Moat Stocks For All Seasons !

Moat Stocks For All Seasons !

It is a dream of any value investor to identify stocks that have some sort of moat in it. What is this ‘moat’ and how does one identify stocks with investment moat? Are these so called moat stocks worth considering? Yogesh Supekar explains how best to identify stocks with investment moat while Karan Bhojwani shares a list of stocks with probable investment moat built in it



Good market condition or poor market condition, ‘risk on’ or ‘risk off’ mood in the market – the hunt for quality stocks is always on. One of the most popular investment terminologies used while identifying quality stocks is ‘stocks with an investment moat’. What is this moat after all and why should investors continue identifying it in stocks? Literally speaking, moat is nothing but a hole dug around a castle, which is later filled with water for ‘safety arrangement’. Safer the arrangement i.e. wider and deeper the hole is, bigger the moat is, and hence more protected is the castle. In those days of yore when kings and dukes ruled regions and lived in castles, a big moat would make it tough for attackers to gain access into the castle.

Similarly, in the business world any company with a wider and deeper safety arrangement or in other words a bigger moat will always tend to be safer relatively and hence profitable in the long term, devoid of competitive pressure, relatively speaking. Such companies with bigger safety arrangement are also known as companies with investment moat. You will find that companies with bigger or wider investment moats are the ones which are actually well-protected from competitive pressures and remain relatively profitable while enjoying larger market share, which of course is crucial in the long run since it proves to be a key determinant of profit margins and consistent growth in profits while also keeping the company in business for longer periods.

The Warren Buffet View

Here is what ace investor Warren Buffet has to say about the concept of moat: “I don’t want a business that’s easy for competitors. I want a business with a moat around it with a very valuable castle in the middle. And then I want the duke who’s in charge of that castle, to be honest, and hard-working and able. And then I want a big moat around the castle, and that moat can be various things. The moat in a business like our automotive insurance business at GEICO is low-cost. I mean people have to buy automotive insurance, so everybody’s going to have one insurance policy per car basically, or per driver. And I can’t sell them 20 policies but they have to buy one. What are they going to buy it on? They are going to buy it based on service and cost. Most people will assume the service is fairly identical among companies, or close enough, so they are going to do it on cost, and therefore I have to be low-cost producer. That’s my moat. To the extent my costs get further lower than the other guy, I have thrown a couple of sharks into the moat.” 

Charlie Munger,
Leading American investor

"The difference between a good business and a bad business it is that good businesses throw up one easy decision after another. The bad businesses throw up painful decisions time after time.”


Value of Moat

Companies with an investing moat are the ones which have higher earnings power, higher profitability, and higher returns on capital invested. A company with an investment moat ideally should not be afraid of increasing its product prices fearing loss of customers to competitors. For example, assume that Tata Motors is a company with an investment moat and has recently announced increase in prices for its key models such as Harrier, Nexon, Tiago and Tigor anywhere between Rs 5,000 to Rs 55,000. If such an increase in prices does not lead to slump in sales in a hyper-competitive segment such as the automobile industry, especially in the passenger vehicle sub-segment, we can say that Tata Motors has some quotient of investment moat built around its company and the brand. It can thus be said that companies with investment moats may not face exodus of customers just because the competitors have reduced their product prices. The competitors in this case are selling similar products and or services with different prices.

Wide Moat Stocks

For companies to fall in the wide moat category they should enjoy a high market share and operate at high profitability levels. Also, wide moat companies are the ones that improve their profitability with time. One can identify the growth momentum by comparing the profitability growth with historical averages. To understand growth in profitability, the historical return on equity (RoE) should be studied. One of the best ways to understand stocks with growth momentum is to identify those stocks that reflect higher current RoEs than the five-year average RoEs. Usually it is a norm that the stocks with moat will reflect higher RoEs than the sector average RoEs.

Says Gautam Diwani, who has been an investor for more than two decades: “Identifying stocks with moat is crucial if you want to be successful in the investment game. One can study numbers, profit and loss statement and balance-sheet, perform ratio analysis and ascertain which stock is better than the other. However, when one identifies the moat in any company the conviction in the invested stock increases tremendously and that conviction helps us remain invested in a good company for long term. And that to me is the key for wealth creation. If one just studies the number without understanding the moat of the company, one will identify a better stock from the other but where will the conviction to hold the stocks come from? Understanding the moat is what matters and helps investors hinge on to quality stocks for long terms.”



