Economic moat of a company

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.

Economic Moat

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.

Four pillars of stock investing

Four pillars of stock investing

“Is it the right time to gain equity exposure ?” The answer depends upon the investment portfolio you want to structure.

For a diversified portfolio (mutual funds and ETFs), you need to wait till the euphoric sentiments cool down. For a concentrated pool of equity, there is no right or wrong time to invest in equity market.

Investing and making a return in direct stock investing is an exercise that combines finance and behavioural skill.

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. You only find out who is swimming naked when the tide goes out – Warren Buffet.

With respect to direct equity investment, there are four pillars of value creation:

  1. The core-of-value principle establishes that value creation is a function of returns on capital and growth.

  2. The conservation-of-value principle says that it doesn’t matter how you slice the financial pie with financial engineering, share repurchases, or acquisitions; only improving cash flows will create value.

  3. The expectations treadmill principle explains how movements in a company’s share price reflect changes in the stock market’s expectations about performance, not just the company’s actual performance (in terms of growth and returns on invested capital). The higher those expectations, the better that company must perform just to keep up.

  4. The best-owner principle states that no business has an inherent value in and of itself. It has a different value to different owners or potential owners. A value based on how they manage it and what strategy they pursue.

Ignoring these cornerstones can lead to poor decisions that erode the value of companies.

An intelligent investor will do his analysis, find out the true value of the business and then decide whether the asking price is justified. Anyone who does not follow this process is just speculating in the stock market.

Do not get caught up in the euphoria of a rising or declining stock market. Do your own due diligence or consult an investment firm that can perform the analysis on your behalf. 

Do not try to answer “is it the right time to invest in the stock market” but rather “is it right for me to invest in the stock market”.

What to expect, when you invest?

What to expect, when you invest?

You must have come across various occasions when a sales agent would push a financial product basis the investment return. The returns of any financial product depend upon its underlying.

A public provident fund (PPF) is a bond instrument and is directly dependent on the interest rate in the economy.

The underlying remains the same for a fixed deposit, government security or a corporate bond. Therefore, the return of any financial product depends upon the underlying and not on the claim made by an agent.

Traditionally the asset classes were broadly equity and bond. However, as investment options have extended beyond capital market products, these basic categories have also expanded to include commodities, real estate and currency.

The risk and return features of each asset class are distinctive. Therefore, the performance for each asset class may vary from time to time.

Debt

Debt instrument provides a fixed return in the form of coupon/ interest income. Risk (short-term volatility) and return characteristics of a Debt instrument are relatively lower than equity and hence, suitable for an investor seeking regular income flows with minimal short-term volatility.

There are a variety of assets that are categorized as debt. For example, the public provident fund (PPF), National Savings Certificate (NSC), Provident Fund, fixed deposit, corporate bonds, government bonds and treasury bills.

Expected investment return for debt or bonds should be 7% p.a. to 9% p.a.

Equity

A stock represents ownership in a company. Empirical study suggests that this asset class provides higher returns if invested for a long run. Volatility is higher in this asset class than cash and bonds as an asset class.

Remember, Life Insurance Corporation (LIC) also invests in equity. Bonus amount in case of an insurance product would also depend upon how the underlying portfolio of equity has performed.

Expected investment return for diverisfied equity over long term (>7 years) is between 10% p.a. to 12% p.a. However, a well-managed concentrated equity investment may generate north of 20%.

Real estate

Real estate involves investment in land or building (commercial as well as residential). Real estate is also considered as a growth asset that has the potential of providing higher returns if invested for a long run. However, unlike equity investment, you cannot diversify real estate investment. REITs in developed markets are a diversified real estate investment.

Expected investment return for real estate over long term (>15 years) is ~10% p.a. Real estate return are lot dependant on the location, an average return maybe quite a broad range.

Gold

Physical gold is preferred by families as a secure and stable investment.The price of a commodity depends upon buy and sell behaviours and not any other underlying future expectation. It is rather difficult to expect a stable return from commodity investment including gold.

Rather than looking at the investment return, a better way would be to reflect on your needs and goals. Once you know what are the needs and how critical it is to achieve those needs, structure the portfolio with the combination of various asset classes. Gold may not be a great investment but if you want to save for a wedding, gold can be part of your portfolio.

If you are saving for your retirement, PF or PPF may not grow your wealth but can only be part of your retirement savings. You have to include growth assets such as real estate and/or equity in the portfolio.

After a point, portfolio management becomes as ‘art’ and the skill depends upon the artist 🙂