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Don't buy stocks that have no competitive advantage

Moats or competitive advantages enable a company to earn higher than normal returns on capital

Don't buy stocks that have no competitive advantage

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Not many investors pause to think if the stock they want to buy has a moat or not. Having a moat is important. The returns that you can get in a company that has a moat far exceeds those from an investment in a company that has none. Moats or competitive advantages enable a company to earn higher than normal returns on capital.

In its simplest form, think of competitive advantages as the ability to produce a product or service that competitors cannot copy and sell easily. Coal India has a competitive advantage by virtue of its monopoly over coal mines. In miniaturised circuit boards, Havells has become a household name. Which would you rather buy: a cheaper Chinese MCB or one that has the Havells brand?

Competitive advantages arise from the following:

Technology: Think Windows. It has had 90 per cent of the global desktop PC market to itself for many years. Technology is a source of competitive advantage. Oracle has a moat based on its technologically superior product SAP. Adobe has its moat in Photoshop.

Branding: Think the iPhone. Apple has created such a brand that it has fans all over the world lapping up the latest release, whatever the price. Many fans form queues the day before a new launch or even longer, so that they can get their hands on one. That's the power of branding. Very few products can claim such customer following.

Low cost: Being a low-cost producer enables a company to earn higher profits than competitors and weather a slowdown better. Cipla made worldwide fame with the world's lowest-cost AIDS drugs. Tata Steel is one of the lowest-cost steel manufacturers in the world.

Switching cost: This is the cost, both monetary and otherwise, of customer switching from one product or service to another. It can be monetary when the switch involves a cost to it. If you are an iPhone user, switching to Android means that you could stand to lose usage of all the apps that you bought on the Appstore. You will have to buy those apps again on Android (monetary costs). It is possible that there is no Android version of the iOS app that you are addicted to (non-monetary switching cost). Apple, in this case, has made switching to Android an expensive proposition.

Sustainability of the moat
Moats are not set in stone. Moats grow stronger as well as weaker over time. There was a time newspapers commanded high advertising rates. Today, with increased competition not only from competing papers but also from new media like the net, that moat has shrunk. Today newspapers cannot hike advertisement or subscription rates without worrying about the fallout.

Another example of a waning moat. There was a time when Indian roads were dominated by Hero Honda bikes. Today there's Hero; there's Honda; there's Bajaj; there's Yamaha; and there are others. So gauging whether a moat is getting stronger or weaker with time is imperative when looking at potential investments.

Here you can read about the other articles in this series:

  1. Introduction - The power of Don't
  2. Don't pay attention to hot stock tips
  3. Don't chase market whims and fads
  4. Don't buy stocks without understanding the underlying business
  5. Don't buy companies that sell nonessential products or services
  6. Don't ignore profit margins and returns on capital
  7. Don't try to predict the next multibagger
  8. Don't forget to check the valuations
  9. Don't lose patience
  10. Don't buy companies that offer no enduring products