It is not enough to say that a company has a moat and then rush to your broker to put in an order. One needs to answer a couple of questions
- Does the company really have a sustainable competitive advantage or a durable moat? A high return on capital is a necessary but not a sufficient condition to demonstrate the presence of a moat
- It is also important to judge the depth and durability of the moat. Deeper the moat and longer it survives, more valuable is the company
Measuring the moat
Model 1: Porter’s five forces analysis
Model 2: Sources of added value
The second mental model i frequently use is the sources of added value – production advantages, customer advantages and government (pages 34-41 of the note)
As you run through this checklist/ template, you will notice that a company could have either production or customer advantages due to various factors. However a company which has both has a powerful combination. If these two sources of value are working together and growing, then we may be able to say that the company has a medium or long duration moat
Model 3: High pricing power
Another key indicator of competitive advantage is the presence of pricing power. The following comment from Warren Buffett encapsulates it
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price 10 percent, then you’ve got a terrible business.”
Other miscellaneous models
Is the competitive advantage structural (based on the business) or the management. An advantage based on the management is a weak moat and can change overnight if the same team is not in charge
Industry structure : A duopoly or an industry with limited competition is more likely to have companies with competitive advantage. Look at batteries, two wheelers or sanitaryware for example. One is likely to find companies with medium or long duration moats in such industry structures.
Govt regulation : This can be due to special ‘connections’. If you find a moat due to this factor, be very careful as this can disappear overnight
A brief synthesis
I have laid out various models of evaluating the competitive advantage of a company. Once you go through this exercise, you can arrive at a few broad conclusions
No moat: A majority of the companies do not have a moat. As you go through the above models and are hard pressed to find anything positive, it is an indicator that the company has no competitive advantage. Even if the company has been earning a high return on capital in the recent past, it could be a cyclical or temporary phenomenon. Look at several commodity companies which did well in the 2006-2008 time frame, only to go down after that.
Weak moats: If the moat depends on single a production side advantage such as access to key raw material or government regulation, it’s a weak moat (think mining or telecom companies). The company can lose the advantage at the stroke of a pen, law or whims and fancy of our politicians. In addition the pricing power of such companies is very low. I would categorize such a moat as a weak one and not give it a duration of more than 2-3 years.
Strong, but not quite: If the moat depends on customer advantages such as brands or distribution network, the moat is much stronger. A company with a new brand which is either no.1 or no.2 has a much stronger moat. I tend to give the moat a medium duration (5-8 years). The reason for being cautious at this stage is that the company clearly has a competitive advantage, but the strength has not been tested over multiple business cycle. In addition, in some case the business environment is subject to change and one cannot be too confident of the durability of the moat.
The bullet proof franchise: These are companies with multiple custo mer and production (scale related) advantages. These companies are able to command high margins, can raise prices and at the same time have a very competitive cost structures due to economies of scale. These companies have demonstrated high returns of capital over 10+ years and continue to do so. In such cases, one can assume that duration of the moat is 10+ years. These cases are actually quite easy to identify – asian paints, nestle, Unilevers, pidilite, HDFC twins and so on.
Moats are not static
A key point to keep in mind is that moats are not static, but changing constantly
The moat of a long term investor
So any investor who has a long term horizon and is ready to invest the time and effort to do this type of analysis will find very little competition. It is a general rule of business that lower competition leads to higher returns – the same is true for investing too.
If you buys stocks, the way most people buy shoes, TV or fridges – after due research on features, durability (how long the consumer durable will last) and then compare with price, the result will be much better than average.