Sunday, May 20, 2018

What Is A Moat?

Recently for my Big Idea 1 and Big Idea 3, I have been talking about discovering "Moats" of the companies.

But I am wonder if those information that I provided are really "moats"of a company? Or am I using this term too loosely?

As per Investopedia (do read this page for a much deeper understanding), an economic moat is a competitive advantage that one company has over other companies in the same industry; this term was coined by Warren Buffett, a renowned investor and executive at Berkshire Hathaway. The wider the moat, the larger and more sustainable the competitive advantage of a firm. By having a well-known brand name, pricing power and a large portion of market demand, a company with a wide moat possesses characteristics that act as barriers against other companies.

The website further explains that economic moat describes a company's competitive advantage derived as a result of various business tactics that allow it to earn above-average profits for a sustainable period of time. Companies that obtain defensible competitive advantage from patents, cutting-edge technologies and other cost advantages can have a wide economic moat that curbs competition within their industry. Also, firms that enjoy strong economic moat tend to demonstrate solid financial performance and rising returns on capital over time. The most common sources of economic moat are cost advantages, switching costs, efficient scale, intangible assets and network effects.

In laymen terms, my understanding of the explanation is that A MOAT is a COMPETITIVE ADVANTAGE over its competitors, that could potentially allow it to earn a HIGHER OR AN INCREASING REVENUE AND NET PROFIT, showing GREAT RETURN OF CAPITAL OVER TIME.

Some examples of a moat can be patents, franchised rights, know-how, and being a market leader. On the other hand, many moats can also be caused by government intervention - such as Singapore require a Telco provider to be licensed.

In addition, I underline "OVER TIME" is that certain comparative advantage, while allowing a company to earn a high revenue, net profit with great returns, is not sustainable. Thus, I believe it is important to understand this concept and analyse a business correctly by placing an emphasis that the comparative advantage is sustainable.

It is also important to note "moats" does not make a company invincible. Just take a look at the traditional businesses getting disrupted over the last few years. An example is Comfort Delgro's drop in taxi revenue with the introduction of Grab and previously Uber. Another example is SPH reducing advertising revenue when internet becomes widespread.

Therefore, even if a company has a moat, there could be a possibility that it could eventually be destroyed. With that in mind, it is important that a company continue to innovate and improve, in order to continue to maintain or improve the company's financial standing.

1 question I have in mind is if a company having cyclical earnings can be considered having a moat? In my opinion, if the revenue and net profit is not consistent, I do not think the company should be considered having a moat.

However, if you disagree, do comment below!

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