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Wednesday, September 4, 2019

The Meaning and Benefit of Having Economic Moat

The term Economic Moat is a term that is used by many value investors in the investing world. The bigger the moat means the safer for the investors to invest their money in the company. It was a term that is popularized by a successful investor Warren Buffett. Economic Moat refers when a company or business that has the ability to maintain its competitive advantages over its competitors in order to protect market share and its future earnings. It’s like a castle in the olden time that have a moat around it, the moat functions is to protect those inside the fortress and their enemies from coming in. Having a stronger moat such as having water surrounding the castle makes it difficult for enemies to attack. This is similar in the investing world. It’s great to buy stocks which companies have a strong economic moat. These companies are able to sustain their business and to stay one step ahead of their competitors. One of Warren Buffett’s secret of success in his investing career is to invest in companies that have strong economic moat. Warren investing in companies with great economic moat allowed him to hold companies for a long period of time. He likes to invest in companies that have a long business prospect so that he’s able to keep holding them in his portfolio without the need to sell the companies often. In this article, I will discuss further about economic moat and why it’s important in the investing world. I will then also explain about how to spot whether a company has an economic moat and why I prefer investing in companies with moats around in my dividend growth portfolio.

Understanding What an Economic Moat Is.
An Economic moat is essentially a competitive advantage for a company to protect competitors from taking market share of its business. It allows a company to provide products or services that are similar offered by its competitors; however have the advantage to outperform them. A good example of using the term economic moat is a company that is able to sell its product at a lower cost than their peers and does have the same function as well as quality. They were able to do this because they have a strategy and capital in doing their business. For example, they can buy raw materials at a lower cost. Having the advantage of buying raw materials at cheaper price enable the companies to sell their goods at a price lower than their competitors which of course will result having consumer to buy their products instead of their competitors. It’s great to invest in companies that provide a strong moat around since your investment can prosper in the long run.

However, bear in mind that a company with a strong economic moat could eventually loses it moat as well. There are many companies that used to be having strong economic moats that eventually went bankrupt. The problem is companies with the best moats often lose these competitive advantages over time. Companies that achieve sector leading profit margins are bound to have other companies that also want to replicate and have a piece of the action in the business. A great example of a company that used to have a strong economic moat is Eastman Kodak (Ticker: KOD). This company used to have a moat as strong as The Coca Cola Company (Ticker: KO). People during the Kodak times had no other ways to take picture except to use their products. However, they let their business moat narrow when Fuji come into the business and start narrowing the moat in various ways. And as today, Kodak products are just a history to us. No one uses those products to take photograph now since people can easily take pictures with their smartphones today. So remember that there will be new companies out there that will have better innovation that could eventually destroy the moat in the business you currently investing in. This reminds me of the greatest empire that exist in the past such as the Roman Empire, no matter how strong they were, as time passed by, there will be a time when the Empire eventually fall.   

Why are Economic Moats so Important?
Economic moats are incredibly important because it is impossible to estimate a company’s future cash flow without having an economic moat. A company might look cheap compared to its competitors when using financial metrics, but a company without a moat means the company might go through trouble in the future. This is crucial when investing and you don’t want to end up losing money like me in one stock investment called Game Stop Inc. (Ticker: GME). When I was investing in Game Stop Inc. (Ticker: GME), I was too concerned with its valuation metrics, and ignoring the factors that the company is facing trouble from its competitors. Before I was invested in Game Stop Inc., I already knew the company was facing many challenges, but I thought the company was oversold and mistakenly thinking that the stock was at a bargain. Instead I landed myself with a stock that was a value trap. The company has customers that are taken away from its competitors and eventually faced a huge decline in their earnings which I wasn’t expecting to happen that fast. Regretfully, I had to sell the stock at a huge lost ($40,000), and learned the hard way that a company without a strong economic moat is not always able to earn the same earnings like before. It is generally too risky when you try to estimate future cash flow of a company if it does not have the economic moat to protect it. Game Stop Inc. earnings were terrible quarter after quarter after I was heavily invested. But from this mistake, I learned that the value of companies that have a strong economic moat. It’s better to invest in a company that have a moat at a fair or decent price compared to investing in one that is cheap but having no moat to protect the business. This is the reason why I think economic moat is crucial in a company that you want to invest in. It helps you protect your investment from losses and most importantly allowing you to keep the company for a long period of time, similar to Warren Buffet did. For me as a dividend growth investor, I want to hold companies that will still be in business decades ahead, for I want the stock portfolio to generate dividends (passive income) for me. 

How to Know Whether the Companies Have Economic Moat?
Finding stocks that have strong economic moat is actually not that difficult. It’s matter of using some common sense before investing. When looking for companies that have economic moat, you want to understand how their business model. See what the business provides in term of goods or services, and see what make this business different from its competitors. A great way to look for companies that have strong economic moat is to see their earnings performance during bad economic times. Do some research on how the company is financially performing during the recession periods. If the company was able to generate great earnings even at tough time, this shows that the company has a good moat surrounding it. This is an indication that the business has something different than its peers that allow it to remain profitable even at tough time. In addition, by checking their balance sheets allow us to see whether the company is holding high amount in cash. A company with a high cash on their balance sheet shows that the company has strong cushion if revenues don’t meet expectation.

