When a company is expected to enjoy a huge competitive advantage over a long period of time (in the future), it is termed as a company with a strong moat.
Anything else translates into a weak moat or a no-moat.
A Company with a strong moat enjoys unflinching brand loyalty, and its demand does not get impacted even when it ramps up prices.
There are many elements that go into the making of a moat and while evaluating a company, you must ascertain if the company’s business ticks almost all the right boxes.
Here are the elements that go into a moat:
ONE: The Company’s Purchasing Power
A company that attracts customers and possesses vast cash resources always attracts vendors (suppliers).
Suppliers typically vie to do business with the company. Let’s take the example of Reliance Hypermart.
It has deep pockets and attracts lakhs of customers (all India) every day.
All this customer attraction increases its bank balances and the company feels the need to replenish its stocks regularly so that customers get what they want. It keeps buying and selling.
Vendors love this kind of business.
And it’s a win-win situation.
The vendor flips his products faster in a B2B setting, and the company saves hugely because it buys in bulk.
Of course, there will be many companies (such as B2B software developers) to whom this rule will not apply.
This rule applies to consumer product companies, or to aggregators like Flipkart and Amazon, which have created huge online marketplaces.
If your company enjoys this advantage, than that is really cool.
TWO: Coping with Disruption
Take a look around check how disruption has destroyed established businesses.
Just Dial was cruising smoothly when Google launched Google Local (listings).
Over a period of time, Just Dial took a dive and it hasn’t recovered so far despite the occasional spike in its share price.
Take the example of ITC.
When cigarettes started going out of fashion, and got labelled as a health hazard, the company diversified into food and IT, and was successful in creating blockbuster brands in the food vertical.
The Just Dial management thought it could compete with Google by heavily advertising its app, using celebrities.
The ITC management completely rejigged its product portfolio and entered new verticals
So what separates ITC from Just Dial?
The difference is in the management’s quality, vision and determination.
A high quality management always keeps up with disruption and changes business direction well before time. It is proactive.
A low quality management is reactive or at worst, passive.
THREE: Push-Pull Product
Does the company make a product that “pulls” the customer?
For example, HUL’s shampoos and soaps, Colgate’s toothpaste, Infosys’s banking software, Twitter, etc.
So, a “pull” product is a product that fulfills a need and therefore attracts demand.
On the other hand, a “push” product is a product that has to be “pushed” to customers.
In other words, the company has to spend crores and crores to create a demand its products.
For example, movie companies pour millions into advertising their forthcoming releases, online businesses too advertise heavily to popularize their websites, and so on.
So, if the company you are researching makes a “pull” product, then you can assume that it will enjoy tremendous competitive advantages.
FOUR: BRAND POWER
If you are an iPhone user, you will find it infra-dig to switch to an Android phone.
If you are a Gillette shaver, you won’t go near a lower or imported-from-China brand.
If you dine regularly at the Taj Hotel, you will likely avoid Dominos (Jubilant), except for that occasional urge.
Point being, if your company owns a formidable brand that users are hooked on to, then your company enjoys a solid competitive advantage.
But if it’s a brand that users will ditch when something better comes around, then you are looking at a company with a below-average economic moat.
It all boils down to how you analyze the brand perception.
FIVE: ENTRY BARRIERS (CAPITAL OR REGULATION)
Will any industrialist in his right mind set up a refinery in 2018 knowing fully well that EVs will be available in the market from 2020 on?
Will any entrepreneur dare to compete with the likes of Amazon or Flipkart?
Will any business owner set up a carrier fleet company in this already overcrowded market?
Well, the answer to all the questions is an emphatic NO.
No sane businessman will ever invest his capital in an enterprise that has very high entry barriers.
Therefore, you should analyze how your company is placed in the market.
Is it in a business that discourages competition because of any reason?
Is it in a business that requires a massive amount of capital and many years to break even?
If your company enjoys any such advantages, then that is a huge plus.
SIX: GROSS PROFIT MARGIN
The gross profit margin is an overlooked indicator that strips down all the layers covering the business.
A company buys raw materials, converts these to finished goods and sells them. Then it pays office and sales expenses out of the gross profit.
Therefore, to make profits and reward shareholders, it must have a substantial gross profit margin that is either equal to or higher than its peers.
If the company you have spotted looks strong on paper but has terrible gross profit margins, despite enjoying a moat in the past, it implies that something is not not right.
What is the point of having a moat when it does not translate into profits?
To judge a company’s efficiency on this front, you must benchmark its GP margin with its peers, preferably with the best companies in the business.
SEVEN: COST OF CAPITAL
It is a no brainer that a company that enjoys a moat will carry huge liquid assets.
If they do, than that is a good indicator of a strong moat (for example, Sandur Manganese, Hikal have solid bank balances and investments).
Also, such companies generate handsome cash flows year after year.
They can easily diversify or expand without obtaining loans.
Even if a strong company with a strong moat requires funds, banks would stand in a queue to lend at low interest rates.
Therefore, such companies can obtain loans at extremely reasonable rates of interest.
To measure the moat, you must always calculate the cost of capital. If it is high, or if the company is beleaguered by debt, then its moat is very weak.
EIGHT: CORE COMPETENCY
Are the promoters qualified and experienced in the business? Or are they managing the company because their dad gifted it to them?
If they are not qualified or experienced, have they employed professionals to run the company (for example, Wipro, L&T and IVP)?
If a promoter and his siblings, wife, sons and daughters are running the show and they are neither qualified nor experienced, avoid investing in the company.
Point is that the management must be qualified, experienced and clean. To check management quality, read this post.
Apply these factors to the company you are researching and check if it ticks almost all the boxes. Even meeting most of the moat conditions can be a good sign, and it all boils down to your analytical prowess.
Go ahead and give it a try.