Head of Equities, Published Apr 19, 2016
Circa 1453. The capital city of Constantinople is witnessing a fierce assault by Ottoman forces under Mehmed II on the Byzantine Empire. Crusaders are besieged by a more modern and larger army. But Mehmed’s forces are unable to overcome an unlikely enemy; a deep and mysterious moat that surrounds and protects the city, giving the motley defenders of Constantinople enough time to rally their forces. Though the invaders eventually overwhelm the subterranean disadvantage, they expend more men and resources than the strategic calculation.
In ancient war fare or in today’s fierce investment scenario, distinct and indomitable advantages can make or break the game. Thus, the term “economic moat” was coined by the celebrated investor Warren Buffett to illustrate such companies that maintain a competitive edge over the competition with a stronger brand name, better pricing power, larger market share and far more sustainable long-term profits. Thus, a company with ‘a wider moat’ can reward its investors more.
The difference between a company which holds a natural competitive advantage as against the one with an ‘economic moat’ is that the latter demonstrates long-term advantages, instrumental for earning premium margins and oversized profits over a period, adding more value to shareholders. Naturally, businesses have a strong incentive to establish ‘economic moats’ and investors would crave to identify such stocks that inherently protect their business. In other words, businesses with ‘economic moats’ will have sustainable earnings, return ratios and stock returns.
Economic moats at work
A key aspect of the ‘economic moats’ is how well a company defends its turf against competitors for a projected period of time. For this, we need to look closely at the company’s historical financial performance; companies that have generated returns on capital, higher than their cost of capital for many successive years, usually will have a moat, especially if their returns on capital have been rising or are fairly stable. Besides, the sustainable superior return ratios (enriched by better margins), high sales and earnings growth, greater free cash flows and a meager or no debt balance sheets further qualify a company’s ‘economic moats’.