A moat is a deep and broad ditch filled with water that acts as a line of defence to a castle. In other words, it keeps invaders out.
Warren Buffett popularised the term economic moat. He looks for “economic castles protected by unbreachable moats”. The castle being a metaphor for a company, and the moat being a durable competitive advantage it possesses.
Let’s say a firm is generating high profits. Naturally, this would result in competition because capital flows to the areas of highest potential return. High profits attract competition and competition reduces profitability. The firms that stay profitable for a long time manage to do so by creating economic moats.
An economic moat is a structural business characteristic that allows a firm to generate high returns on capital for an extended period. It acts as a barrier that protects a company from competition.
Nitin Jain of inves4.com shares his perspective on moats. Read what he has to say.
When you ask someone what a MOAT is, they tell you that it is a competitive advantage that a business has. It could be in the form of strong brand image, customer loyalty, extensive distribution, efficient production processes, access to resources, economies of scale or likewise.
Theoretically, I am fine with this definition. Except that one word is missing.
I would define a MOAT as the sustainable competitive advantage of a business that gives it an edge over the others. The key word being sustainable.
Having a competitive advantage is one thing. Being able to sustain it is quite another.
- Established brand image and customer loyalty will not always ensure business. Eg: Hero Motors, Nokia, Blackberry
- Wide distribution will not ensure the highest growth rates for ever. Eg: Large FMCG companies facing challenges from innovative start-ups
- Access to resources may not matter anymore due to the change in the technology. Eg: Established ICE supply chain vs. new EV requirements
No competitive advantage is sustainable by default. And to believe otherwise, in today’s world of disruption and digitisation and abundant private capital, is foolhardy. Breaking brand barriers is not impossible.
So what is important to strengthen the MOAT of a business?
The way management absorbs information and trends, processes it and acts accordingly is what will make the difference.
There is heavy price to be paid when the management ignores emerging competition or changing consumer preferences. Remember Maruti ignoring the SUV segment for long? Or Hero taking customers for granted?
Then we come across companies that expand too soon, too fast and too wide, during good times. Borosil Renewables announcing huge expansions and also international acquisitions.
Or companies, instead of returning cash to the shareholders, acquiring questionable assets. Cartrade going for OLX Autos is a recent case in point.
The ones with the laser-sharp focus on what they are doing, who the stakeholders are, why they are doing it, and how can they adapt, are the ones who will thrive. In fact, I will go one step further and say that this is what the real moat is. This is what will protect them and allow them to attack when required.
Bajaj Finance has achieved over the years by remaining focused. It started from nothing and built one of the best NBFCs by remaining focused. I am hard pressed to find any other real competitive advantage that it has or had.
Bharti Airtel survived the onslaught from Jio by remaining focused on the customer service. Compare that with what happened to Vodafone Idea.
Checkout AIA Engineering or Ajanta Pharma or Alkem Laboratories for their distinct focus. Do listen to some of their quarterly management calls.
Look for businesses that:
- rarely seem to be in a hurry
- are not averse to say no to investors’ demand to return money
- work in a stealth mode on new launches
- are opportunistic but do not divert their energies towards temporary unrelated businesses
- never overpromise and highlight the red flags
- respect competition, customers and the regulators
- err on the side of caution while providing for contingencies
- value changing preferences and technologies
- may not be the best innovators but are very quick adaptors
- know how to cut the noise and focus on what really matters
- openly accept their mistakes and underplay the positives
- are happy not being always in the limelight
To be clear. I am NOT suggesting that focused companies become automatically investible. Business and valuation dynamics need to be right too.
But the odds are very much in their favour if they possess that. Look at it as an excellent filter and a differentiating factor.
Unlike many other factors, focus in general is integral to the culture of an organisation, therefore more permanent in nature. It mostly changes only when there is a significant overhaul in the ownership and/ or the management.
Isn’t that the kind of permanency that MOAT actually implies?
Read the definition again and you might agree.
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