I want to know what are companies with moat as mentioned in your magazine. What is the ideal time frame for investing in such companies?
– Sangram Dash, Rajgangpur, Odisha
Companies with moat, the expression as popularised by Warren Buffett, are basically companies that are durable in the long run. Economic moats, are competitive advantages that enable a few firms to sustain their above-average profitability for years, and sometimes for decades. These are companies with competitive advantage derived from their scale, brand or some other reason and show the ability to translate their advantage into growing the business and profits, and staying ahead of the competition.
Just the way a moat protects a castle from invaders, economic moat is competitive advantage that a company has over other companies in the same industry. The moat puts entry barrier through 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 based on a new proprietary technology, it commands the first mover premium. Till the time the competitors develop something better than that, it will continue to earn super normal profits.
Branding: A 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 and hence are willing to pay premium for the product.
Low cost: If a company can offer a product at low cost but with similar features as that of the rival it enjoys a powerful economic advantage. Firms become cost leaders either because of the processes they employ or due to economies of scale. 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 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.
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.
Warren Buffett would hold onto a company with moat forever. But as an investor we look for growth and profits from investments. You can hold to a company with moat as long as the moat stays and you do not feel the need to book profits. However, as and when you see the company losing the moat cushion, you should consider exiting the same. You could also exit when you feel you have achieved the desired value from your investment in such a stock.Wide moat businesses may not be available at cheap prices.
This article was originally published on January 17, 2013.
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