Economic Moat – A Factor Providing an Edge to a Company Over its Competitors.

This blog addresses Economic moat which is a term used By "Warren Buffett"

We are familiar with the word moat, it was a deep and wide channel filled with water, that surrounded the walls of the castle to protect it from being attacked by the enemies. The longer and the deeper the moat, the more protected the castle was from the intruders.

The same way an economic moat protects the companies from the competitors and learning about these moats can assist the investors in analyzing the stocks of the company.

An economic moat is a clear-cut advantage the company enjoys over its competitors which aids the company to protect its market share and profitability. It is the sole advantage primarily enjoyed by the company which is difficult to be matched by any other competitor in the market.

How the term economic moat originated?

The concept of economic moat originated by Warren Buffet, who is one of the most successful investors and the CEO of Berkshire Hathaway. He had published an article in ‘Fortune’ Magazine on November 22, 1999 conferring an idea of economic moat.

Warren Buffets investment strategy revolved around the companies with solid fundamentals, robust earning power and potential for continued growth. According to him, the products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

An economic moat is a durable competitive advantage

The existing companies in the market understand that the biggest threat the companies face is from potential competitors and the new entrants. Hence to enjoy market power and to have dominance, the existing companies make an effort to establish an economic moat.

• The companies who have an established moat relish greater average profits as compared to companies who fail to establish an economic moat.
• The advantage is not limited to the companies but it further moves to the investors who seek to maximize their stock value in the future by investing in companies having competitive edge.
• The companies possessing an economic moat form a reputation of generating strong returns and large amounts of free cash flow in the market directing the stock prices to escalate.

Types of economic moats

There are different types of economic moats which provides a competitive advantage to the company. Few of those are listed below: -

Companies possessing competitive advantage over its competitors

There are some companies such as Reliance Industries Limited, Infosys, or Maruti Suzuki that enjoy a high monetary worth as compared to their peers. Therefore, due to economic moat, companies can secure an advantage in the world of competition.

• Cairn India Limited has a low-cost advantage. It can produce a product and can provide it at a low price to the customers. As the company has a low cost, it produces a greater quantity at less price. Cairn India Limited has the lowest operating expenses of $6 per barrel in the world. It has been able to achieve this earmark by installing the latest technology. This level of efficiency exhibited by Cairn India limited is hard to match by its competitors.
• Castrol India has an economic moat in the distribution of products through a large distribution channel. Large distribution channel reduces the cost of production, ensures wider customer reach, logistic support (providing, receiving, handling, storing, transporting the orders on time), and confirms faster growth of the company. Castrol India has 380 distributors, servicing over 110,000 retail sites. The economic moat in the distribution channel benefits Castrol India in reserving a huge market share in the lubricant market.
• Nestle India has a large market capitalization of Rs 149,495.46 crores in the Food Processing Industry, ensuring stable returns and minimizing risk for the investors. Nestle bask the advantage of withstanding extreme market situations and can effortlessly ride the volatility in the market.

A company with an economic moat is desirable to the investors. The moat stocks are traded at an overvalued price as the investors add the stocks of the companies having an edge to maximize their portfolio.

List of Moat Companies in India

A combination of factors such as market capitalization, return on capital employed (%), return on equity of the sector, the average return on equity of stocks in the last five years (%) identifies good companies stocks with a moat.

How can a company create an economic moat?

Different companies use different strategies for creating an economic moat. The five approaches to create an economic moat are as follows: -

Developing a unique brand

Branding is the most powerful tool for creating an economic moat and ensuring the continuous growth of the business. Branding gives recognition to the products over an unfamiliar product. The awareness of a brand confers greater customer loyalty that lasts for a lifetime. The company can charge a premium on its products as the customers get attached to the brand, thereby increasing sales of the company.

For example: - customers who are attached to the Lakme brand are willing to pay an extra price for the product, as they have trust and loyalty in the brand.

Exercising the power of patents

Various companies use patents to create an economic moat. Coca-Cola company has obtained 550 patents. It has a secret formula for beverages that is concealed for 100 years. Since Coca-Cola has patents, no other company can duplicate its taste. Hence Coca-Cola commands a high-profit margin and is one of the favorites of Warren Buffet for investing.

Establishing an obstacle to entry

Have you ever wondered why there are few companies in the automobile and cement industries, but zillions of companies in the Fast Moving Consumer Goods (FMCG) market in India? That is because of obstacles to entry in the cement and automobile industries. Few companies dominate the entire market-creating difficulty for the new entrant to enter into the market. A few companies dominate the market, garnering a larger market share and profit.

Creating value by innovating

Innovation is the creation of a new product or a new business model that is hard to imitate. Innovation provides a secure economic moat.

For example, Amazon started as a bookseller company and gradually took up all consumer products. Amazon has shown a desirable business model that is hard to imitate. Anybody can order anything from any corner of the world, a company like Flipkart is simply following the model built by Amazon.

Switching cost

Switching cost is the cost that the customer incurs while changing the brand, product, or supplier he preferred earlier. One of the examples of switching cost is Netflix, where Netflix provides original and exclusive content. If the customer switches from Netflix to any other online streaming platform, such as Amazon prime, the customer will not have access to original and exclusive content presented by Netflix. This way Netflix enjoys an economic moat where users have to pay the price fixed by Netflix to access the product.

Hence, the companies which can generate economic moats survive in the market for a long period and enjoy a competitive edge against its competitors. Such companies manage to create value for the shareholders, ensuring long term profit and increasing the wealth of the shareholders.

Such companies generate stable returns on the stock during fluctuating market conditions.