Investment Moat

Usually companies with investment moats are those with the following competitive advantages, termed economic moats:

 Better products, as for example, Apple.
 Intellectual capital in terms of patents and copyrights, as for example, big pharmaceutical companies.
 Economies of scales and lower cost structure, such as Tata Steel.
 Captive customers. This is observed when the switching cost is high as in banks and sophisticated technology like ERP systems.
 High entry barriers to business, as for example companies like RIL, ONGC, Microsoft, etc.
 Distribution network, examples being HUL, Flipkart, Amazon, SBI, etc.
 Brands such as Nestle (Maggi, Nescafe), Pidilite (Fevicol), Eicher Motors (Royal Enfield), Bisleri, etc.

Companies with economic moats are the ones with better products and those that reinvest the profits earned into intellectual capital. Moat companies are found to enjoy economies of scale and lower cost structure compared to their competitors. It is a common observation that customers of banks find it difficult to switch to new banks; hence a greater number of captive customers are seen depending on the same banking services. This leads to a wider moat for the bank, which in turn contributes to its higher profitability.

Offering his view about the concept, Atul Gugale, a small time businessman from Jabalpur, Madhya Pradesh, says, “I have a bank account in one of the leading private banks in India. I have both savings and current accounts along with loans against property, personal loan, cash credit (CC), debit card, credit card fixed deposits, gold locker, and also online mutual fund investment account with the same bank. Several other private banks approach me and pitch me their banking services, but I am not able to switch my bank account anywhere else. I have become their permanent customer and I have noticed every year that I end up buying their additional or incremental products and services.” 



Market Outlook 2020 

Yes Securities


Mid-to-late 2020 or early 2021 will mark a fresh secular journey for Indian equities. Many headwinds should recede in 12-15 months. A gradual recovery in economic growth, so also an improved access to credit in the months to come, a pickup in bad asset resolution following the Essar Steel settlement, a bumper Rabi crop, and swift government measures pertaining to ease of doing business, structural reforms and less government in business are likely to take shape. An attractive earnings yield, lacklustre alternate asset classes, our view on benign long-term oil prices, and a supportive global risk-on trade are other positives for equities.

A moat refers to business enterprise’s ability of maintaining competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.
 



Conclusion

While the outlook remains strong for the equity markets in 2020 and experts recommend being optimistically cautious on markets, the best that investors can do for themselves is to identify stocks with wider economic moats and construct a portfolio of such stocks. Moat stocks are expected to deliver positive results in the long term as the moat gets wider and deeper and impacts the profitability positively. Thus, a portfolio of moat stocks should be constructed with a long-term view. While doing so it should be remembered that not all stocks reflecting moat will be meeting investors’ expectations as it is quite possible that the moat wanes instead of getting wider as time passes.

This is the exact reason why investors have to be on top of their portfolio investments and need to monitor them regularly. History teaches us that very few companies are able to sustain for very long. Asian Cables, Ballarpur Industries, CEAT, Century Textile and Bombay Burmah Trading Corporation are examples of stocks that were once constituents of the Sensex. After passage of three decades, these index constituents have not grown in line with investors’ expectations. Even in the history of corporate America, General Electric is the only company that has remained a constituent of its key benchmark index for over 100 years!

Thus, wider moat is great but to assume that it is going to exist forever would be a mistake. Investors thus have to exercise caution in constructing a portfolio of wider moat stocks. Identifying a company with a moat is one task and to continuously keep tracking the company for the changes in its competitive position is another essential aspect of successful investing using moat stocks. Certain quantitative aspects should be examined before investing. Those stocks showing higher gross profit margins and net profit margins indicating pricing power can be considered for further research and preference can be given to those companies that indicate minimal investment required to stay competitive.

The ROCE is almost always greater than the cost of capital for moat stocks. ROIC should be high along with RoEs. Investors can also focus on consistency in dividend distribution and the dividend yield. The dividend aristocrats can be good candidates with investment moats. A diversified portfolio of moat stocks is the ultimate solution if you are looking to focus on quality without compromising on growth. Indeed, a portfolio of moat stocks constructed diligently could be your answer to beat markets in long run because here is where quality meets growth.

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