The Art of Spotting Economic Moats

Link to the article

Notes

• Economic Moat:
  • The sustainable competitive advantage of a company over others in the industry which enables it to maintain its market share and profitability over time.
  • Should be sustainable and durable:
• Why moat is important?
  • Shows a company’s long-term potential for growth and profitability.
  • Protects a company from inevitable mistakes from the management.
  “We want to find a business that any idiot can run – because sooner or later, any idiot is probably going to run it.” — Warren Buffet
• Types of Economic Moats:
  • Intangible assets:
    • Strong brand
    • Patents
    • Intellectual Property
    • Licenses
  • Economies of scale:
    • Large scale operations → lower per unit costs.
      • Enables a company to charge lower prices and still be profitable.
  • Network Effects:
    • The phenomenon whereby a product or service gains additional value as more people use it.
    • Eg. Google Search, Social media platforms like Facebook, Twitter, etc.
  • Switching Costs:
    • The expenses and efforts a customer has to incur to switch from one product to another.
    • Eg. Switching from Apple to Android.
  • Cost advantages:
    • Ability to produce goods at a lower cost.
    • Can be due to :
      • Superior technology
      • Efficient processes
      • Access to cheaper raw materials
• Examples of companies with wide moats:
  • Apple
  • Amazon
  • Coca-Cola
  • Visa
  • Johnson & Johnson
  • Microsoft
• How to identify economic moats?
  • Analyze industry trends:
    • High Barriers to entry → strong moats for existing players:
    • Barriers to entry:
      • Investment in Research and development
      • Network effects
  • Management quality:
    • Look for companies with a track record of innovation and adaptability in the face of changing market conditions.
  • Study Financial Metrics:
    • Some of metrics are:
      • Gross profit margin
      • Free cash flow
      • Long-term debt to equity
      • Earnings per Share(EPS) Growth
      • Return on Invested Capital(RoIC):
        • RoIC = [Net Operating Profit After Taxes (NOPAT) / Invested Capital]
        • RoIC should be greater than the Weighted Average Cost of Capital.