The naive investor thinks that investing is an easy task. All he has to do is identify companies that have posted great returns in the past. And if their valuations are also reasonable, he can go ahead and invest in those companies. Alas, after losing money and a considerable amount of time, he discovers that this rather simplistic approach to investing doesn’t work. Why?
The primary reason lies in the inherent nature of capitalism. Capital flows to the point of maximum return. When a firm produces outsized profits, its success attracts competition. Other entrepreneurs enter the field with their own, often lower-priced offerings, and take away the first mover’s market share. Competition forces the leader to cut prices and this whittles down his margins. Thus, over time the returns of most firms tend to regress to the mean.
A few exceptional firms, however, manage to buck this Darwinist trend. Despite competition, they produce above-average returns for years, sometimes decades. Such firms are said to possess “economic moats”.
While it can’t be said with certainty who coined the term, legendary investor Warren Buffett has done his bit to popularise it. When asked what type of firms he liked to invest in, he said: “Look for durability of the franchise. The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.”
The moat analogy is drawn from medieval times when kings lived within formidable castles surrounded by deep and wide moats that kept invaders at bay and enabled them to perpetuate their rule. The modern corporation too tries to develop competitive advantages that will allow it to earn high profits for a prolonged period.
Developing an economic moat
A firm’s economic moat arises from one or more of the following factors: technology; branding; low cost; high switching cost for customers; or high entry barriers for rivals.
Superior technology. When a company launches a product with better features based on a new proprietary technology, it is invincible in the market (at least for a while). Until competitors can match the technology, the first mover commands a premium. Industries like computing and consumer electronics are driven primarily by innovation. Apple, for instance, has been on a roll in recent years with the launch of blockbuster products in succession: ipod, iphone, and ipad.
In the Indian context, the banking sector offers an example of firms using superior technology to gain competitive advantage. When this sector was thrown open to private players in 2000, the latter had to compete against well-entrenched public-sector banks with vast branch networks and massive deposit bases. The new private players harnessed technology in their favour. They offered ATMs, mobile and internet banking — features that Indian customers had not experienced hitherto — and rapidly garnered customers.
However, investors must remember that an economic moat based on technology is deep but not wide: while it lasts, the company earns high profits (as Apple is earning currently from its ipads). But sooner, rather than later, competitors catch up and launch me-too products with similar features. Apple may have an overwhelming share of the tablet market today but this will not always be so, given the number of tablets that are set to flood the market in the near future. In the Indian context, every bank today offers ATMs, mobile and Internet banking, so these are no longer the source of competitive advantage they once were.
Another pitfall of trying to build an economic moat using technology is that innovation is a crapshoot (predicting with certainty who the winner will be is impossible). There is no guarantee that today’s technology leader will be able to innovate and come up with tomorrow’s blockbuster products and thus perpetuate its lead. Microsoft and Nokia were overwhelming leaders in computing and mobile handsets respectively but have turned into laggards in recent years.
Moreover, when an economic moat is based on technology, a large proportion of the company’s profits have to be constantly ploughed back into research and development in order to maintain the lead.
Branding. A more lasting source of economic moat is differentiation based on branding. If a firm consistently produces products or services that are perceived to have better quality, then over time it becomes a trusted brand that customers prefer over rivals.
Besides quality products and services, advertising too plays a major part in brand building. Through consistent advertising, a firm can firmly implant in customers’ minds that its products or services have certain desirable attributes. Titan’s jewellery foray has been a success because in a segment dominated by Mom and Pop stores, it is regarded as a trusted brand. Since it belongs to the Tata group, customers feel that the company will not cheat on the quality of gold or diamond that it uses in its jewellery.
Globally the best example of a brand that has thrived not for decades but for more than a century owing to the power of branding is Coca Cola (the product itself, after all, is only flavoured sugar water!). From the investor’s point of view, a firm may be said to possess a powerful brand if customers are willing to pay a premium for it compared to a commodity version of that product.
Low cost. A company that offers a product with similar attributes as that of its rivals, but at a lower cost, enjoys a powerful economic advantage. However, for it to be meaningful, the low-cost advantage must be sustainable and not temporary. In commodity businesses (where customers are indifferent to brands and make their choices based more on features and pricing), say, computers and airlines, low cost can be a powerful source of economic advantage. Firms become cost leaders either because of the processes they employ or due to economies of scale. Computer manufacturer Dell manages to keep its costs low through its process-based advantage. In the US, Dell begins manufacturing a computer only after it is ordered (over the Internet or phone), thereby saving on inventory costs. Insurers like GEICO keep their costs low by selling insurance over the phone (instead of via agents, which is far more expensive).
