What is an Economic Moat – The Concept of Economic Moat in Evaluating Stocks

What is a Moat?

Moat is a big hole dug all around the castle, which is later filled with water.  It is a safety arrangement built around the castles in ancient times. The wider and deeper is the moat, more protected is the castle. This arrangement makes it tough for the attackers to access into the castle. In the stock market, economic moat was first used by legendary investor Warren Buffett in 1999. During an interview with Fortune magazine, he remarked, ‘The key of investing is not addressing how much an industry is going to affect the society or how much it will grow. But, rather determining the competitive advantage of a company. The products or services that have wide and sustainable moats around them are the ones that deliver rewards to the investors.’ Ever since Warren Buffet described ‘economic moat’ as his main investment strategy, there has been a lot of interest in this term. Investors often wonder, ‘what is an economic moat?’.

In this article let us understand:

1. What is an Economic Moat?
2. How Does a Company Achieve Strong Economic Moat?
3. How to Identify a Company with Economic Moat?
4. Importance of Understanding Economic Moat for Your Investments

What is an Economic Moat?

An economic moat is a means of identifying a business that holds a competitive edge over others. Companies with economic moat have:

• Rapid growth potential
• High profits

Economic moat allows the company to keep growing for a very long period and continue to gain market share to increase profitability. The company with an economic moat has an edge over others in these ways:

• The company will have low or no competition
• The industry will have high entry barriers.
• The company will have a distinct cost advantage.
• New players will not be able to achieve the company’s scale and pricing.
• The company has a proven track record of generating huge profits.

How does a Company Achieve Strong Economic Moat?

It takes years for a company to achieve economic moat. In India, Dabur, Asian Paints, MRF, P&G etc are companies with strong economic moat. On the other hand, new-age technology companies may take a few years to achieve economic moat. For example- Infosys, TCS, etc.

How Companies achieve Economic Moat?

1. Pricing Power

What is pricing power? No matter if the company decides to increases the price of its goods or services. There will still be no fall in demand. Examples: BMW Car, Titan Watch, etc. These companies or brands enjoy the widest economic moats. People usually buy them to maintain their status and desire to use their products. The desire for the products from these brands are so fierce that people often stretch their spending powers and buy them. This in turn gives the pricing power to the company – which ultimately leads to more profits, more  EBIT, PAT and EPS.

2. Branding

The brand value of the product is an economic moat for the company. When we think of a few products, these are the brands that instantly come to our minds:

These companies have impressive brand recognition. In fact, most of the time the company is identified with the brand name itself. In many ways they have transformed themselves from “regular products” to “necessity” for its customers and how this happened? This is because the company have used their money to invest in the following, thereby building the customers preference for their product and brand.

1. Product development.
2. Marketing.
3. Distribution and sales.

Hence, the brand is an important material advantage for any business.

3. Patents and Licenses

Patents and licenses protect the production process of the product. For example, Pharmaceutical companies earn significant profits for patented medicines. Similarly, a company having a license to do a specific type of business can be considered an economic moat as well. A company with a license to provide piped gas in a specific region is also an economic moat. For example Mahanagar Gas Ltd. is India’s leading natural gas distribution companies. Also, they also supply CNG to more than 700,000+ vehicles in Mumbai.

How to Identify a Company with Economic Moat? 

Now that we are clear with the meaning of economic moat. Let’s discuss how to identify companies with economic moat.

1.  Solid Performance in Slow Economy

Most businesses would not perform when the economy is stagnant. But a company with economic moat will do well even in a slow economy. The performance of the company will be better than the overall sector.

2. Market Share

Companies with strong economic moat will always be way ahead of their competitors. With time their annual profits and revenue will also increase. This shows that their company size and market capitalization will be way ahead of any competition.

Importance of Understanding Economic Moat for Your Investments

For value investors, there is nothing better than a wide moat stock which is trading at undervalued price levels. While making an investment decision, identifying companies with an economic moat are very important. In the financial reports, which aspect will help you discover the companies with an economic moat?

• Sales growth.
• Profit growth.
• Profitability enhancement (ROE, RoCE).

Beyond the financial reports, it is also advisable to observe the overall market sentiment in general. Try to locate brands which are gaining more recognition due to high quality products and services coupled with marketing. Just like blue-chip companies, these companies are highly reliable and profitable. You can diversify your investment portfolio by investing in companies with economic moats. So, start your investment journey by making a long-term investment in economic moat companies. Open a Demat account with Samco -  India’s best equity stock broker as awarded by CNBC Awaaz and get,

• Demat account
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Happy Investing