As a wise investor, it’s important to identify companies with wide investment moat/economic moat. Why does it matter? Well, let say you meet this beautiful woman at a bar. She is sexy, funny and attractive. She seems to have everything you’ve been looking for. The next question she’s asking you is “Will you marry me?” Wow it seems like you just strike lottery! Will you say “I DO!” immediately? Or you’ll think twice? If you are thinking twice, that’s great. Because when you marry someone, you’ll want to find a partner that has more than just appearance. You’ll want to look at his/her character, values, and so much more. If you don’t, the marriage is not likely to last for very long. (I assume if you want to get married, you will want it to last. If not, don’t even bother!)
The same thing applies when you look at a company. When you invest, ask yourself truthfully the following question – do you look at the company’s price (appearance) or performance (value)? If your answer is performance, congratulations! You already beat more than 90% of the “investors” out there, who only bother looking at the stock prices and charts. If you fall into the first category, no worry, you’ll soon be joining the top 10% at the end of this post. In this post, you’ll get to learn the importance of Economic Moat and most importantly, how to find wide moat stocks.
Just to get me clear, I’m not saying that Technical Analysis is not important. It’s a wonderful technique to help investors to observe market movement and respond accordingly. However, if you only look at prices and charts, and not at all care about fundamental analysis, you are not going to go very far.
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What is Investment Moat/Economic Moat?
Before we delve into the topic, I would like you to take a look at this picture. Between these two beautiful castles, which one do you think it’s easier to defend? No brainer, it’s definitely the one with the river surrounding it. In this case, river acts as a moat, to defend the enemies and prevent them getting in easily.
In reality, we want to apply the same analogy and find companies that have moat, and are be able to defend themselves against the competitors.
Investment moat or economic moat is the company’s ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms. Just like a castle that has the river as a protection, the company must have certain qualities to be considered to have a moat.
How to Find Wide Moat Stocks –the Five Moat Sources
- Intangible Assets (brands, patents, license)
- Cost Advantage
- Switching Cost
- Network Effect
- Efficient Scale
These five moat sources are extracted from Morningstar. Now, let’s look at them one by one.
If a company has intangible assets, it has things that block competition and/or allow companies to charge more as the result. Brands are one of the intangible assets. The wonderful thing about a brand is that as long as customers perceive your product or services to be better than the competitors’, it makes relatively little difference whether it actually is different.
Think of a woman who doesn’t love Tiffany? I guess you can hard fine one! Tiffany is a fabulous demonstration of the power of a brand to create excess profits. The simple fact that a piece of jewellery is packaged inside the famous little blue box, allows Tiffany to charge a significant premium for its products. The brand itself convinces customers to be willing to pay more for a virtually identical diamond ring from Tiffany than from a local jeweller.
Apart from brands, patents, license and government approvals also contribute to a company’s intangible assets. You just need to delve deeper to identify them.
If a company enjoys Cost advantage, it’s able to drive cost down and offer similar products or services at a lower price. This will allow the firm to have higher profit margin or/and attract more customers, by selling cheaper goods. Firms can achieve cost advantage through 2 ways, be more efficient or achieve a greater scale.
One example of cost advantage is Walmart. Because the company is so big, it has a lot of bargain power over its suppliers. That’s why it’s able to drive down cost and sell customers cheaper goods as compared to its competitors. And customers continue to patronize Walmart due its cheap prices. The whole profit cycle just continues.
In a consumer perspective, it’s costly to switch to other brands. As the result, they tend to become loyal customers and stick around with the same company for many years. You may be wondering, why is it difficult for customers like you to switch to other brands? Well, most of the time, it’s due to either time consuming, cost too much money, or simply it’s just not worth the effort to switch. In order words, the companies are making it very difficult for the customers to run away. Sounds evil? But that’s what many companies are striving to do!
Do you agree that it’s easy to switch between different brands of tomato sauce, but it’s harder when it comes to medical devices like artificial joint? That’s why companies like Stryker are making tons of money every year due to customer loyalty.
4. Network Effect
As obvious as it sounds, a company’s network becomes more valuable as the number of users increases. One great example will be Facebook. You use Facebook for one simple reason, to connect with your friends and other users. As more and more people use Facebook, the network effect of the company grows stronger. By the way, LIKE OUR Facebook page to receive more investment related tips!
Another example will be Google. In case you are wondering, Google now has 3.5 billion searches every day and 1.2 trillion searches per year worldwide. This just shows how powerful its network effect is. That’s why these 2 companies are able to charge so much for advertising.
When a company serves a market limited in size, new competitors may not have the incentive to enter, as it would cause returns for all players to fall below cost of capital. It’s just like this pie, to the outsiders, the pie may look attractive, luring people to eat it. But as it’s such a small pie, it can only serve up to 2-3 people. If more people come in and fight for the pie, it’s going to turn bloody.
The same analogy goes to companies that serve a market limited in size. It wouldn’t make sense for other players to enter, as It’ll be a Lose-Lose situation for everyone. That’s why companies with efficient scale are profitable by creating monopoly in the niche market. Examples will be airport and pipelines.
How to Find Wide Investment Moat Stocks – It’s a Journey
As you can see, the more investment moat/economic moat source a company has, the merrier it is. It shows that the company has a strong moat that is going to be durable for the next decade. There are also companies that have wear or no moat. That’s when you need to be very careful before investing in them.
Just like the great Value Investor Warren Buffett says, no formula can tell you the exact moat. Although estimating how long a moat will last is not an easy task. But you should at least give it some thoughts, even though you can’t come up with precise answer.
Pat Dorsey from Morning Star also shared about Economic Moat. It basically summaries everything I shared earlier. So if you are lazy to read, watch this video!
Hope you enjoy reading this post and find the information useful. Now you have the ability to find Wide Investment Moat/Economic Moat Stocks, all you need to do is look a little closer in to the companies. And your effort will be rewarding!
If you are a beginner and wondering how to buy stocks in Singapore, feel free to comment below and keep the learning going. 🙂