Firms also manage to keep costs low by using economies of scale, i.e., by spreading their fixed costs over an increasing number of units of products sold. For Microsoft, for instance, once the cost of developing a piece of software has been incurred, the marginal cost of producing another unit is nearly zero. Wal-Mart’s business model too depends on scale. Because of the size of orders that it can place, Wal-Mart is able to pare its suppliers’ margins to the bone.
Having gained the low-cost advantage once, market leaders can develop a stranglehold on the market by using their profits to lower costs further, spend more on advertising, offer greater commissions to distributors, and so on. For rivals, it becomes progressively more difficult to break the leader’s stranglehold.
High switching cost. Firms also create economic moats by creating high switching costs for customers, which make the latter reluctant to shift to another product or service provider unless the benefits are very high.
The high cost of switching could be in terms of money, but it could also be in terms of time. Take the example of Adobe’s Photoshop software. Most illustrators learn this software in their formative years and gradually develop expertise in using it. A new software for designers would have a difficult time weaning customers away from Adobe Photoshop. Unless the advantages are substantial, an illustrator would be reluctant to jettison the software that he has become accustomed to.
Mission critical products, and those that require a lot of training for users, usually carry high switching cost.
High entry barrier. Another source of competitive advantage for firms arises from making it difficult for rivals to enter the market. Such entry barriers often arise from regulations, say, via licences or patents.
Patents create strong economic moats. Once a drug has received all the regulatory approvals, the regulator grants the pharmaceutical company the exclusive right to manufacture and sell that drug molecule for 20 years. Since no other company can manufacture the same molecule, the patent holder has limited or no competition and enjoys high profits. Patents account for the consistently high profits of pharma majors such as Pfizer.
Firms also create high entry barriers for rivals by using the network effect to their advantage. The network creates a virtuous cycle: as more members join the network, the latter becomes more valuable; and as it becomes more valuable, more members get attracted to it. Facebook and ebay (the auction site) owe their success to the network effect.
Who in India has it?
Indian companies (by and large) don’t possess economic moats based on intellectual property, as an Apple, Intel or Microsoft does in the technology sector, or a Pfizer does in the pharmaceutical sector. Indian companies’ moats are usually the result of first-mover advantage, size and scale, powerful brands, strong distribution networks, and government regulations.
Technology-based moat. In the auto components space, Bosch enjoys competitive advantage because of its technological superiority, especially in the realm of diesel fuel injection pumps where it enjoys about 90 per cent market share. Says Mahesh Patil, head-equities, domestic assets, Birla Sun Life AMC: “Players in the auto ancillary business are highly dependent on original equipment manufacturers (OEMs) who dictate terms to them. During downturns OEMs squeeze them and their margins fall. But Bosch has stood out because of its technological advantage. Its margins remain high and it enjoys large free cash flow.”
In the capital goods space, Cummins India, whose parent, Cummins USA, is a global leader in manufacturing engines for different segments such as power, automotive and industrial space, is an example. Because of its focus, the parent company understands its field well and is ahead of rivals in technology. Cummins India benefits from having access to its parent’s technology.
Brand-based moat. In the financial services space, LIC is a powerful brand that enjoys customers’ trust. Despite the advent of 30 private insurance companies, it has managed to retain a 70 per cent market share because of the trust that it enjoys and also by virtue of having the largest agent network (6.5 lakh agents) that extends even to tier III and IV towns.
In the listed space, HDFC Bank and HDFC, the housing finance company, have built powerful brands that customers trust.
In the FMCG space, Nestle has effectively used the power of branding to create top-of-the-mind recall for its products. Says Patil: “About 20 years ago, when Nestle introduced Maggi Noodles, it initially lost money on the product as the Indian market was not ready for a readymade snack that could be prepared in two minutes. (Indians then preferred home-cooked food and were suspicious of readymade foods.) But Nestle persisted and has been rewarded with market leadership today.”
Low cost. In India the best example of a low-cost product is the Nano. Says Aseem Dhru, managing director and chief executive officer, HDFC Securities: “Many car companies had in the past tried to build a $2,000 (`1 lakh) car, but it was Ratan Tata’s single-minded focus that helped deliver this product.”
Tisco, one of the world’s lowest-cost steel producers, has managed to keep costs low by having access to its own mines.
Witness also the success in recent years of low-cost airlines in India in taking away market share from their full-cost counterparts.
High entry barriers. Entry barriers, as we said, could get created by regulations, such as the need to obtain a licence to run a particular business. Players in the Indian telecom and aviation sector have benefited from this type of entry barrier.
Only a limited number of licences are issued in each telecom circle, which limits competition, while in aviation foreign airlines are not allowed into the country.
The spirits business is another that is highly regulated. United Breweries is the chief beneficiary here. Liquor companies require licences to set up bottling units in each state. Restrictions also exist on transporting liquor produced in one state to another. According to Patil, “It is also difficult to create new brands in this business as the government does not allow direct advertising. So no new brands have come into this space in recent years. Companies have to take the surrogate advertising route which is time consuming. This gives the incumbent a huge competitive advantage.”
