How to identify economic moats | Value Research We identify the companies which have created economic moats using the criteria of Morningstar

How to identify economic moats

We identify the companies which have created economic moats using the criteria of Morningstar

How to identify economic moats

Ancient castles had deep, wide ditches filled with water around them called a moat, which protected them from attacks. Similarly, successful companies build 'economic moats', in simpler words - competitive advantage. These moats can be either qualitative or quantitative, and they protect companies from their competitors. Some common ones are proprietary technology, patents, intangible assets, cost advantages, efficient scale, customer switching costs, network effects, etc.

The telltale signs of moat
Who wouldn't want to invest in companies that have an advantage over their peers? Hence, investors are always on the lookout for companies with a moat.

So the next question is how to identify companies with moats.

Experts like Pat Dorsey of Morningstar believe moats are often evident in a company's long-term financials.

In his book, 'The Five Rules For Successful Stock Investing', he lays down specific criteria to identify companies with moats.

Quantitative identifiers
Pat Dorsey mentions that one should look for both qualitative and quantitative factors to identify businesses with wide economic moats.

He suggests that if a company has created a strong enough moat, it will satisfy certain quantitative criteria for at least five years. And if it meets these financial criteria for 10 years, the moat is particularly strong.

The criteria given by Dorsey are as follows:

  • Market cap > Rs 1,000 crore.
  • Free cash flows (FCF) by sales > 5 per cent.
  • PAT margin > 15 per cent.
  • ROE > 15 per cent.
  • Returns on assets (ROA) > 6 per cent.

Hence, we decided to look for BSE companies that satisfied the above in each of the last 10 years. Here's what we found.

Qualitative identifiers
While quantitative screening is a good starting point, qualitative factors should also be considered while searching for companies with moats.

To this end, Dorsey has also written about different kinds of qualitative moats, factors that can't be quantised but help companies grow.

  • Real product differentiation
    This is related to superior technology or featured products for which the consumers are willing to pay more.
  • Perceived product differentiation
    Companies with better products also require a strong brand in the market. Brand loyalty is one of the factors behind customer retention and repeat business.
  • Lower cost offerings
    Offering lower-cost products can be a compelling differentiator for a company.
  • High switching costs
    When a customer has to bear high costs to switch to a competitor, the company benefits from it.
  • High barriers to entry
    Some companies achieve great heights in the markets. Hence, it is very difficult for a new player to enter.

In short, there are both qualitative and quantitative aspects to moats. But, as Dorsey says, these benchmarks are just the rules of thumb, not strict cut-offs. Therefore, do the due diligence before investing. Moats are just one of the multitude of factors that should be considered before investing in a business.

Suggested read: Six parameters to look for in a company before investing

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