In Stock Investment Framework, I shared the 5-step process and under Fundamental Analysis, Economic Moat analysis is an important factor. Economic Moat was actually coined by Warren Buffett and it refers to sustainable competitive advantages which protect a company from its competitors. This is like how a moat protects a castle (as pictured).
Value Investing seeks to find fundamentally sound companies and a company with a strong economic moat enhances its long term intrinsic value.
Morningstar has taken the concept and expounded it as a core stock selection criterion and classify stocks into categories: no economic moat, narrow economic moat vs broad economic moat.
Sources of Economic Moat
There are a few sources of economic moat which will be elaborated briefly below but it is important to first understand why having an economic moat is important to a company.
A company exists primarily to make a profit, and the profit can then be paid to employees, suppliers and the shareholders etc. When a company makes a lot of profit, it is bound to attract other companies which are keen to also take part of the profits offering the same products and/or services.
Unless you have competitive advantages which can be sustained over time, you will soon face competitors doing the same thing as you and the competition will lower your profits as your existing customers now have additional choices.
Our job as intelligent investors is to examine whether a company has an economic moat or not.
The 5 Moat Sources (extracted from Morningstar) are:
- Intangible Assets (brands, patents, license)
- Cost Advantage
- Switching Costs
- Network Effect
- Efficient Scale
With examples of both Singapore and US stocks, I will elaborate on each.
This refers to companies with strong branding and commands a price premium for the products they sell, i.e. consumers are willing to pay more, think Apple for smart phones or they are “protected” by patents (think pharmaceutical companies) or license (like the local telcos SingTel, StarHub and M1).
Many of you will understand economy of scale. Walmart has such a wide retail network and has so much bargaining power with its suppliers and so much scale that it has huge cost advantage compared to its peers. This gives it a great economic moat for a very long time and it is able to generate great Return on Invested Capital (ROIC).
This is when it is very painful or inconvenient when consumers of an existing company wants to switch to another solution. For example, customers of Oracle or SAP where work processes are already tightly integrated with the software and users are already familiar with how to use the software systems. Apple similarly also enjoys having this moat. It is not easy to switch when your music, movies are with proprietary iTunes and your files are already on iCloud etc.
This happens when consumers enjoy more and more benefits when more and more consumers come on board the same platform service provided by the company. Examples of companies which have network effect moats are Google and Facebook. Google as a search engine enjoys a dominant position and many advertisers use their advertising platform, similarly Facebook has about 2 billion users worldwide and it is a dominant social media platform.
This is perhaps best illustrated using an example. The Singapore stock market is quite small in terms of total market cap and SGX is the sole exchange in Singapore. The limited market actually does not provide enough sensible profits for another provider to come into the fray.
The topic of analysing and examining whether a company has an economic moat is an important one. However, to do this well is not the easiest. You need some experience, know the industry and the company well which is why we suggest you stick to your circle of competence when picking stocks.
For further readings, I strongly suggest the following 2 books from authors who have worked with Morningstar.
This is like THE book on Economic Moat and very well written by Pat Dorsey. It is also quite a short book to have a good understanding of the topic.
The other book is much more comprehensive and applicable when you really want to have a deep understanding. There is a good discussion on various industries too.
I do recommend that you have a good appreciation of this topic as a company with a strong wide moat typically has high returns for many years and you can hold for a long time. Interestingly, there is also a Morningstar Wide Moat Index for you to consider investing in or use it as your stock screener for further analysis.
The video below is a presentation from none other than Pat Dorsey himself. It is a little long, but it may be worth your while.
This is part of a series of articles which will be parked under Stock Investments (Singapore / US).
As always, your comments below are appreciated for us to enhance our articles.