There are a few firms that produce above-average returns for years, sometimes decades, despite competition. Such firms are said to possess “economic moats”. An economic moat gives a company competitive advantages that will allow it to earn high profits for a prolonged period.
An economic moat arises from one or more of the following factors:
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). However, investors must remember that an economic moat based on technology lasts till competitors catch up and launch me-too products with similar features.
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.
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, the low-cost advantage must be sustainable and not temporary.
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.
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, and network.
Who in India has it?
Indian companies’ moats are usually the result of first-mover advantage, size and scale, powerful brands, strong distribution networks, and government regulations.
Technology: In the auto components space, Bosch enjoys competitive advantage because of its technological superiority. In the capital goods space, Cummins India, is an example.
Brand: In the financial services space, LIC is a powerful brand that enjoys customers’ trust. In the listed space, it’s HDFC Bank and HDFC, the housing finance company. In the FMCG space, Nestle has effectively used the power of branding.
Low cost: Here, the best examples are the Nano and Tisco, one of the world’s lowest-cost steel producers.
High entry barriers: Players in the telecom and aviation sector have benefited from this type of entry barrier. The spirits business is another that is highly regulated. United Breweries is the chief beneficiary here. ITC is another player that enjoys a competitive advantage that is government mandated.
High switching cost: DTH service providers and banks benefit from having high switching costs.
Distribution and after-sales network: 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 reach.
A moat isn’t always enough
After identifying a company with a moat, pay attention to a few more points before you decide to invest in it. If a company has an economic moat, that moat must translate into strong financials. It is important to think whether the stock’s moat will last for your pre-determined holding period. Companies with moats often trade at high valuations. While you should be ready to pay a high valuation for these stocks, you should also be wary of overpaying.
Don’t relax your vigil
Invest in a company with a strong moat, ensuring that you have not overpaid for it. But thereafter, keep a close watch because over time, a lot of moats get breached. And despite its competitive advantage, other things could go wrong. Thus, even when you invest in a company with a visible economic advantage, you can’t afford to let your guard down.