Save your castle

Introduction

Let’s first begin with a story, John a proud business owner ran his operations for over 3 decades side by side with his partner Mark, the co-founder of the business. Mark still in his late 40s wants to continue the business whereas John in his early 60s decides to retire and enjoy his life in the Bahamas. Life isn’t good for little Peter, John’s son, job after job he hasn’t had any progress in his career, still he managed a paycheck just enough to pay the bills and save a little for emergencies. With John in the Bahamas Peter inherited 50% stake in the business and a home of his own (so he doesn’t have to pay rent anymore), with no business expertise Peter decides to be a silent partner in the business and enjoys the bonus paycheck from dividends, soon-after the pandemic hits and Peter looses his job, even though he had some savings they weren’t enough for Peter to live on comfortably but with the businesses profit split coming in and it’s networth being intact(for when mark ages and they have to sell the business) he could’ve lived comfortably no, even better he could’ve lived extravagantly. But what exactly would’ve assured Peter that the business would be operational for long, atleast long enough for Peter to be able to retire and seek retirement benefits? Well, the answer to this question in one word would be a ‘Moat’, a moat in business terms is a significant competitive advantage and in literal terms it’s the deep trench around castles which is filled with water to keep the castle guarded.

The business is the castle it needs to be protected from competition and it needs a lot of leverage over it’s competitors to be able to deliver that big fat dividend paycheck to Peter. For the business to survive and thrive it needs to have atleast one of the five moats: Networking effects, Intellectual Assets, Low-cost producers, Switching costs and lastly production scale. The wider the moat the higher the entry barrier for new companies and the more protected our market share against competitors. In my opinion a significant moat not only protects our market share from competitors but it also positions the company for quicker and more robust growth and as and when the moat widens the profits eventually do get bigger. In Peter and Marks case the business has lived through 3 decades which means it already does have a moat, it’s in the interest of both partners to widen this moat but Peter needs it more out of the two given his situation, we as investors are Peter after all even we depend on a business to give us dividend and to reward us handsomely in terms of stock price when we sell the business. I sometimes say to myself before making an investment, “Investors need to see a visible moat more than the promoter needs to see it and only for that reason are we given the choice of different equities.” With that being said lets dive deeper into the 5 moats.

The 5 Moats

Networking effects: This ones easy to explain lets just say Instagram. The apps so popular today that no matter who you are you are compelled to make an insta account because all your friends and family use it and you want to be updated with everything everyone does, you all want other gossip and news and you figured apart from your friends and family literally everyone you can think of uses insta. Well that is exactly the matrix on which network effects feed off of, it is nothing but a loop of positive feedback as more and more people use a product or service like Insta in our case, more and more new people get attracted to it and the cycle continues this network just keeps growing infinitely and as it grows so does the revenue. In most network effects once the popularity curve pivots the success becomes visible, the platform becomes a cult and the revenue becomes sizeable, in the end it becomes very tough to reverse a network effect for a long long time, the model in itself is a robust one.

Intellectual Assets: These are the intangible assets a business has such as brands, licenses and patents. We all tend to overpay for brands don’t we, there are various reasons for our behaviour as consumers but as a business this behaviour just becomes a revenue machine. As an investor I would be profiting twice [only on its purchase not to mention it’s price hike later] if I got the stock of Ferrari at a cheaper rate than what would supposedly be it’s fair price. Patents on the other hand let businesses walk the path to becoming monopolistic until a disruptor comes in. Though I don’t trust pharma and chemical companies with their patents because 1 the industries are too dynamic and sooner or later in most cases you find a disruptor or 2 there is always someone who will go on to create a generic drug or in the chemical industry case a generic chemical if you know what I mean. Another intangible moat could be the share of mind, this is most common in FMCG products, share of mind or as Warren Buffet likes to call it owning a piece of consumers mind is a phenomena which occurs mostly times in large retail stores where consumers tend to shut their second order thinking and solely rely on their first order thinking by choosing a particular brand in a particular product eg. gillette in blades and without considering other options presented to them on the shelf. This could be an extension of the brand moat.

