Stock Shastra #4: Look for companies with unbreachable moats

We said in Stock Shastra #3 that you need to look at only 5 financial parameters over a 10-year period to shortlist a wonderful company. Once you have identified such a company, you need to determine whether the company has what it takes to remain a winner in the future. So, how do we do this? The answer is Stock Shastra #4:  Look for companies with Unbreachable Moats.

What is a moat?

In olden days, a castle was protected by the moat, a wide channel that was dug around it and filled with water. The wider the moat, the more difficult it was for enemies to enter and capture the castle. For us, the castle is the company we want to invest in. And, the moat is: A sustainable competitive advantage which protects the company from competition and tough economic conditions. Now you know why we use a rarely used word like moat!

So, why is it important to look for a moat?

As discussed in the earlier shastras, a company worthy of our investment must be able to grow its profits consistently, despite competition and tough economic conditions. We emphasize on competition and tough economic conditions because every company has competitors and sooner or later faces tough conditions. During such times, companies fight harder to win customers which usually leads to a fall in prices and thus margins. Only a company with a wide, unbreachable moat – a competitive edge – can maintain and grow its profits even during tough economic conditions. As Warren Buffet said,

What are the moats that can stand the test of time?

While all this may sound a little conceptual to some of you, moats in business are really easy to understand, because it is common-sense. Check out these 5 types of moats!

If you had to buy toothpaste, which name comes to your mind? Most of us would think of Colgate and many of us would buy it. Why? Because this is a name many in India have come to trust over the years. It is quite easy to make toothpaste, maybe even better than Colgate, but without the Colgate brand name, you will sell very little in India. This is the power of the Brand – the first moat. A strong brand helps a business to command a large market share and higher prices, and makes it very difficult for competition to grow.

Wouldn’t we love to own a company that was the only one who could manufacture a particular product and had no direct competition? That is exactly what happens if a company has a patent or a trade secret – the second moat. The most common examples: Pharma companies with patents and food and beverages companies with unique and usually patented recipes like Coca Cola and McDonald’s fries (which are made from specially grown potatoes!).

We travel between cities quite frequently and we always use the expressways/highways, paying a toll. Though the old highways have improved from earlier times, we have never used them since the time the new expressways were inaugurated. The wide empty roads, the time saved and the hassle free driving make the expressway easily the only way to travel between these two cities. Wouldn’t you love to own such a business, that makes money every time someone uses it and people really have no option but to use it. Some companies have exclusive control over particular areas. That gives them the ability to collect a toll – the third moat. For example: If you want to advertise a product in South India on a television network, you would have no real option but to advertise on Sun TV, because of the very high viewership it commands.

We are all creatures of habit. We do not like to change, especially if the change requires a little bit of effort. The fourth moat that a company can have is based on this and is called Switching.  It means a company has a product or service you are so used to, that changing or switching it is either very difficult or not worth it. The most common example of this is Microsoft Windows. We are so used to it, that changing to say Linux is not worth it – even though it is free and offers certain advantages over Windows. IT Companies like Infosys and TCS get around 90% of their business from repeat clientele because of this very moat.

One of the biggest factors on which companies compete is price – the fifth moat. A company which can price its products really low and still make a profit makes it difficult for anyone to compete with it. Consider Koutons Retail, the largest discount retailer for readymade apparels in India. Its strong retail network and a value retailing format combined with a franchise based model enables it to offer heavy discounts on apparels.

So, the five types of moats that a company can have, that can stand the test of time are Brand, Secret, Toll, Switching and Price.

A company can also have other moats like network effects, distribution network, etc.

So, how do you find such a company?

A company which has an excellent financial track record will most likely have at least one moat. Companies without a moat will not usually pass the gold standard of an excellent Financial Track Record, about which you have read in Stock Shastra #3. What we need to check is whether this moat is sustainable in the future. If the company has sustained it for 10 years, it most likely will in future, but check this out before investing.

In the next few Stock Shastras, we will talk more about each of these moats, starting with Brand – the first moat. See you next week with Stock Shastra No. 5….

You should also read the following:

1. Stock Shastra #1: Stock Investing is not Rocket Science!
2. Stock Shastra #2 – Buy a wonderful business and not just a stock!
3. Company Shastra
4. Stock Shastra #5: Great Brands are an unbreachable moat
5. Stock Shastra #8: ‘High Switching Costs’- a recipe for companies to hold customers for life