The concept of moat in business and using it for investing advantage

Moat is one of the parameters for identifying stocks or funds. (iStockphoto)
Moat is one of the parameters for identifying stocks or funds. (iStockphoto)

Summary

  • The term economic moat was popularized by Warren Buffet. He has the knack of picking up fundamentally good businesses that have the ability to maintain competitive edge.

The medieval concept of moat is relevant in today’s world, for identifying businesses that have a significant competitive advantage. In medieval ages, some castles or forts would dig a trench around, and fill it with water. It would provide the competitive advantage as the moat makes it that much difficult for invaders. The analogy is, businesses that have a competitive advantage, that is expected to stay for long, have something akin to a moat around a castle. To understand the concept, let us say you start a fruit juice business. You discover that if you procure stock of fruits in bulk, it gives you a cost advantage. However, this is not moat. It is moat when you discover a technology that enables you to extract more juice out of the fruits, or do a better level of product customization that is not easy for competition to emulate.

If you are investing through a fund, you may analyse the stocks in the portfolio or converse with the fund manager on the moats of the portfolio constituents, unless the portfolio is constructed on a different rationale e.g. momentum. The term economic moat was popularized by Warren Buffet. He has the knack of picking up fundamentally good businesses that have the ability to maintain competitive edge. What are the ways a business can have a moat?

Cost-effectiveness: A manufacturing plant situated near to the sources of raw materials, e.g. coal mine or limestone mine, has a cost advantage. If the mine is captive or on exclusive lease, it is difficult for competition to set up a plant with similar cost advantage.

Size superiority: Sometimes customers flock to a business because it is big, and that itself becomes its moat. In commodity exchanges, Multi Commodity Exchange (MCX) has the majority share of trades, which means higher liquidity and lower tick size. While there are other commodity exchanges, MCX is big “because it is big". We have NSE and BSE, but the regional exchanges have withered away. In telecom business, there are licensing fees and infrastructure costs to set up the towers. It makes it that much difficult for new entrants.

Brands: In FMCG or consumer durables, there are certain brands which represent dependability and pull in customers. While nothing stops new businesses to be set up, it will take them a long time to build commensurate pull factor. The tables may turn only if the new business comes up with innovation that is disruptive and the segment leader fails to innovate. An illustration of this is Apple. While competition is there in all of Apple’s product segments, Apple commands a price premium and customer-pull.

Transition price/ shift cost: In some businesses, it is easy for the customer to switch. The service provider has to have the edge to retain the customer. In certain businesses, the nature of the service makes it sticky and customers do not switch easily. People have multiple bank accounts, but usually have a primary bank account. The primary bank account would have various linkages e.g. salary, EMIs, SIPs, demat account, bill payments, etc. Customers would not switch on just one service deficiency.

Community advantage: In online shopping, food delivery apps, ride hailing apps, etc. there are only a few leading ones that have more recall value than others. More service partners get attached with the leaders as more people avail of the services. It may sound like stating the obvious, but more people use it because more people use it.

Proprietary ideas: Where there is a patent or similar exclusivity, it gives a moat to that business. There are so many soft drink manufacturers and brands, but Pepsi and Coke have their own place. Though these are sugar concoctions, they have their customer base. In pharma industry, a patent that gives some extent of exclusivity for a long time period, can be an example of moat.

Conclusion: Moat is one of the parameters for identifying stocks or funds. This is a bottoms-up approach, rather than top-down. The revenue and profit leaders of an industry or segment will give you a clue on the entities that have a moat. You will pick the business with a moat, if the valuation is reasonable. Charlie Munger said, “a great business at a fair price is superior to a fair business at a great price". But the price should be fair and not stretched.

Joydeep Sen is a corporate trainer (financial markets) and author.

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