What if someone told you that he has a formula for generating above average returns in the stock market for a long period of time? How much would you pay for that formula? Here is the good news: You do not have to pay for it and the best part is you do not have to look anywhere to find it. The secret to generating above average returns is from multi-billionaire, Warren Buffett himself.
According to Warren Buffett, the key to successful investing is finding companies that possess a durable economic moat.
Stock market investing can seem like rocket science to the untrained. However, applying different perspectives of analysis can help you gain confidence in stock market investing. Looking out for economic moats is one such perspective.
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
Defining the Economic Moat
A moat is a broad ditch filled with water that surrounds a castle. The primary purpose of the moat is to make it difficult for enemies to attack the castle. Using the same analogy, a company possessing a wide economic moat stops its competitors from attacking the company’s competitive position.
Warren Buffett originated the idea of the economic moat as an essential criterion when on the hunt for investing prospects, an idea that soon transcended into the different business and investment paradigms.
The economic moat is a formidable fortress, which shields its castle from the cut throat business universe, allowing it to maintain its competitive advantage and a market share against its competitors in the long term. But how do you go about stock picking investment opportunities with a strong economic moat?
Here are six ways which can help you identify companies with an economic moat:
1. Solid Identity
When investing in the stock market, identify companies with a solid identity. Differentiation of the company from the rest of the players in the market place is one way to spot a company with a solid economic moat.
When stock picking companies, identify companies with a distinctive and outstanding look, brand name or brand symbol because these products ensure the companies’ profitability, which makes your investment profitable as well.
Examples of strong brands which have strong brand identity are Coca-Cola, McDonald’s, Mercedes Benz and Apple.
2. Exclusive Rights
Investing in a company with exclusive product rights is almost always a good idea. Patents or copyrights grant a company exclusive rights to manufacture and market products, which translates to a monopoly of the market for the duration of its patent or copyright, which can be a considerable amount of time.
This is indicative of a strong economic moat, which makes it a good choice for investing because it ensures a profitable investment. When stock picking companies, bear in mind that multinational pharmaceutical companies usually have products with such exclusive rights.
3. Looking to the Future
A company with clear long-term strategy is a company that visualises its growth and the strategies necessary to achieve it. It also plans for unforeseen circumstances that can hamper the company’s growth.
When stock picking and making decisions on investing in a company, the company’s future directions can account for an additional competitive advantage.
4. Deterring Customer Switching
With the many choices available in the market today, switching products and services has become a common practice among customers. When the cost for switching is negligible, customers are more open to vary their product consumption. This is one thing to look into when stock-picking and investing.
Companies and products with a higher cost for switching will have stronger economic moat. When switching is hampered by high cost, product loyalty is assured and high stock performance can be expected.
Apple products create this scenario. Since you have to invest in Apple software, which is exclusive to Apple products, the urge to switch is significantly curbed.
5. High Capital Requirements
Products that need high capital to develop, maintain and innovate also strengthen a company’s economic moat. Industries with high capital requirements will guarantee a limited number of competitors.
When there are limited competitors, the customers will also have limited choices from where to source their products. Examples are cable and telecommunications companies.
6. Cost Leadership
On the other end of the spectrum, ultra-low cost sourcing or production of products and offering consumers the lowest and most competitive price allow a company to dominate a broad consumer market. Walmart is the most famous example.
This increases the company’s economic moat and should be considered when stock picking.
The best part of the search process is that these companies are everywhere. You do not have to be a genius to figure out that the company has an economic moat.
Here is a practical suggestion: Go to a supermarket and notice what products people are buying. More often than not, these brands are produced by companies that possess a strong economic moat.
Case Study – Company with a Strong Economic Moat
Cerebos Pacific Ltd manufactures, markets and distributes supplement products such as essence of chicken, bird’s nest, coffee products and sauces in Asia and Australasia.
Some of its prominent brands are BRAND’S® Essence of Chicken, Riva, Gregg’s, Hua Tuo® and Asian Home Gourmet. The group used to own Yakult and Woh Hup but they were later divested in 2003 and 2010 respectively. Thailand (US$456.9 million) and Taiwan (US$133.3 million), when combined, contributed 49.4% of total sales in 2010. Australia (US$288.7 million) and New Zealand (US$183.2 million) accounted for 39.5%.
Sales of BRAND’S® Essence of Chicken, their flagship product, contributed 56% to the group’s total revenue in 2010. There are other players such as Eu Yan Sang and New Moon which also sell similar products.
However, BRAND’S® is the market leader in Asia with a market share of over 80%. By going to a supermarket or any convenience store, one can easily spot their products prominently displayed on the shelves.
The group has managed to successfully navigate economic downturns like the 9/11 terrorist attacks, severe acute respiratory syndrome, Avian flu and the 2008-2009 Great Recession.
Despite these events, top line sales were more or less unaffected. On top of that, it has hidden intangible assets like its well-known BRAND’S® brand identity in Asia which is not recorded on the balance sheet.
Having said that, a good business with a good management team like Cerebos Pacific might not necessarily have its shares selling at the right price; you could be overpaying for its shares.
– Ken Chee, Co-Founder of 8I Holdings Limited