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Warren Buffett will look for Moat companies in India. These are basically
such companies which primarily operates as a monopoly business. These
companies gets highlighted by their high profit-margin levels.
TOPICS
1. What is moat?
2. What is economic moat?
3. Moat and customer’s preference.
4. Concept of widening moat.
5. How economic moat converts into more profits.
6. How to identify wide moat stocks?
7. Explanation of RoCE.
8. Indian companies with moat.
9. How to buy moat stocks?
10. Excellent resource for moat companies.
1. WHAT IS A MOAT?
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It is a hole is dig all around the castle, which is later filled with water.
The wider and deeper is the moat, more protected is the castle.
ANALOGY REPRESENTS
Attackers Competitors
What is the current position of the company? High market share, high
profits,
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Now lets get slightly deeper into the financial side of “moat” (economic
moat).
The company’s market share, profit etc is not in danger from its
competitors.
There can be several factors. Two of them which are more evident and are
also logical are these:
Customer’s preference.
Market’s Limitation.
Market Limitations: Restrictions in the market can also give a company its
competitive advantage. Example: Hindustan Motors (HM), Maruti & Fiat in 1980’s.
Those days, 90% people in India had these cars only. Indian economy was closed
and Giants like Ford, VW, Toyota could not enter India. The restriction in Indian
economy gave HM, Maruti etc its economic moat.
Economic moat can only be built in long term. For any company, it might
take decades to reach the stage of having a moat.
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Let’s take names of few companies whose products we love. We will
continue to buy their products no matter what. Why?
They have used their money to invest in the following, thereby building the
customers preference for their product and brand.
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Product development (R&D).
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2. Marketing.
3. Distribution and sales.
What is a moat? Hole dug around the castle which is later filled with water.
What needs to be done for the widening? Make the hole deeper and wider.
This eventually gives more safety to the castle. Moreover, it also ensures
that, in future, if a bigger enemy-attack happens – the castle will be still
safe.
How to do it?
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By continuing to invest predominantly on the following:
Examples: BMW Car, Bose’s music system, Rolex’s Watch, Gucci’s clothing
line etc.
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These few companies (brands) enjoy the widest moats.
The have attained a cult status among its customers. People buy them to
maintain their status symbol.
The desire for the products from these brands are so fierce that people
often stretch their spending powers to buy them.
This in turn gives the pricing power to the company – which ultimately
leads to more profits (growing EBIT, PAT and EPS).
But screening stocks based on long term RoCE growth may not be simple
for many. Hence I’ve used an alternative screening criteria to identify moat
companies.
7. EXPLANATION OF ROCE
There are two companies ABC and XYZ (makes same type of product).
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financials of these companies are like this:
ABC
XYZ
For every Rs.100 put in the business, ABC is generating Rs.10 and XYZ is
generating Rs.12.
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Allow me to explain how to screen wide moat stocks using this tool. One
can use the below screening parameter.
Market Capitalisation: Wide moat stocks are dominant companies of the market.
Hence I’ve used “high” market capitalisation one of the screening criteria (Market
Cap more than Rs.50,000 Crore).
High RoCE: Another key parameter to screen wide moat stocks is RoCE. Why?
Because high RoCE represents such business which are inherently profitable.
Profitability Growth (ROE): Wide moat stocks improve its profitability with time.
How to judge it? By looking at their ROE history.
A company hose ROE is higher than its rivals is one good indicator (ROE more
than the sector’s ROE).
A company whose current ROE is higher than its last 5 years average ROE is
also a good indicator. It says that the profitability of the company is increasing.
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Company Mcap ROCE ROE ROE.S ROE.5Y
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HUL 3,74,792.00 83.47 79.93 14.68 74.08
No matter how good is the stock (blue chip or wide moat), if it is not
bought at a fair price, returns will be small (or even negative).
How to measure stock’s fair price? You can use stock analysis tool for this
purpose.
Cost Advantage: What is cost advantage? Example: two companies A & B sell a
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similar product at same price. But A’s margin is better than B’s. In this case A can
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said to have a cost advantage over B. In other words we can say that A has a wider
moat than B.
Switching Cost: It is a cost on customers. Suppose there is a company which is
using SAP as its ERP system. Now the company decides to switch from SAP to a
Cloud based ERP (like Workday). To do this, the company will have to make a large
investment (switching cost). When switching cost is high, customers might prefer to
stay with the existing product. This choice of customer gives a moat to company’s
like SAP.
Intangible Assets: Suppose you like a company whose main line of operation is
machining. If you want, you can duplicate and establish a similar workshop of your
own. But suppose, instead of a machine shop – it is a company which has a huge
“Brand Name”. It will be very difficult to create a parallel of such a company. Strong
brand recognition gives moat to companies.
Market Limitation: Suppose there is an island country whose population is 1 million
only. There are already 3 automobile companies which operates profitably in the
place. A new company wants to enter the market. What will happen? First, as it is an
Auto company – cost of capital will be huge. Second, as the market is limited, a new
entry will only reduce the profitability of every competitor. Company’s do not prefer to
set up operations in such a market. Hence, such a market allows moat build-up for
existing companies.
Network Effect: Recently we have seen Auto companies like KIA and MG, etc
entering Indian market. Do you know what is their biggest entry hurdle? Not product
– but building a network. Companies like Maruti, Tata, Honda, Toyota, VW, Skoda etc
already has a dealer-service network. Considering India being a big country,
establishing a wide network is a huge cost for the company. They may opt for the
franchisee model, but that too will take time as their brands are not as established.
This network effect gives moat to existing auto companies like Maruti, Tata etc.
Updated: 21-Feb-2020
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SL Name Price Moat Valuation Financial Health
More Stocks
CONCLUSION
For value investors there is nothing better than a wide moat stock trading
at undervalued price levels.
In the financial reports what is more important for moat finders will be the
following:
Sales growth.
Profit growth.
Reinvestment (back to operations, R&D, marketing, sales and distribution etc).
Profitability enhancement (ROE, RoCE).
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Beyond the financial reports, it is also advisable to observe the overall
market in general.
Try to locate brands which is gaining more recognition due to high quality
product, services coupled with marketing.
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