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Wednesday, 27 March 2019

Be Careful of Moats

Moat is a concept that was brought into the forefront of investment discussions by Buffett. He made it famous by describing it as, "But all the time, if you've got a wonderful castle, there are people out there who are going to try and attack it and take it away from you. And I want a castle that I can understand, but I want a castle with a moat around it."

A business with a moat would imply one which has higher earnings power, higher margins and higher returns on capital than one without. A good way to think about moats is by asking yourself, if prices can be increased without loss of customers or can competitors reduce price and take away the customers of the company?

Some sources of sustainable competitive advantage can come from the following:
-     Better products – Google, Apple etc
-     Intellectual capital (Patents / Copyright) – Big Pharma, Disney
-     Lower cost structure – Shree Cement, Tata Steel
-     Captive customers (high switching costs for customers) – Banks, Corporate ERP systems (e.g. SAP)
-     High entry barriers to business (huge capital, license, hazard, geographical dominance etc) – ONGC, Maruti, Microsoft Windows
-     Economies of scale – Incremental cost of production reduces – Android
-     Distribution (ability to reach more customers) – Hindustan Unilever, Amazon etc
-     Better known brands, which help customers reduce search efforts – Nescafe, Levi’s, Pidilite (Fevicol) etc

Just having a well-recognized brand does not comprise a moat. The brand needs to be able to translate into better higher earnings power. For example, in consumer electronics, Sony is a globally well-recognized brand. But will anyone pay a significantly higher price for a Sony TV today? A good brand is one which is able to reduce search costs for alternatives for a consumer. It becomes an automatic choice. And that can become a very powerful tool for a company.

Moat comprises of two components - sustainable competitive advantage and competitive advantage period. Most of the time, investors focus on only the first. In real life, the second (the duration of time when the competitive advantage period plays out) is equally or sometimes, more important. As we have seen over history, very few companies are able to sustain for very long. We only have a handful of companies which used to operate a hundred years back. In the US, which has a much longer documented history of capital markets, General Electric is the only company which remained a constituent for over a hundred years. If we look at the Sensex when it was first constituted, the list of companies was as follows:
Asian Cables, Ballarpur Industries, Bombay Burmah, Ceat Ltd, Century Textiles, Crompton Greaves, Glaxo Smithkline, Grasim, GSFC, Hindalco, Hindustan Motors, HLL, Indian Hotels, Indian Organics, Indian Rayon, ITC, Kirloskar Cummins, L&T, M&M, Mukand, Nestle, Reliance Industries, Scindia Shipping, Siemens, Tata Motors, Tata Power, Tata Steel, Zenith.
A large number of these companies either have ceased to exist or are a pale shadow of their former selves. This just goes to prove that a competitive advantage does not last indefinitely. A company needs to continuously work at widening its moat. As an investor, even if we identify a company with an apparent moat, we need to continuously keep an eye out for the changes to its competitive position.

1 comment:

  1. Hello Sir, I am an admirer of your contribution to the investment community especially for the elaborate discussions and learnings shared by you on valuepickr forum. I want to ask few questions to you regarding Kolkata as a place for starting independent investing career. As I belong to that region. Can u pls share ur email id, i was unable to msg u on twitter. Or pls ping me on nikhil.mybiz@gmail.com Thanks