Economic moat of a company
How can investors be 100% sure of not losing their capital despite investing in the equity market?
The first step in identifying the right set of companies is to understand ‘what they bring to the table’. You don’t want to be investing in companies whose strategies and products can easily be replicated by competitors.
In 2007 Berkshire Hathaway letter to shareholders, Warren Buffet gave ‘economic moat’ concept to the world.
Just like a castle has a moat that surrounds the castle with muddy water, crocodiles etc. This moat prevents enemies to enter the castle. Similarly, economic moat represents some sort of protection of business cash flows.
Businesses with economic moats have sustainability.
A competitive advantage is an advantage that currently allows a company to earn premium margins over its competitors. But an economic moat is a sustainable competitive advantage–a competitive advantage that will last.
Here are few “symptoms” to help us identify economic moat:
Intangible assets: Fanatically loyal customers. Profit margins or cash returns on invested capital that consistently exceed the industry average or those of their competitors. Successful companies with high priced, quality products or services for decades, supported by their brand strength.
Customer Switching Costs: Products and services that are not easily abandoned for a substitute or for a competitor’s product.
Networks Effect: Networks that become more useful as more people join.
Example: Colgate India
One way to understand whether a company has an economic moat is to look at financial reports of the last 10 years. High return on capital employed with high growth in sales and profit will indicate economic moat of a company.
Colgate India manufactures and markets oral care products and other toiletries in India since 1937 and has demonstrated high returns (ROCE) and cash flow generation (Growth) over the years.
They have large established brand and distribution network in place. The company spends 15-16% of revenue each year for marketing (protecting the moat).
Toothpaste is one of the first things that someone puts in his or her mouth in morning. Hence, there is switching cost (psychological) if someone wishes to switch their toothpaste.
So does that mean, you go ahead and invest in this company – “NO”
Price is what you pay and value is what you get. You will wait for the price to be in the range where you get maximum value. This is where valuation comes in or what we call as knowing the fair worth of the company/intrinsic value.
There is a lot of literature on DCF based valuation but that value may be speculative. A conservative approach to understanding the fair value of a company is to compare its asset value with earning power value.