What strategy do you adopt while selecting stocks within your investment portfolio? Is it selecting stocks with consistent growth or having a healthy cash flow? Or do you prefer stocks with a strong brand and product mix or having strong operating efficiencies? These are certain parameters desired by every investor, and that is why a large section of investors rely on the parameters while making their investment decisions.
However, in the long term, even the best companies and the market leaders might not be able to sustain these attributes and continue deriving benefits from them. Further, these attributes might not suffice towards sustaining a firm’s business during uncertain business and economic environments.
Ever wondered why some businesses manage to preserve their dominant position for decades while some companies remain prosperous only for a few years? You can find this answer in a concept coined by investment guru Warren Buffet. This concept is referred to as ‘economic moat’, which is vital for a business to sustain all forms of economic and business uncertainties.
What is the Concept of an Economic Moat?
Warren Buffet uses the analogy of a moat or deep water-filled channels, which were used to surround castles during the medieval era. These moats protected the castles from invasions and attacks; it would be difficult to storm castles with wider and deeper moats.
Warren Buffet has used this analogy to identify some of the most formidable stocks that can withstand every form of economic weather.
Here, the moat refers to a company having the position of a sustainable and competitive advantage, which allows the company to earn profits and surpass its competition in the long run. Companies having a wide economic moat are said to be able to survive for long periods and consistently earn high profits.
It also enables these companies to sail through stormy weather and battle through difficult economic periods and market conditions. Many companies are known to have more than one moat, which gives them an additional edge over their competitors.
However, very few companies can boast having a competitive advantage, and even fewer companies can pride themselves on having a sustainable competitive advantage.
According to the principles of modern economics, the competitive advantage enjoyed by a firm will be eroded by the competition.
For instance, a company that enjoyed a first-mover advantage will be forced to face competition from imitators and another form of competition, and the company will no longer be able to rake in the levels of profits it enjoyed when it was the only firm in the marketplace.
As a result of this, it is vital for companies to protect and sustain their competitive advantages, a.k.a., economic moats, for a longer period. The wider the moat, the more difficulties the competition will face in impacting the market share and profits of the company.
How can investors identify moats?
It might not be easy for investors to identify moats at the time of its creation. Economic moats are built and created over a period of time. For instance, the brand value of Asian Paints acts as its economic moat, allowing the company to prosper and sustain in spite of increasing competition.
It would have been difficult to notice this economic moat in the early 1990s, as the company has built its brand image and positioning throughout several years.
A lack of farsightedness can make it difficult for investors to identify, invest, hold stocks of companies with economic moats, and reap the benefits of their multi-fold growth.
Further, once an economic moat is identified, it is difficult to evaluate its sustainability; it can be breached by the innovations of a competitor; changes in technology; and changes in consumer demand can be unpredictable.
For instance, the Canadian company known as Research in Motion, which owned the BlackBerry brand, enjoyed its economic moat for many years until competitors such as Apple and Samsung entered the smartphone business.
This caused a breach in its moat, and the company lost its market share and dominant position to its competitors.
- Strong Business Fundamentals
Another thing investors need to keep in mind is that merely having an economic moat does not suffice for making a long-term investment in a company. While it is obvious that a company with an economic moat will have strong financials, investors need to investigate any deterioration in the company’s revenues and margins, as this can be an indication that the company’s moat is under breach and it might not be able to hold on for long.
Also, the investors should evaluate the external business environment of the company and analyze the innovation, growth, and strategy of its competitors, which can breach the economic moat of the company.
And do you know when to sell your investments?
- Quality of Management
Another way to identify an economic moat is by analyzing the quality of the management of the company. It involves analyzing the future business plans of the company, the past innovations undertaken by the company, and the ability of the company to change its products, services, distribution channels, etc. to meet the changing tastes, preferences, and demands of the consumers.
For instance, companies like Apple and Microsoft have maintained their dominant and economic moat for decades. This was done by investing in research and development, launching new products, constantly improving existing products, and creating a new economic moat before its previous economic moat has been breached.
Investing in stocks of companies having economic moats during the early days of the company’s growth phase can earn investors multi-fold returns in the long run.
How are economic moats created?
A company can create an economic moat in several ways. Some of the most common economic moats are created in the following ways
There are some ways that a company can develop an economic moat. Here are some of the most common ones:
- Cost Advantage
While imitators and its competitors can replicate a company’s product, what gives a company a competitive edge over the competition is its ability to make the products cheaper while still retaining the quality and its profit margins.
This can be done by incorporating a wide array of techniques such as sourcing cheaper raw materials, economies of scale, backward integration, cost reduction, etc.
- High Switching Cost
Many companies offer products that make it difficult for their customers to switch to their competitors’s products. For instance, Microsoft Corporation enjoys an edge over its competitors due to the high switching cost involved in switching from the Windows operating system to the operating systems of its competitors.
Due to this, Microsoft retains the majority of its customers for a long time, thereby creating a wider moat.
- Brand Value
Brand value is one of the most sustainable methods of building an economic moat. Companies with strong brands are known for their high-quality products and the ability to charge a premium from the customers.
Although creating a strong brand is a long-term process, once a company can create strong brand value, brand recognition, and brand image by consistently offering good-quality products and effective marketing initiatives, Once the company earns the trust of its consumers, it can be very difficult for competitors to attract brand-loyal customers towards their brand and products.
- Technology and Innovation
Technology and innovation can act as one of the best economic moats for a new company to grow rapidly within the marketplace. Patents and intellectual laws can protect technology and innovation.
But an economic moat created due to technology and innovation can be breached without warning by a competitor offering products with much more advanced technology and innovation.
For instance, Kodak was the market leader in photographic films for decades, but the company’s economic moat was breached with the introduction of digital photography technology.
And today, the economic moat of leading players in digital photography is being breached by smartphones with cameras.
- Barriers to Entry
Many companies operate in industries that have strong barriers to entry. These barriers to entry can be due to high investment, government barriers, legal barriers such as licenses and patents, etc.
For instance, Air India enjoyed an economic moat for decades and a monopolistic position within the Indian aviation sector due to legislative barriers not allowing private players to invest in the aviation sector until the early 1990s.
The Bottomline
Identifying a company with an economic moat during its growth stage is equivalent to finding a diamond in a coal mine. Investors should aim towards identifying and investing in companies having an economic moat and enjoy multi-fold returns on their investment.