First let’s start with basics of what exactly is a moat?
Moat is nothing but a first line of defense. It is a deep, broad ditch which is either dry or filled with water and it surrounds the castle. It was meant to stop the barbarians from entering the castle in Europe.
Similarly, economic moat is a line of defense for companies. They make the company impenetrable from their peers which helps them retain and grow their market share and profits. It is the ability of business to maintain its competitive advantage over its competitors. This competitive advantage can be any factor which will be similar to its competitors, yet giving it an edge. It can be as simple as providing better after sale-services or a secret recipe hidden in the underground vault of its headquarters!
You have to study the company and its peers in depth to find an economic moat at attractive valuation. For example, Coal India is a good example of economic moat in our markets. It has a clear monopoly in the markets due to entry barriers.
How to identify economic moat?
Generally, it is very difficult to identify the economic moats of a company. It is only after the company has reached new heights does an investor understands about the moat. But it doesn’t matter when you identify it. What is more important is how sustainable or for how long the company can reap the benefits of the moat.
Moats can be classified as:
- Wide moats: They provide economic benefits over a prolonged period of time.
- Narrow moats: Having economic benefit but for considerably shorter period of time.
Here are few indicators that investment managers generally use to find economic moats:
- Intangible Assets: This is goodwill which increases the intrinsic value of the company. (e.g.:- patent for new technology.)
- Cost Advantage: Providing the same services as competitors at a cheaper cost but at the same time providing such benefits that no matter if competitors follow suit, customers stick to the company.
- High Switching Cost: When it is expensive or troublesome for consumers to switch from an existing brand to another the company has an advantage. Apart from monetary cost, it can also be psychological, effort and time based cost.
- Barrier to entry: If a company enjoys a monopoly or has high barriers it can enjoy a moat, provided it uses it in an efficient way. A good example of inefficiency could be the airline industry in India.
We hope this article was helpful. If you any other query or want to learn about any other investing theory let us know.
