22 Oct 2015

What is a MOAT?

What will you learn in this post:
.What is a moat
.Why bother with a ‘moat’
.What are different types of ‘moats’
.How to identify a ‘moat’

Recently, anyone even remotely familiar with investing would have been continuously bombarded with phrases like – this is a great business with ‘moat’; I love this business because I think it has a moat which is deep and wide, etc. So much so that the term ‘moat’ has become the most abused investing term during the years 2014-15.

What is a ‘MOAT’ you beg to ask. Well Wikipedia defines a Moat as follows:-
A moat is a deep, broad ditch, either dry or filled with water that surrounds a castle, fortification, building or town, historically to provide it with a preliminary line of defense. In some places moats evolved into more extensive water defenses, including natural or artificial lakes, dams and sluices.

However, the Moat which we as investors are concerned with is an “Economic Moat”, which is the competitive advantage of a business.

In the words of legendary investor Warren Buffett (who incidentally coined the term and made it famous), following is the characteristic of a good business– “I want a business with a moat around it. I want a very valuable castle in the middle and then I want the Duke who is in charge of that castle to be very honest and hard working and able. Then I want a moat around that castle.” He has highlighted that he wants a big moat with piranhas and crocodiles. He wants his managers (which he refers to as Duke of the Castle) to widen and deepen this moat over time.

Why bother with a ‘moat’?
While doing fundamental research, you would have noticed two companies with similar absolute products trading at significantly different market values. You ask a logical question –why should a steel company get a P/E of 5x its profits, while an internet company gets 50x.

The stock price depends on two factors –
a) Earnings of a company, and
b) P/E multiple

We restrict our scope of discussion to P/E multiple to understand the importance of a Moat. P/E multiple depends on ability to redeploy capital in business and level of sustainable return on invested capital (RoIC).
a) ability to redeploy capital in business depends on demand for the company’s products or services.
b) sustainability of a high ROIC depends on the moat surrounding the business.

Thus the moat around a business significantly impacts its P/E multiple and as a result investment returns over the long term. Wider and deeper the moat, lesser the chance of the company’s RoCE changing from its existing levels.

What are different types of ‘moats’?
Government Permissions: Sometimes governments grant a business rights to exclusively conduct a business. This can be because of capital investment required, high business risks, etc. Pipelines, Transmission lines, etc are examples of government granted monopolies.

Low-Cost Producer: Businesses that can provide goods or services at a low cost, typically due to superior economies of scale, have a moat because they can earn a ‘fatter’ profit margin even by selling their products at competitive prices. For example – low cost airlines like Ryanair, Southwest have thrived while their competitors have struggled. Costco is another example of a wholesale shop selling at ultra low prices and still earning a strong return on invested capital.

High Switching Costs: Switching costs are tangible expenses or intangible inconveniences a customer incurs in order to switch over from one product to another. Thus, once you open a bank account and distribute that account number to all your other financial services providers, you are unlikely to switch to alternates as there is a huge intangible cost in terms of paperwork and hassles in shifting.

The Network Effect: The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service. For example you use your favorite Chat App (like WhatsApp) because many of your friends use it and are available on it. An exchange like Chicago Mercantile Exchange attracts traders on its platform as it has more volumes, and more volumes are because there are more traders. Some of the other examples include a social networking website like Linkedin, Taxi aggregator like UBER, etc.

Intangible Assets: Some companies have an advantage over competitors because of some nonphysical, or "intangible," assets. Intangibles assets can be intellectual property rights (patents, trademarks, and copyrights), Brands, etc. Some of the examples are brands like Gillette, McDonalds, Colgate, etc.

How to identify a ‘moat’?

Generally you can easily spot the existence of a moat by looking at a company’s RoIC over long periods of time. If a company consistently generates a RoIC of more than 15% over time, it can only do so due to the existence of a moat. 

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