Economic Moat as a Framework in Evaluating Stocks

Summary

The concept of an economic moat in stock evaluation is a crucial framework that helps investors identify companies with sustainable competitive advantages. Warren Buffett introduced this concept in 1999. This has been a helpful tool for investors, ensuring reliability and long-term potential in their investment portfolio. This article aims to help you identify those companies with long-term sustainable growth and understand which companies display strong economic moats.

In school we were taught that a “moat” was a man-made body of water surrounding a castle to fortify it and protect it against enemies of the state. In the world of stock investment, its purpose remains the same. An economic moat will give you a competitive edge over other market competitors.

Let’s discuss further.

What does an economic moat mean?

Warren Buffett first introduced the concept of an "Economic moat" during an interview with Fortune magazine. An economic moat refers to the sustainable competitive advantages that a business possesses. Advantages that not only sets it apart from other competitors, but will sustain long-term growth, continuously expand its market share and bolster profitability. Therefore a companies’ moat can determine how long it can maintain its competitive edge in the marketplace and for how long. The deeper the moat, the better.

How can you identify a company with an economic moat?

In today's technology-driven business landscape, economic moats are becoming increasingly significant. Companies who have been able to create and carve out sustainable niches for themselves - regardless of their size or industry exhibit the following characteristics:

• These companies will have limited or zero competition.
• They will have a unique cost advantage.
• It will be difficult for new entrants to enter the industry due to various barriers set by these companies.
• New players will struggle to match these companies’ scale and pricing.
• These companies exhibit strong performance even in sluggish economic conditions.

Some good examples of companies with economic moat

Creating a robust economic moat usually demands a significant time investment from companies. However, thanks to technological progress, newer enterprises can now build such moats more quickly. Here are some strategies companies use to create economic moats.

• Products – Assets that are intangible such as brand reputation, patents, regulatory permissions, and trademarks, can also create an economic moat. They allow a company to distinguish itself from competitors, charge premium prices, and maintain customer loyalty.

Coca cola is a classic example. It is a well-known global brand that has been around for over a century. It possesses a patented product that is impossible for any other company to duplicate, thereby safeguarding its customer base. Furthermore, Coca-Cola boasts an extensive distribution network, making it difficult for potential competitors to enter the market. 

• Cost advantage – When a company can make and deliver its products or services for lesser money than its competitors it creates a cost advantage for itself. They create value internally and allow the company to achieve superior margins, often leading to a bigger market share and more profitability. 

Walmart excels in this approach. The company provides consistently low prices by capitalizing on economies of scale and securing the best available prices for products.

• Network effect - The network effect occurs when the worth of a service or product, both for the company and its current customers, grows with an increase in its user base. This provides an economic moat, as the company becomes more valuable over time. 

Visa, MasterCard, Microsoft, and Facebook exemplify this effect. In the case of the Facebook app, its individual value is limited. However, as more users join Facebook, existing members benefit from the expanded connections available to them. As the Facebook network expands, there is a stronger incentive for new users to join the platform.

• Minimum efficient scale (MES) - MES is achieved through economies of scale. In such a scenario, the market is suitably served by just one company or a small number of them. Introducing more competitors could lead to losses for all involved, thus establishing an inherent barrier to entry.

Maruti Suzuki, has effectively maintained its cost leadership position by leveraging substantial economies of scale. Significant production volumes, more favourable prices with suppliers, resulting in lower material costs enabling them to offer vehicles at competitive prices, thereby enhancing their market share. They have even introduced their own insurance services.

• Switching cost - Switching costs refer to the expenses a customer must bear - both financial and non-financial when transitioning to an alternative product or service. Switching costs can also manifest as loyalty rewards or the hassle involved in switching. As these costs rise, customers become more committed to a particular company. 

Microsoft, Adobe, and Salesforce have successfully established significant barriers for their customers when it comes to switching.

Quick ways to identify companies with an economic moat

If you want to be a smart investor, it's a good idea to put your money in an undervalued stock with a wide economic moat. Before making any investment, make sure you tick off these points while going through their financial reports:

• First, review the company's complete sales performance.
• Examine the growth in earnings and profitability.
• Check for improvements in profitability - ROE and RoCE.
• Consider the overall market sentiment.
• Keep an eye on brands that are gaining traction due to high-quality products and services.
• Rule of thumb - companies with a good market reputation and profits tend to be highly reliable.

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Disclaimer

The investment options and stocks mentioned here are not recommendations. Please go through your own due diligence and conduct thorough research before investing. Investment in the securities market is subject to market risks. Please read the Risk Disclosure documents carefully before investing. Past performance of instruments/securities does not indicate their future performance. Due to the price fluctuation risk and the market risk, there is no guarantee that your personal investment objectives will be achieved.