Furthermore, know what the company products that is dominant in the market. Apple Inc. (Ticker: AAPL) is considered to have a wide moat when it comes to smart phone industries. Their iPhone sales far outpace any other competitors. Similar to Intel that dominated the semiconductor industry since its chips are commonly used by most computer manufacturer such as Apple, Lenovo, HP, Dell any many other computer devices. Having powerful intellectual property also gives a company to have a strong economic moat. When companies have a unique patent on a product or technology, it let the company have power over their products from being replicated by other competitors. This can be a powerful driver of revenues that competitors can’t match. Brand recognition gives the ability for consumers to loyal with their brand. When a company has a strong brand that is recognize by consumers. It shows that it has a moat around it that can prevent consumers from switching. A good example of a company with a powerful brand is The Coca Cola Company (Ticker: KO). Consumers have a brand loyalty to stick with this brand for their choice of Sodas beverages. I myself have a tough time drinking other sodas brands that are available in the market, and stick with drinking coke when ordering my meals at a restaurant. Even if there is another soda similar to coke that is selling at cheaper price, people who are already loyal with this brand tend to stick with it since they don’t want to go through the trouble of switching. Furthermore, see the network effect and user stickiness of the products or services. The network effect is when additional user of a good or service improves the value of that product to others. Facebook Inc. (Ticker: FB) is a great example for this, since not only the company able to acquire new users “virally”, but also keep their existing users active with their service. The network effect builds a strong barrier of entry for other social network players to enter. People like myself who use Facebook have tough time switching to another social media app since there are many loyal users who use its service. And the great strategy that Facebook Inc. uses to have their users stick is because the contents the application provides are made by the users themselves. This has made Facebook Inc. successful and dominant in the social media industry.

Moreover, by having the economies of scale and low-cost producer give the ability for a company to have an economic moat that protects its business. As companies grow in size, they gain the ability to bargain more aggressively against their supplier. They are also able to spread the same amount of fixed cost over a larger number of goods and services produced and sold. Having economies of scale allow companies to produce their goods and services at a low cost and have a distinct moat since they are able to undercut their rivals on price. In addition, they are able to sell their products at the same price or lower price than their competitors making them the winner in the market. A great example of a company that has great economies of scales and the ability to provide lower cost to consumers is Wal-Mart Inc. (Ticker: WMT). Since Wal-Mart Inc. is really huge and dominate most department stores in America, they have the ability to purchase good at a mass which enable them to bargain for the products at a lower price compared to its competitor. It gives them the moat that prevents competitors to enter the market since Wal-Mart Inc. is really big. The more stores they opened, the bigger the scale the company become. They then able to generate more cost savings as sales volume increase. As a result, Wal-Mart Inc. becomes better and more competitive as it’s grows in size over time. This gives a strong moat around the company like Wal-Mart Inc.

Why I Like Companies with Great Economic Moats in My Dividend Growth Portfolio?
The reason why I like holding stocks that have strong economic moats in my dividend growth portfolio is because I want to keep companies that are still going to be in business decades ahead. I don’t like the fact that I need to sell my stocks after I purchase them, since I like to hold them for a long term period. As I hold companies with great economic moats that pay dividends, I’m able to reinvest the dividends into the portfolio or use the money for my expenses. I was able to purchase some stocks that have a strong economic moat when it was priced at fair price and below the intrinsic value. I managed to receive dividends from these stocks and experience capital appreciation in the share price. After learning my mistake of investing in companies that don’t have moat around them such as Game Stop Inc. (Ticker: GME) and experienced a huge lost, it made me to be more aware of finding companies that have some kind of moat that protect the business. I found out that the companies that had performed well in my dividend growth portfolio are companies that have some kind of economic moat. For example of stocks that have economic moats in my portfolio are Wal-Mart Inc. (Ticker: WMT) and Intel Corporation (Ticker: INTC). These are stocks that I hold in my portfolio and they perform very well. It showed from the capital appreciation as well as the dividend increase I receive each year. I’m planning to keep holding these companies since I know they will still be in business and stay profitable decades ahead. I don’t have to worry about companies such as these to go down in price because I understand their core business model and have strong economic moat that protects its business. If their price goes down in value, I would use this as an opportunity to actually acquire more shares. I am confident in holding companies such as these for they are not only having strong economic moat but an investment that is within my circle of competence.

To Sum Up
After finish reading this article, I hope you readers now understand the meaning of economic moat and why it’s important to invest in stocks that have one. I hope you can use this term when investing in a stock. Having invested in companies that provide strong economic moat enables investor like me to hold onto the stocks for a long period of time. I am confidence in owning these stocks in my portfolio because I know these stocks have great business model that competitors have tough time trying to capture market share of their business. Always remember to not invest in companies that don’t acquire some kind of moat around them since they are more difficult to predict how the stocks are going to perform in the long run. A successful investor like Warren Buffett himself like businesses that have moat around them since he himself likes to hold into the companies he invested for the long term. He believes that a company requires having moat in order to protect its profitability and to fence itself against competitors. Moreover, Warren Buffet mentioned in his letter to Berkshire shareholders that great businesses have an enduring ‘moat’ that protects excellent returns on invested capital. Applying this term in his investing career has made Warren Buffett a successful investor and wealthy. And average investors are able to find stocks that have economic moat. What you all require is to have some common sense before investing such as knowing how the company is different from its competitors, and the advantages it has that enable it to stay profitable for a long term. However, be aware even companies that used to have strong economic moat around their business model would probably have declined due to new and better innovation that can eventually replace their business. As an investor, you want to be updated with the latest trend in the business world. I hope by me writing this article, you readers can gain the knowledge and experience I went through to become a better value investor.

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