Significance of moats in value investing

What is value investing? As per me, it is investing in asset classes with the intention of not only earning a yield or a dividend from such asset classes but gain significantly from capital appreciation due to the fact that the intrinsic value of the asset class is safely above the market or traded price of such asset class.

What is a moat? From a plain simple google search, a moat is a deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defense against attack. How can one relate moat to value investing?

Let us take a simple example. If we want to drink a soft drink, what is first drink that comes to our mind? Coca Cola. If we want to shave, what is first razor that comes to our mind? Gillette. If we want to brush, what is first toothpaste that comes to our mind? Colgate. If we want to search anything on the internet, what is the first search engine that comes to our mind? Google.

What does Coca Cola, Gillette, Colgate and Google have in common? Answer is simple. Through the targeted, strong and intense marketing done by them over the years, these companies have created such strong presence in the minds of consumers that knowingly or unknowingly, these products have become a part of our daily life leading to consumers buying them over any other (or maybe better) substitute available for them. Moats need not be only global brands but can be local brands catering to local customers like Haldiram’s and Rameshwar eating outlets in North India which serve good quality vegetarian Indian food and alongwith sweets. Both of them have a number of franchises in and around Delhi. Thus, the wide ditch of the castle or fort as explain in case of literal definition of moat can simply be related to the undeniable existence of such brands/ products in the minds of consumers which creates an artificial but natural defense against competition. In the longer run, not only the marketing and brand building efforts needed by such brands for every extra unit of sale tend to be lower but at the same time, it becomes extremely difficult (and to some extent even impossible) for new entrants to enter the market due to huge costs needed to change the mindset of consumers.

In typical financial terms, such moats lead to increased pricing power, increased sales volumes, lower costs (due to economies of scale and decreased brand building efforts). All such factors combined lead to increased profitability. Such profitability when mapped with shareholders funds translates to increased return on equity (‘ROE’) which is sustainable over the longer duration than other usual normal companies. Usually typical valuations are conducted assuming long run ROEs of companies to converge to their long run cost of equity (‘COE’) after a period of short term outperformance of ROEs but when we assume (whether or not due to existence of moats) that long run ROEs of companies are greater than their long run COE. Sustained higher ROEs even over the long term would lead to higher valuations of such companies from their peers.

To move away from the technical aspects and simply speaking companies with moats hamper the creation of perfect competition in the market and thus, the concept of zero normal profit (revenues minus costs including opportunity cost) in the long run usually does not apply to them. These companies tend to earn premium profits even in the long run.

Now let us see companies with moats if one wants to invest in Indian stock markets. Below I have listed few companies which influence day to day lives of most of individuals in India in some way or the other. These companies have some way or the other developed a niche in their sector and have managed to fight out competition well enough to maintain high ROEs and high RONWs (return on net worth). All companies taken in this analysis are private companies (as opposed to public sector companies) managed by people who are largely uninfluenced by the high end government officials (babus, bureaucrats and politicians).

Company Name	Industry	(Based on March 2014 data)			Mkt Cap (Jan 23, 2014)	CAGR of stock since 1.1.2004	CAGR of stock since 1.1.2008	CAGR of Sensex since 1.1.2004	CAGR of Sensex since 1.1.2008
		ROCE	RONW	Current P/E (consol)
Maruti Suzuki	Automotive Industry	16.77%	13.17%	38.50	109,010.12	22.86%	20.22%	15.73%	5.37%
Hero Motocorp	Automotive Industry	51.41%	37.66%	27.12	57,103.64	18.33%	22.29%	15.73%	5.37%
Reliance Industries	Oil & gas	9.80%	11.34%	11.59	286,974.42	11.03%	-6.60%	15.73%	5.37%
Sintex Industries	Storage/ Diversified	10.68%	10.79%	9.07	3,983.56	20.62%	-13.26%	15.73%	5.37%
Kajaria Ceramics	Ceramics & Granite	33.18%	26.05%	41.98	5,574.35	39.88%	53.87%	15.73%	5.37%
Asian Paints	Paints & Varnishes	44.08%	31.50%	67.81	82,673.26	34.81%	33.66%	15.73%	5.37%
MRF	Tyre	24.79%	19.87%	18.29	16,425.86	28.97%	27.61%	15.73%	5.37%
Exide Industries	Battery	22.86%	15.78%	31.37	17,089.25	27.68%	14.46%	15.73%	5.37%
Pidilite Industries	Adhesive (Chemicals)	31.78%	23.22%	65.04	29,242.29	36.34%	28.91%	15.73%	5.37%
ITC	Cigarettes & others (FMCG)	48.12%	33.45%	31.13	279,357.17	23.98%	17.86%	15.73%	5.37%
Shriram Transport Finance	Commercial Vehicle Finance	16.95%	15.28%	18.18	24,684.84	36.29%	14.97%	15.73%	5.37%
Larsen & Toubro	Engineering	17.18%	16.31%	32.17	158,466.32	30.82%	3.00%	15.73%	5.37%
HDFC Bank	Private sector banking	N/A	19.50%	29.38	252,111.44	27.31%	17.21%	15.73%	5.37%
					Average	27.61%	18.02%	15.73%	5.37%

