Are your stocks protected by MOATS? We are all familiar with tales from the Middle Ages that featured castles surrounded by large moats, fending off hordes of knights and enemy armies. A moat is a deep, broad ditch, either dry or filled with water, that is dug and surrounds a castle, fortification, building or town, historically to provide it with a preliminary line of defence. These moats were designed to keep out intruders, and the longer and deeper the moat, the more protected the castle would be. Businesses too have moats. In investing terms, the word "moat" usually refers to a competitive advantage. To say that a company has a "wide moat" is to say that it has a unique edge over other companies in its industry. In a broader sense, it can be used to describe something in the company's business that serves as a protective barrier An ideal stock is one that offers steady growth over time and an ability to withstand market downturns and tough economic times. Long-term investors should look to invest in companies that are resilient in the face of competition and changing conditions. Warren Buffet is often credited with using the term moats. He said "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. The Sensex and Nifty have hit all time highs at a time of Covid crisis has diminished corporate earnings potential. Now valuations are high, making investments in equities riskier than usual. However, one can minimize the risk by choosing companies that have economic moats in place. There are several ways in which a company creates an economic moat that allows it to have significant advantage over its competitors. 1. Monopoly and near monopoly (e.g., Pidilite) When the entity is the only player in the industry, or the player covers most business in an industry. Since Styles 1. Monopoly and near monopoly (eg., Pidilite) When the entity is the only player in the industry, or the player covers most business in an industry. Since there is only one supplier or service provider, monopoly companies can charge high rates. But in the current environment quite a few monopolies are losing their status which result in negative fallout like Coal India. In case of near monopolies, they are a result of smart moves by companies over decades and chances of this moat breaking is low. 2. High entry barrier (eg., Reliance, ITC) Companies that require huge investments are unlikely to have too many competitors. The same holds for companies that are from restrictive industries like cigarette or liquor manufacturing. Limited competition helps generate high profits. However, competition may still come from players with deep pockets and break the most of existing players like Reliance entry into the telecom industry. 3. Patents (eg, Biocon) Building an advantage by spending more on R&D and getting patents for products or processes. Since others cannot use the same product or process, companies can generate extra profit till the patent expires. 4. Low cost of advantage (e.g., Nalco) The advantage of access to cheap raw materials or low cost of capital expenditure for new capacity. Low cost of production compared to peers helps a company to increase market share by undercutting competitors or generate higher profits when it is selling at the market determined rate. However, this is not a vary strong moat as competitors will always try to reduce their cost. 5. Strong brand (e.g., Titan) Some companies are able to price their products higher by creating strong brand appeal. Despite the additional spend on brand maintenance in the form of advertisements, brands help companies to generate higher margin and profits. Brand loyalty also helps retain customers and ward off competition 6. Complex process (e.g., Reliance) Highly complex facilities help companies to command higher margins than competitors like Jamnagar refinery remains Reliance's main cash cow. This higher profitability will continue till a better refinery is established, which will be costly and also time consuming 7. Network effect (e.g., MCX) It occurs when new customers get into a space only if other people are already there. For example, traders want to be with the stock or commodity exchanges with maximum turnover. Network effect creates WE Styles 5. Strong brand (e.g., Titan) Some companies are able to price their products higher by creating strong brand appeal. Despite the additional spend on brand maintenance in the form of advertisements, brands help companies to generate higher margin and profits. Brand loyalty also helps retain customers and ward off competition. 6. Complex process (e.g., Reliance) Highly complex facilities help companies to command higher margins than competitors like Jamnagar refinery remains Reliance's main cash cow. This higher profitability will continue till a better refinery is established, which will be costly and also time consuming. 7. Network effect (e.g., MCX) It occurs when new customers get into a space only if other people are already there. For example, traders want to be with the stock or commodity exchanges with maximum tumover. Network effect creates "Winner takes it all" situation and ensures steady customer base. Of course, some moats are more durable than others. Those based on regulation can be precarious as they tend to invite intervention. Even those based on brand loyalty or past performance eventually disappear, particularly as new technologies come along Economic moats are generally difficult to pinpoint at the time they are being created. Their effects are much more easily observed in hindsight once a company has risen to great heights. Investors should attempt to focus on wide and narrow moat companies when formulating their portfolio. It really helps sort out companies that may not be around in the long term or may not earn those returns that you are looking for as an investor. Wide moat companies are very hard to attain and very few companies globally have a wide moat rating. Generally, analysts expect a wide moat company to earn excess returns for the next 20 years or so. Companies with a narrow moat are those that should eam excess returns for the next 10 years or so. While it makes for an excellent investment strategy, investing in a wide or narrow moat company is no guarantee to success. Valuation does play a very critical role. Questions What is an Economic Moat? Explain different types of moat identified in businesses? What is difference between wide and narrow moat? Does relying on economic moat makes for a good investment strategy? Identify the economic moat of the following companies and give reason for the same. Indian Railways United Breweries Shree Cement Asian Paints Visa (payment network)