“Economic moat” a term coined by legendary investor Warren Buffett which refers to the competitive advantage a company haswhich protects it from its competitors – the way a moat protects castle.
Contrary to what many people believe economic moats are hard to find.
A business is like abig machine that intakes capital and produces goods or services to create more capital. A company that churns out high return on capital over a period of time creates immense wealth. However, it is rare to find such companies that keep on giving above average return because higher profit attracts competitors like a bee to honey. That’s just how capitalism works. And almost always, competition eats away such above average profit.
Therefore, true economic moat can be found in a company that have:
- A patent, brand, regulatory license that prevent competitors to copy its products, give purchasing power or repeat businesses.
- A product that is hard for customers to give up, leads to higher switching cost which allows the company to charge higher price.
- A process, scale or access to unique assets that allows a company to provide goods or services at lower price than the competitors.
A pharmaceutical company that has patent for drugs can create immense return on capital by being the only one in the market to sell such product.
Once gotten the approval a utility company creates a recurring source of income for providing services.
A powerful brand has such a psychological effect on consumers that they cannot find same kind of product from different company as equal let alone be better.
There are two companies Page Industries and Rupa & Company. Both are serving in the competitive industry of inner garments. However, their results largely defer.
|(10 years)||Page Ind.||Rupa & Co.|
- Page Industries by having a strong brand power can increase its product price year after yearwithout losing customers which results in it giving tremendous returns.
- While, Rupa & Co. without any special advantage or pricing power gave average results.
Think of Apple Inc. for switching cost. They have created such an ecosystem with its product and services that it becomes almost impossible for its customers to switch to other products.
A company having access to regions with better technology or low cost labour or a long-term contract and economies of scale can provide customers with goods and services at price that are simply not viable for other competitors.
Whereas in the absence of any competitive advantage, a company have to keep fighting for customers that requires additional capital again and again for returns that are just average.
Hence, instead of investing in many companies which generate average profit find few companies with huge competitive advantage and stick with it until the advantage doesn’t disappear.
However, it’s also important to be disciplined about the price you pay for wonderful businesses. Paying high price can dampen your portfolio performance.
Purchase companies with economic moat at less than intrinsic value (margin of safety) and hold it for a long period of time.
This will have a compounding effect on your wealth that cannot be matched by any other kind of investment in the world.
*Stocks mentioned above are just for educational purpose and not a recommendation to buy or sell.
(Sources: Pat Dorsey – The Little Book that Builds Wealth,
- Adnan Amroliwala.