What is a MOAT?
ItIs a hole is dig all around the castle, which is later filled with water. Moat is a “safety arrangement” built around 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)?
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-
The term “economic moat” refers to a long-term competitive advantage that a company holds that protects its position in the marketplace. The term is inspired by the moat that surrounded medieval castles to protect the valuables within from invaders. A company with a strong moat possesses a competitive advantage that is both strong and sustainable.
Customer’s 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-
The product is useful & unique.
Product is value for money.
The product is trending.
The 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, and 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.
Economic Moat and Customer Preference:
Let’s take the names of a 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 their customers. How does this happen?
This credit must go to the company.
They have used their money to invest in the following, thereby building the customer’s preference for their product and brand.
- Product development (R&D).
- Distribution and sales.
How to identify wide-moat stocks?
Let’s ask a very basic question about the 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 Capitalization can help us identify wide moat stocks.
Explanation of ROCE
There are two companies ABC and XYZ (make the same type of product). The financials of these companies are like this:
Cost of doing business: Rs.100
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 a simplified example of Return on Capital Employed (ROCE).
How to Buy Stocks with wide MOAT?
Like blue-chip stocks, moat stocks also often trade at overvalued price levels, Hence it is essential take care while buying these stocks.
What is the logic?
No matter how good the stock (blue chip or wide moat) is, 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.
The Bottom Line:
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 that are gaining more recognition due to high-quality products, services coupled with marketing.
Disclaimer: All the information here in this article is for educational purposes only. Investing of any kind involves risk. While it is possible to minimize risk, your investments are solely your responsibility. It is imperative that you conduct your own research. We are sharing our inputs to educate traders and investors with no guarantee of gains or losses on investments. Please learn and analyze your stocks by yourself or you can contact to your financial advisor.