Thus, the above analysis makes it quite clear that companies that develop a niche in the market (like those mentioned above) tend to outperform the general market as far as stock market returns are concerned. The outperformance as seen above have been to the tune of more than 10% on an average when the holding period of such stocks have been 11 years or 7 years. Though it may be clearly pointed out that the returns on stocks given above are not indicative of any future returns, it is more important to perceive the importance of understanding and investing in stable businesses that are a “natural” choice of consumers (like you and me) and/ or other businesses to do business with. But of course, valuation of such businesses must be done with extreme caution rather than painting a supremely rosy picture. I am not going to harp on how to value businesses in general but assuming a reasonable investor knows how to value them, my advice would be not to hurry and invest in such businesses as mostly they are available at rich valuations. Be patient. Time and again markets correct themselves and such businesses become available at reasonable (if not cheap) valuations and there comes the time to enter and make big bucks.

Its not very difficult to find moats. We just have to be observant and aware of our surroundings. We have to talk to people like our servants, drivers, neighbours, friends, relatives, parents and people in different kinds of businesses to gauge the demand, supply and general mood of people with regard to different products in the market or different businesses. We get to know not only the products (be it daily use or rarely used products but those that garnering huge market share and minds of the consumers) but also about the general talks that go around the owners of such businesses (e.g. proximity of Adani Group with our new PM, Kingfisher owner Vijay Mallya defaulting on huge debt while at the same time leading a lavish lifestyle). These points would make us aware about the businesses and make us google about the owners and their businesses while also make us curious to look into the financials and annual reports of such businesses. These acts would eventually make us take decisions and be sure of the fact whether moats (i.e. competitive business advantages) exist or not.

Though living in a developing country and finding such companies can be extremely difficult at times as companies established and listed in developed countries have carved their place in the minds of consumers and businesses of developing countries due to great and unmatched quality of their products and services that have been tested and approved by people all over the world. Besides this, if need be, these companies are already sitting on huge cash piles to create mayhem if anyone intervenes and tries to drive them out of their core market. A classical case can be made of electronics industry where foreign companies like Apple, Samsung, Dell, Lenovo, Sony, LG, Philips, have camouflaged and downgraded any new Indian intervention (though Micromax has ventured out bravely till now being backed by Sequoia Capital and TA Associates but it has a long way to go to make a dent in the eyes of Indian consumers to garner huge margins and actually cut genuine sales of Apple and Samsung phones). Similar is the case of chocolates industry where Cadbury (owned by Kraft Foods Group) is almost considered as a local brand by us Indians while every boy’s dream is to shave with Gillette razor (owned by P&G, USA). Even in case of shoes industry middle to high premium group people prefer Bata, Nike, Adidas, Puma, Hush Puppies, Woodland, etc. all of which are foreign brands. The list can go on and on. Eventually due to almost negligible capital account convertibility in India, it is extremely difficult to take stock positions in such companies. Its funny but the more we Indians consume such brands, the more the average American and European investor gets rich by investing in such companies.

However, having said that, all is not lost. I am confident of businesses in this country and confident that given few years, slowly and steadily businesses in India would make significant (if not comparable) presence in the world and the products sold by them or services rendered by them would be such that the consumers and businesses around the world would not be able to live without. Moats developed at that moment would eventually lead to CAGR stock returns beating the market (by as high as 10%) for not only 11 years as shown in the figure above but even extended periods of 25-30 years. But considering the potential of this country having the second largest population and ability to grow at 6-8% growth rate in future, businesses focusing on even in-house domestic consumption and investment story would be also able to create moats significant enough to provide huge stock returns in near (5 years) and long term term (15-20 years) future.

Lastly, I would like to end this article by quoting what Mr. Warren Buffett says (which should inspire many investors to look at businesses in a different manner) –

“A good business is like a strong castle with a deep moat around it. I want sharks in the moat. I want it untouchable”.