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4 simple steps to Value Investing: Step 2

Apr 24, 2013

In the previous article, we discussed the first of the four steps to successful value investing created by none other than the legendary Warren Buffett. Let us now move on to the next step in this article.

A 'moat' to protect your castle

If we look at the castles, there is one feature which is pretty much common across all of them. The feature is a deep trench all around the castle. In the old days this trench was typically filled with water and crocodiles or other predatory reptiles. The idea was that the trench would keep the enemy away from the walls of the castle. Thereby acting as an important security measure. This trench is called a moat. Since they provided security, the kings of the time were obviously big fans of moats. But there is someone who is still a big fan of these moats. This is none other than the legendary investor Warren Buffett

He had once said "In business, I look for economic castles protected by unbreachable 'moats'." In simple words he looks for companies with a sustainable competitive advantage. The larger the advantage, the wider the moat. This moat would protect the business from competition. And if the company is able to use its competitive advantage to widen the moat over time, then it is the perfect business to be in.

Companies that have a wide moat are able to earn higher returns for its shareholders. And it is able to do so consistently year after year, every year. This in turn propels its stock value over years. The best part about such companies is that they are able to do well even when conditions are bad. Given the gloomy picture that the current macroeconomic scenario paints, won't such a stock be a good idea? But how do you identify a stock with a solid moat? For this you need to understand how a company can build a moat.

How to build a moat

This safety moat that Buffett has mentioned can be built by the business in a lot of ways.

  1. Brand: A good way for a business to build a competitive advantage is by building a brand. A brand that has consumer recall. It would take years and lot of investment for another company to challenge the authority of a good brand. Take the example of Coca cola. It is one of the most well known brands in the world. This brand gives it pricing power. Despite the number of soft drink manufacturers who have been in existence, none has been able to dethrone Coke as a leading soft drink brand.

  2. Economies of scale: A good way to look at economies of scale is to think of a company that can increase its operations without increasing its costs at the same pace. Such companies tend to have a massive size of operations. They have already incurred huge fixed expenses. Additional costs that are more variable in nature are not very high. So as sales increases, these companies are able to expand their operating margins. The economies of scale help the company make a moat because for any competitor to enter the market, it would need to make a huge investment. Something that is only possible if it has very deep pockets. And even if it is able to make such an investment, it would still take time for it to become a low cost producer something that economies of scale can help in. As a result, the dominant company could cut prices to retain its competitive advantage. Think of Walmart. The company has been able to reach the size where it is today simply due to the economies of scale.

  3. Switching costs: When you buy a laptop or a computer, more often than not it comes loaded with the Microsoft operating system. Have you even thought about changing the operating system? The answer would most probably be no. Why? Because there is a cost involved. This is what is called a switching cost. High switching costs make it costly for a customer to switch from one product to another. Or from one company to another If a company is able to create this moat, then it ends up having a customer following without the threat of competition. Switching costs create a barrier of entry in a way that it deters competition.

  4. Patents: A great way to build a moat is to simply patent the product. If competition has to enter, then it has to wait till the patent expires. Or will have to buy the patent from the company. Typically pharma companies have been able to build such moats.

  5. Monopoly: Being in a unique or niche business makes for a good way to create a safety moat. Being the only company in the area means that there is literally no competition. But there is something important to note here. The company should not be a monopoly in a business that has demand. However, this advantage is something that needs a lot of work to be sustained. The higher returns that a monopoly earns can and does end up attracting competition. Therefore the test for the company is whether it can defend its competitive advantage over long term.

These are just some ways in which a company can create a safety moat. Other ways include creating network effects. Having cheaper access to raw materials. Government regulations that favour one company over another.

The bottom line is that the company should have a competitive advantage. The advantage should help it generate superior returns over time. And the advantage should ideally be growing over time. If the moat is too tiny, then competitors can easily cross it over time. So safety moats need to be getting wider and/or deeper as the years go by. And if you find such a company, then make sure you invest in it when it is available at cheap valuations. Such a stock can help you earn superior returns in the long term.

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