ITC is another player that enjoys a competitive advantage that is government mandated. Says Dhru: “Foreign tobacco brands such as Rothmans or Benson & Hedges can’t come into India and start manufacturing cigarettes as the Indian government will not permit them. So between bidis at the lower end and imported cigarettes at the top end, ITC has the entire market to itself.” Its brands are so powerful that whenever the government hikes excise duty rates (at Budget time), it is able to pass this on to customers without losing market share. The company has further cemented its leadership position by building up a powerful distribution network (it doesn’t give products to retailers on loan; it collects money from them right away, something that few companies can afford to do). High switching cost. In India, both DTH service providers and banks benefit from having high switching costs. When you take a dish from a DTH service provider, you pay a cost for the set-top box and the dish (around `2,000). If you wish to switch, then you would have to pay this amount again to the new service provider. This acts as a deterrent to switching.
Switching from one bank to another has become such a painful exercise today that few customers would undertake it unless they have a strong reason. Says Dhru: “Typically, the customer would have given his bank account for dividend payment from mutual funds and for income-tax refund. He would have issued post-dated cheques for repayment of loans and given ECS mandates for SIPs. Thus there are just too many things linked to the bank account. To open a new bank account, he would have to get KYC done again, go through a lot of documentation processes, and then re-issue all the instructions given in the past.” So the switching cost in terms of the pain involved is high. The ushering in of mobile number portability, by allowing subscribers to take their numbers with them to a new player, works in the opposite direction by lowering switching cost for customers in telecom.
Distribution and after-sales network. Many Indian players are able to sustain their lead by virtue of the powerful countrywide distribution networks they have built over the years. New entrants can’t develop them overnight as doing so requires both time and money. Exide, the leader in batteries, has a distribution reach that is twice as large as that of the number two player, Amara Raja. In the automobile sector, Maruti, Hero Honda and Mahindra and Mahindra all owe their dominance partly to their product suite but also partly to a strong network of sales and service centres that extends even to semi-urban areas. Honda, which separated from Hero Group recently, will not be able to compete effectively against its erstwhile joint-venture partner immediately despite having a richer product pipeline, precisely due to the absence of a strong distribution and after-sales network in India (it is estimated that it will take at least four to five years and crores in investment for Honda to develop a similar network).
A moat isn’t always enough
Having identified a company with a wide and deep moat, you then need to pay attention to a few more points before you decide to invest in it:
Are the return numbers strong? Patil says that if a company has an economic moat, that moat must translate into strong financials. If it doesn’t, then the moat is not very relevant from an investor’s point of view. “Pay a premium valuation for these companies only if they have high return on capital employed and a high level of free cash flow,” he says.
Will the moat sustain? If your holding period is going to be five years, then it is important to think about whether the stock’s moat will last for the next five years. Hero Honda may be the market leader still with nearly a 50 per cent share of the two-wheeler market. But after the recent parting of ways with Honda, there is a question mark over where the technology for the next-generation bikes will come to rejuvenate its aging product line.
Is the valuation right? Often companies that have economic moats trade at high valuations (most good things of life are usually expensive). While you should be ready to pay a high valuation for these stocks, you should also be wary of overpaying. How do you deal with this issue of high valuation?
One, you could wait for markets to enter a bear phase when even blue chips become available at generous valuations.
Two, you could do a discounted cash flow (DCF) analysis that will tell you whether the current market price is attractive vis-à-vis the stock’s intrinsic valuation. Remember that when you do the analysis, you will have to project earnings for a longer period, at least 10 years (your holding period will also have to be long to justify paying high valuations). The terminal value that you attach to these stocks will also be higher because of their ability to sustain a high level of earnings for long. The discount rate that you apply will also be lower due to the lower risk these stocks carry.
Three, you could focus on mid- and small-cap players whose moats are visible but whose valuations have not yet reached stratospheric levels.
Don’t relax your vigil
Finally, having chosen a company with a strong moat and ensured that you have not overpaid for it, invest in the stock. But thereafter keep a close watch to ensure that the stock’s script unfolds along expected lines. One reason is that over time a lot of moats get breached. And second, despite its competitive advantage, other things could go wrong, say, the management could slip up on execution. Take Suzlon’s example. It was one of the early movers and its name was synonymous with wind energy. But then the company made expensive acquisitions from which the payoff (in terms of technological acquisition) didn’t arise as expected. Its debt level rose. It got a number of orders from the US and Europe for setting up wind energy farms, but the blades that it supplied developed cracks. A good story suddenly went awry.
Thus, even when you invest in a company with a visible economic advantage, you can’t afford to let your guard down