Know specific competitive advantage to pick stocks better

Want to shortlist stocks for the long run? Look for companies that have moats, says Warren Buffett, the legendary investor. Moats refer to sustainable advantage that a company enjoys. It is not easy for a competitor to breach an impregnable fortress if it is protected by a moat of competitive advantage.

The book Why Moats Matter, authored by Heather Brilliant and Elizabeth Collins of Morningstar Investment Research, presents a guide to how an investor can pick ‘great’ businesses that have moats. A great business, as the authors mention, can fend off competition and earn high return on capital for several years, secure behind a moat.

In the first half of the book, the authors detail how they put the concept of moats, valuation and margin of safety into practice. In the second half, the authors provide a detailed guide, with examples, for analysing moats in eight different sectors such as basic materials, consumer products, energy, financial services, healthcare, etc, to name a few.

Competitive advantage can come from sources like intangible assets, cost, switching costs, network effect and efficient scale. Each of these sources is explained in great detail.

Intangible assets, such as brands, patents and government licences, can keep competitors at bay. The authors give one such example of Sanofi, a pharmaceutical company that benefits from patent protection that makes competing with it tough. Similarly, Walt Disney had built a moat around its brand in the entertainment business and Google in the search business.

Firms that enjoy economies of scale have a certain kind of moat around them—that of cost advantage. Railroads in America have enjoyed such competitive edge from their sustainable low-cost advantage compared to barges, ships, aircrafts and trucks.

Switching costs indicate the costs that a customer has to incur if she has to switch from one product to another. The higher the cost of switching, the more beneficial it is for the company. Citing Apple, as an example, the authors mention that there are a variety of switching costs around the iOS platform of Apple that allows the company to retain a good portion of its user base. Applications or media purchased from the iTunes store may not run on other devices that use a different operating system.

The value of a product increases as more and more users join and use the service; it makes a strong company become stronger. This moat is often sought to be created by social media and online e-commerce sites. The sheer numbers and a large interconnected community then becomes a moat.  
Expedia, an online travel agent, is one such example; due to its huge transaction volume, it is a highly coveted distribution channel. Travel suppliers are eager to list their service on its site. The larger the number of options, the larger is the number of consumers visiting the site, creating a virtuous cycle.

At the other end, there can be a market of limited size which can effectively be served by just one or a few companies. Pipelines, the authors mention, are the best example. Because these companies secure long-term contracts and there is little risk of disruption, the economic profits are sustainable.

Further, the authors explain how they give moat ratings. A low moat rating is given when a company is likely to benefit from competitive advantage and earn excess return for a period of at least 10 years. When the firm is expected to deliver excess returns for the next 10 years or more, it is given a higher moat rating.

Moats that seem unassailable in one period may disappear with technology or other changes. Once a top mobile handset manufacturer, Nokia, and hand-held gaming device manufacturer, Nintendo, have been swallowed up by their competitors. While they commanded a huge market share when they were new in the market, it wasn’t long before competitors came in and capitalised on that opportunity. While initially they had a ‘wide’ moat, as the competitors came in, the moat ‘narrowed down’.

There are plenty of investment books that focus on business fundamentals and valuation. This book tries to be different by adding how businesses with a competitive advantage can benefit. The book will give you a fundamental framework for long-term investing—how to identify a great business and when you should buy, to maximise return. Now, it’s your turn to find companies with moats in India and hold their stocks for the long term.