Setting the Context
When it comes to investing money – the primary goal is to identify companies that provide you the highest return on capital. Now there are companies which shoot up in stock-price only to come plummeting down, there are hot-picks by business channels every day, month and quarter. But every stock has it’s day until…it doesn’t.
Competition is a key element which levels the playing field, chomping off profit margins.
There are certain companies which consistently post high returns on capital over a long-period of time and competition seems to have nothing on them. Well, such companies are known to have “Economic Moats”.
Part I gave a good overview to what Economic Moats mean. In this article let’s dig into the concept a step further by summarising Pat Dorsey’s excellent book on the subject called “Little Book That Builds Wealth”.
Let’s get started…
To jog your memory, an economic moat is a structural characteristic of a company which enables it to have competitive advantages relative to it’s other peers in the market. Such that the economic moat affords investors with high, incremental rates of investment over long periods of time.
That’s cool, but so what?
- Companies that have economic moats have greater resilience, which enables them to bounce back rather quickly even after temporary set-backs.
- Such companies also have a higher probability of increasing their Intrinsic Value over time. Such that, even if the current share price is a tad high, the growth in Intrinsic Value over time will protect your investment returns in the long run.
The single most important point to remember about moats is that, they are structural characteristics of a business (listed below) that are likely to persist for a long, long time, such that it would be very hard for a competitor to replicate it’s success story.
So basically, unless a company has an economic moat, it is susceptible to competitors showing up on it’s doorstep and chomping away its profit margins!
List of Moats
- Brand, Patents, Regulatory License
- Switching Costs
- Network Effect
- Cost Advantage
Part (Ia) Brand Value
A brand is considered to be an economic moat only if it increases the consumer’s willingness to pay or increases consumer captivity. Consider the following two examples to really drive that point home.
Scenario 1: Let’s consider two detergents, Tide and Surf Excel. Both are pretty well known brands in India. But would anybody pay significantly more to purchase them? No (unless you fancy collecting and storing detergents for fun…). After all, a detergent is well, just a detergent. So, popular brands are not always profitable brands. Because well, brands cost money to build and sustain. If that investment doesn’t yield a sustainable Return on Capital via some pricing power or repeat business, then it is not creating a competitive advantage.
Scenario II: Now, consider Tiffany and Co and some other less known brand like…ABC Diamond Company. A 18-carat princess cut diamond, is worth pretty much the same from any jeweller (factoring out the minor design differences), yet, a person would definitely pay a premium to get that diamond in a cute-blue Tiffany box rather than buy the same product from a random ABC Diamond company, yeah? That’s when the brand value is said to be an economic moat.
Inference: Brands can create durable competitive advantages, wherein the actual change it brings about in customer behaviour (like them willingly paying more for a product which would be available for a cheaper price elsewhere) matters much more than the popularity of the brand.
So if consumers pay more for a product or purchase it regularly solely because of the brand, then we can say we have strong evidence of identifying an economic moat in the company.
Part (Ib) Patent Lawyers Drive Nice Cars
Companies owning patents definitely have a competitive advantage. However, one must be cognisant to invest in companies which hold a diverse patent portfolio and a spectacular track record of innovation (E.g. 3M)
Remember “diverse” patent filings by the company is key. If a particular company hinges it’s entire growth story on just ONE patented product, then their promises for high future returns which sound too good to be true, are well…too good to be true. A patent requires periodic revivals and in the mean time the competitors can come up with a similar if not better product to chomp away the profits generated from the existing patent held by the company.
Part (Ic) Isn’t it nice to have the Government Folks on your side?
Having regulatory licenses can virtually convert a company into a oligopoly or a monopoly, invariably keeping competitors at bay. This competitive advantage of having a regulatory license (e.g. license to provide Bond Ratings (Moodys), license to manufacture pharmaceutical drugs, license to build casinos, etc) is even more pronounced when the company is not subject to economic oversight with regard to how to price its products. For instance..
Both the Pharma companies and the utilities companies in the US require regulatory licenses to operate (i.e. require regulatory approval to sell their products). However, while the utilities companies are subject to a pricing cap by the government, the Pharma companies have no such restrictions with respect to the pricing of most of the drugs sold. Thereby giving the latter, an obvious, ginormous, economic advantage.
- Brand value is a great competitive advantage to have as long as the brand value entices customers to either pay a higher price (E.g. Tiffay & Co.) or regularly return to buy more of the product (E.g. Coca Cola).
- Companies holding multiple, diverse patents and who herald a history of consistent innovations are true gems (E.g. 3M). Those which rely solely on a singular patented product maybe in for a lot of legal trouble when competitors come up with similar products as the patent period expires.
- Regulatory licenses is synonymous to a genie (read: the government) granting wishes to Aladin (read: companies who bag the licenses).
Companies who hold brand value, patents and regulatory licenses are thus known to have a competitive edge (aka an economic moat) over their competitors and thereby make great picks for investing since they are really good at defending their profit margins!
And that’s a wrap for this week!
Articles delineating points 2, 3, and 4 of the Section “List of Moats” AND an Explainer of certain moats present in the Indian and US Markets are coming up soon! So stay tuned…
Coffee Time Finance