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The Art of Spotting Economic Moats

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  • 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.
Shreesha S
Shreesha S

Shreesha is a Qualified Certified Management Accountant(CMA) and Certified in Strategy and Competitive Analysis(CSCA).

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