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How to find companies with moats

We dig into certain parameters to uncover the source of a company's moat and what gives it the position it commands. Read on

How to find companies with moats

A moat is a competitive advantage that gives a company an edge over its competitors. Such advantages can arise in the form of brand, technological superiority, patents, low cost, wide network and other factors.

Only companies with competitive advantages can sustain long-term earnings momentum. A high earnings growth, in turn, can be sustained only when for every rupee a company invests, it can generate a value of more than a rupee. This return on invested capital is a measure of a company's capital efficiency and can be utilised to understand the source of a company's moat. We dig into 'return on invested capital' to uncover the source of a company's moat and what gives it the position it commands. Read on.

Spotting a moat
Did you know that the source of Hindustan Unilever's moat in the Indian FMCG space could be something more than just its brands? That ratings company Credit Analysis and Research (CARE) derives its moat from the lucrative large-ticket bank-loan and bond-rating industry? Or that Castrol India gets its moat from both high consumer demand as well as the technological superiority of its products?

We know companies with moats. These are entities competitors find it tough to compete with. Will you use an adhesive cheaper than Fevicol? Or a low-cost health drink as compared to Horlicks? Or how about a local brand of cigarettes?

We understand companies that have a stranglehold over their customers but what we, as investors, often don't ask is what the source of the moat is.

What makes Hindustan Unilever or Britannia tick? Is it just their brands or something else, too? What about Oracle and how does its competitive advantage differ from that of TCS?

Source of a company's moat
A company with an enduring moat will meet two key requirements. First, it must earn in excess of the cost of capital and, second, it must earn more than its competitors. The return on invested capital (ROIC) can be used to determine the source of a company's moat. ROIC can be defined as follows:

How to find companies with moats

In the equation above, NOPAT is net operating profit after tax, i.e., cash earnings of a company before financing costs. Invested capital is the amount of net assets a company requires to run operations. ROIC can be further broken into two parts:

How to find companies with moats

The measure of NOPAT/sales measures the profitability per unit, while sales/invested capital measures capital efficiency. When both the above terms are multiplied, sales cancels out, leaving NOPAT/invested capital or return on invested capital (ROIC).

But these two terms taken individually can be used to uncover the source of a company's competitive advantage. When NOPAT/sales margin is the dominant factor contributing to the overall ROIC, a company enjoys consumer advantage. When sales/invested capital is stronger, the company enjoys production advantage. Where both NOPAT/sales and sales/invested capital are high, these advantages are reinforced by the economies of scale.

A detailed description of net operating profit after tax and invested capital is as follows:

How to find companies with moats

How to find companies with moats

Three sources of value creation
When a company generates earnings higher than its cost of capital, it creates added value. There are three sources of added value:
Production advantage A production advantage arises when a company is able to produce its goods or services cheaper than those of its competitors as a result of privileged access to inputs or patents or some proprietary technology.

Consumer advantage A consumer advantage arises when a company's products are habit-forming and repeated in use, when the switching costs to a competitor's products are high and when the cost of searching for an alternative makes such an exercise unviable.

External advantage An external advantage is when a company has an advantage given to it by the government or any other authority and it enjoys benefits on account of that advantage.

Getting back to our examples above, Hindustan Unilever has a NOPAT/sales margin of 11.26 per cent for FY16. Its capital-efficiency ratio is astounding 6 times. Therefore, the company gains more from production advantages.

The ratings agency CARE has a sales/invested capital ratio of only 0.36 times but a massive NOPAT/sales margin of 36 per cent. CARE benefits from consumer advantages.

Castrol has a NOPAT margin of 15.77 per cent and a capital-efficiency ratio of six times. It enjoys both consumer and production advantages.

Let us take a look at the three advantages in details.

Production advantages

Consumer advantages

External advantages