During ancient times, the huge walls of the royal castles and expensive mausoleums were protected by digging the earth around the tomb and filling it with mud and water. This is called ‘moat’ and it helped the tomb to survive in case any of their enemies attacked.
This moat was actually a defensive system which their enemies were not able to break easily. And hence, many of the castles and tombs were able to survive for a long time.
The same concept of ‘MOAT’ can also be applied to Stocks.
Many companies have created invisible protection around themselves, which give them an advantage over their competitors and help them to keep their business profitable for a long time.
So, What is an Economic MOAT?
An economic moat can be defined as a competitive advantage for a company against its competitors or the companies in the same industry. It helps to create a closed market with a profitable business which is difficult for the competitors to copy.
The moat can be because of multiple reasons like brand value, business monopoly, intangible assets (patents and regulations), low production cost, good networking, technology etc.
The economic moat helps the company to sustain success for the long-term.
This effect occurs because once a firm establishes competitive advantages, its superior operations generate boosted profits for itself, thus providing a strong incentive for competing firms to duplicate the methods of the leading firm or find even better-operating methods.
The ‘Moat’ concept is old and effective. Benjamin Graham, the mentor of Warren Buffet and father of value investing, discussed the same in his book ‘The Intelligent Investor’.
Warren Buffett’s thoughts on Moat.
Warren Buffett always looks for an economic moat in the company before making his investment decision. Here’s a quote by Warren Buffett from his company Berkshire’s 2000 annual meeting:
“A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns.” -Warren Buffett (2007- letter to shareholders)
5 Most important characteristics of big ‘MOAT’ Companies:
- Production advantage:
Many companies create an economic moat around themselves by developing a cheaper production cost compared to its competitors. As their production cost is low, they can make a good profit margin.
For example: ‘Maruti Alto’ has been the best-selling car of the passenger vehicle for a very long time. This is because Maruti Suzuki has been able to build ‘Alto’ at a cheap price (with superior quality) for over 15 years according to the demand of the Indian audience.
Low production cost can be created because of different reasons like cheap raw material, low labor cost, highly-efficient plants etc.
2. Brand Value:
There are a number of companies whose consumers get ‘used to’ the products and creates a habit for it. They become a fanatically loyal customer and either do not need or do not want to look for any another company for that product or services. Few companies with big brand value in India are Asian Paints etc.
In India: Adhesive means Fevicol (Pidilite Industries) , Noodles means Maggi (Nestle), Cigarettes means ITC (ITC Ltd sells 81 % of the cigarettes in India), Paints — Asian Paints (As of 2015, it has the largest market share with 54.1% in the Indian paint industry.) etc.
There is only one listed company in India which deals in Poker business,
Any guesses? Delta Corp.
If any company is the single supplier or single service provider in an industry, then it can be considered as a business monopoly. There are no direct competitors for these companies and hence, they cover the whole market segment.
4. Switching Cost:
A company can also create an economic moat if the switching cost for the customers is too high. Few products and services are not easily abandoned by the customers as they involve switching cost. The best example of a company with switching cost as the economic moat is TCS. This information technology giant provides the best service in this field. Moreover, in order to switch to other company, it might require a lot of technology/service change which might be a little difficult for the customers.
5. Entry Barrier:
There are few industries where the ‘entry-barrier’ acts an economic moat for the company. These barriers can be because of multiple reasons like patents, brand recognition, a high cost of set-up, government licenses etc.
For example, A pharmaceutical company has an advantage over its competitors due to patented drugs, which will act a moat. No other pharmaceutical company can produce that patented drug.
Footnotes: Moats are important from an investment perspective because any time a company develops a useful product or service, it isn’t long before other firms try to capitalize on that opportunity by producing a similar — if not better — product. Basic economic theory says that in a perfectly competitive market, rivals will eventually eat up any excess profits earned by a successful business.
For Example: Observe Airtel profitability after Jio came into the market.
So, In other words, competition makes it difficult for most firms to generate strong growth and profits over an extended period of time since any advantage is always at risk of imitation. The strength and sustainability of a company’s economic moat will determine whether the firm will be able to prevent a competitor from taking business away or eroding its earnings.