnipresent. Not only it is a strong brand, but no matter where you are in India, you can easily pick up a pack of Kurkure.

A very strong moat indeed.

3/ High Follower-ship 

When numerous people congregate on a network, it increases the value of the network itself so much that others who aren't a part of the network are compelled to join it. 

It becomes like a magnet pulling smaller prices towards itself.

Think of Facebook, Twitter or even LinkedIn or Whats App. 

Example 1:

Once my close friend introduced me to a Microsoft chatting app by the name of Kaizala. 

On his insistence, I installed and tried it. 

It is an awesome app indeed. And I truly felt that it was many notches better than Whats App. Host of features. But here is the challenge.

Whats App has a very strong Follower ship Moat, which is difficult to break.

While I desperately wanted to use Kaizala, and even sent invitations to download this new app to so many of my friends, hardly anyone installed it. I want to move, but all my friends are on Whats App. Who is going to convince them to move to Kaizala? Ultimately, I dumped the idea of moving. The though of moving all my friends seemed very painful.

Example 2:

Take the example of Microsoft Windows. 

Windows is run on so many computers and so many of us have grown accustomed to it that switching to a different operating system becomes difficult. 

4/ High Switching Cost

While switching from Whats App was painful, there could be products which demand high cost of switching.
Example 1:

Look at Indraprastha Gas Limited (IGL) - the company providing piped cooking gas. If someone has to give them competition, they will have to first setup pipelines across the length and breadth of Delhi, and then give a strong reason for a customer to move. Very costly indeed.
Example 2:

Adobe's software such as Photoshop and Illustrator are the ones on which most designers hone their skills during their training period. For them to shift to another design software would require the investment of time and effort. 

Unless the gains from such a switch are substantive, they would be reluctant to switch.

The more tightly integrated a company's products are with a customer's business processes, the more difficult it is for the latter to switch.

5/ Low Cost 

A low-cost producer can drive its competitors out of business. It can sell its product at wafer-thin margins, which its competitors can't emulate. The low-cost advantage is especially relevant when the product itself is not the differentiator. 

Dell is an example of how a better process can reduce costs. 

Dell's PCs are built only after purchase orders are received. This way Dell avoids stocking up on inventory (thereby lowering its working capital requirement). This is especially beneficial within the computer industry where the value of inventory erodes very fast. 

At the same time, Dell is able to take advantage of any late decrease in the price of PC components. 

However, the low-price advantage is also difficult to sustain over a long period of time.

Data Points to look out for when identifying a Wide Moat Company
There are certain data points that might help you identify wide moat companies:

1/ Earnings Performance During Bad Economic Times
Take a look at whether the company still seems to be doing well, even when the broad economy is struggling. This may be an indication that there is something about its business that allows it to remain resilient in the face of tough times.
2/ Financial Performance Compared to Competitors
First, identify the company’s key competitors. Then, compare their revenues and profits. If there’s a big difference between your company’s earnings and those it competes against, you can say it has a wide moat.
3/ Dominance of a Single Product
Apple is considered to have a wide moat because sales of its iPhone far outpace that of any other company. Intel has dominated the semiconductor industry for years because its chips are commonly used by most computer manufacturers. The popularity of these products gives these companies a moat, protecting them against competition and sometimes even the failure of its own other products.
4/ Powerful Intellectual Property
It’s not uncommon for one company to have a unique patent on a product or technology that other firms have little choice but to use. This can be a powerful driver of revenues that competitors can’t match. 
5/ Name Recognition

Is the company practically synonymous with the industry? 

Summary

Economic moats are difficult to express quantitatively because they have no obvious dollar value, but are a vital qualitative factor in a company's long-term success or failure and in the selection of stocks.

Regards

Manoj Arora

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