Two ‘Must-follow’ rules for successful stock investing

Amongst the deluge of information on stock investing, a retail investor is often confused about which stocks to invest in. More often than not, the stocks which seem to be extremely promising and are expected to give extraordinary returns turn out to be the biggest losers. Having experienced such loss of capital, we often wonder: Is there a sure shot way to make money in the stock market?  Or is it all a matter of pure luck?

While you have millions of books telling you about the best strategy to profit from stock investing, we at believe, it ultimately boils down to 2 time-tested, must-follow rules.

So, what are these rules?

Rule #1: Buy stocks with wide economic moats

Rule#2: Buy such stocks at a margin of safety

Let’s learn more about these rules, one at a time.

Rule #1: Buy stocks with wide economic moats

Before we understand what an economic moat is, let us understand how capitalism works. Any company that is working with high profit margins in a particular industry attracts competitors. If it is easy to set up shop, more and more competitors will enter the industry, to grab a share of the pie (think of the Indian Telecom market). As the competition increases, profit margins start eroding and are reduced over a period of time.

So, can a company maintain its profitability in such a scenario? The answer is ‘Yes, it can; provided it has an economic moat’.

So, what are these Economic moats?

Warren Buffett introduced this concept of economic moat when he said that the companies with wide economic moats tend to generate higher returns for its investors over a sustained period of time.

Economic moat is a competitive advantage that a company has which makes it difficult for other companies to enter into the industry and operate profitably. This enables the company to maintain its high profit margins resulting in greater value creation for us investors. Economic moats are structural (inherent to the business) economic attributes that helps companies generate high returns on capital for an extended period.

At this time, it is important to understand that just having high returns is not enough as long as the returns are not sustainable. And returns are sustainable only when the companies have wide economic moats that cannot be breached easily.

Say for example if we come across two companies with similar growth rates, Return on Invested Capital and reinvestment needs, which one of them would have a higher intrinsic value? Which one would command a higher valuation multiple (eg P/E)?

It is the company with wider economic moat.

So, how do we identify these economic moats?

There are five major sources which can lead to the creation of an economic moat for a company. These are
a) Intangible assets
b) Cost advantage
c) Switching costs
d) Network effects
e) Efficient scale

Let us understand these different sources and how to spot them as a source of competitive advantage in companies.

a) Intangible assets: These include assets such as Brands, Patents, Exclusive licenses etc. Let’s take a look at each of these

Brands: Companies like Pidilite which have strong brands like Fevicol, m-Seal are examples of companies that have maintained high margins due to their strong brands.

Patents: Most pharmaceutical companies that are into R&D have filed patents which ensure that no other competitor can sell the same product in the markets. This ensures that the company has guaranteed sales over times to come until the expiration of the patents. Many pharmaceutical companies have patents which provide them with such an economic moat.

Licenses and Government approvals: The licenses and government approvals are needed for many industries in our economy. Few examples of such industries are Banking, Telecom and Oil and gas exploration. Companies having such licenses have the economic moat which ensures lower competition and higher profit margins.

b) Cost advantage: If a company has a cost-advantage, it allows the company to sell at the same price as the competition but still earn higher profits. The cost-advantage may be primarily due to two major factors:

Economies of scale: One of the best examples of a company with a wide economic moat due to economies of scale is the US based semiconductor manufacturing company, Intel. The economy of scale that the company has in the field of semiconductor chip manufacturing has ensured that the company can provide a similar product at a relatively cheaper price than its competitors.

Low-cost resource base: Any company which secures license to drilling and producing crude oil or natural gas from a given oil field provides the company with a right to access the resource over the lifetime of the licence. This ensures constant supply of the commodity / resource to the commodity. As the company has already paid in advance for right to the field the price of the commodity for the company is fixed despite the increase price of the commodity globally. This proves as a source of economic moat.

c) Switching cost: Companies like SAP are present in an industry where once the client has bought its services, the cost of switching to an alternate service-provider is high. This creates a wide economic moat for the company. It is important to note here that the company has such a product that the additional and incremental revenues are generated due the fact that the user cannot easily switch to other supplier of a similar product or service.

d) Network effect: The value of the service grows as more and more people use the network. This creates a virtuous circle. More buyers attract more sellers which in turn attract more buyers. With each additional node, the number of potential connections in a network grows exponentially. One of the most widely known examples of such a company is Amazon. With more number of users using the services, they have more number of sellers / advertisers which further leads to more number of buyers.

e) Efficient scale: Serving a naturally limited market serves as a source of competitive advantage. With addition of competitors The business becomes inefficient for all the participants. Incumbents generate economic profits, but new entrants would cause returns for all the players to fall well below cost of capital. Example of companies with moats is natural gas transmission pipelines companies like GSPL or Indraprastha gas. As these companies already have their widespread network of pipelines in a particular region there is no incentive for a new player to come and set up its own network. Any attempt by a competitor to set up such a duplicate network would lead to falling of the profit margins for both the players below the economically profitable level of operation.

Most of the people confuse some other things as economic moat, and hence it is important to know that the following are not an economic moat.

  • High market share is not the same as high return
  • Technology is rarely moat-worthy
  • Hot products can generate high returns but they must be sustainable
  • Process can be made irrelevant or imitated

Another most widely confused parameter is Management of the company. Though quality of the management is the most important criteria in the success of a company, it is not an economic moat in itself. CEOs can create or destroy a moat, but management cannot act as a moat in isolation.

Moats are not distributed equally across sectors and industries. There can be fewer moats in highly commoditized or competitive sectors. There are more moats in areas with durable brands, patents and switching. Again it is not necessary that a company may have just one economic moat. Some companies may have more than 1 economic moat.

After finding out a company with a wide economic moat, it is also necessary to ensure that the value of the moat is not already priced in. It may be possible that the value of the economic moat is already priced in; however this happens sometimes and not always. This leaves you with ample opportunities to select the right stock.

As a result of this the stocks of good investment-worthy companies may be trading below their fair value (MRP). If we say that the stock are trading below their MRP, then how does one determine what is the right price to buy the stock. How much below the MRP should you buy the stock? This can be easily determined by applying a suitable Margin of safety. What exactly is this margin of safety and how does it exactly work? To know more about Rule#2: Buying stocks at Margin of Safety, you can read our article on Margin of Safety by clicking here.

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