Low-cost producer: A famous quote from Jeff Bezos comes into mind when one says low cost it goes, “There are two kinds of companies those that work to raise price and those that work to lower them.” As an investor I not only say that the companies should produce at an extremely low cost compared to their competitors but also they should pass it on, you might be shocked you might be thinking it is understandable for a consumer to say so but an investor? aren’t we the ones always nagging about higher profits and higher margins and top-line growth blah blah blah.. Yes we do all those things but let’s understand whats in it for me as an investor to let my business pass on the low cost benefit to consumers. First the competition dynamics become favourable now in this example my business is able to price a product at $150 whereas the cost of production for my competitors is $200, all the competition is instantly wiped off but it’s too good to be true so lets change it to $200 selling price and $200 cost of production in this case even if my competitors decide to sell at a breakeven all the other inefficient players are out, I am rest assured that my business will survive the minor business downturns whereas my competitors might not and most importantly my margins are guarded so all I have to focus on is improving my turnover to maximise my ROCE. [with inefficient players out of the market that should be easy too].

Switching costs: This is when business or consumers find it hard to switch from one product or service to another, look at it this way by eliminating all close substitutes a business forces its target audience to use its products and services giving it monopolistic powers. Usually this is done by creating a complex product as in there is so much value addition to an existing product that all its features and characteristics become just perfect and too essential for customers to switch from, in order to catch up with such a business its competitors would have to burn tons and tons of cash in R&D or they would have to somehow match the level of satisfaction derived by these products or services which becomes very difficult as constant value addition keeps making the existing product / service more and more complex. One example could be the case of AIA engineering, its High Chromium balls became way too essential for the cement industry for grinding and crushing purposes since the chromium balls designed by AIA increased production whilst reducing costs(the two most essential things any business needs ) and also provided consistency in end product’s(cement) quality. To further add value and widen their moat AIA now offers services to these cement players wherein they make product designs which specifically meet a customers requirements and production methods, they also design some of these productions methods to seal their customers.

Scale Economics: Benefits of having this moat might somewhat overlap with the low-cost producer moat but it varies in a few ways here the business outgrows everyone in the industry, imagine a business so big that even if a competitor burns all their cash it wouldn’t be able match the business in size. You might be thinking there is no such business but let me name two such popular ones: Coca-cola and Costco. Having such business means that suppliers have to match your cost conditions, you decide what you buy and at what, well Costco went a step ahead and told its vendors to cannibalise their own products by selling under Costco’s brand and even keeping quality above their original counterparts. As an investor scale economics feels like a powerful moat to have on your side but sometimes it can be broken in twisted ways well not in entirety but somewhat creating a bypass for a sub-industry as in these big business on one side and the other parts of the industry on another side example in the case of Coca-cola, red bull is its competitor a drink which tastes worse, is packaged in a smaller tin and is even costlier that is considered breaking the market in a twisted way.

The sixth Moat

[Disclaimer: This is highly opinionated since I truly believe it to be true, I might be wrong on this one]

As investors we have to make lots of decisions, one of the decisions we have to make is choosing the people we partner up with A.K.A the promoter / chairman / MD / CEO. This brings me to the sixth moat, well this isn’t an economic moat as you might’ve already figured but nevertheless it is as important if not more important than any of the other Moats because at the end of the day any business is made and run by people. I’d say this moat isn’t a textbook moat either because even in practicality it defies all logic and convergent business stories and historic probabilities of business success and failure. Yes, I am talking about the promoter being the moat, there is something about these people, their behaviour they just can’t seem to accept defeat nor do they shy away from persistence. Work is life and life is work there is no difference between the two. No matter how sloppy the industry, no matter how competitive the business landscapes these guys just find a way to defy all textbook rules of success and failure, their business stories follow their visions no matter what one such example I can give you is Phil Knight and the story of Nike, in his book shoe dog he explains how he couldn’t find a balance between work and life, how he took crazy amounts of debt and almost always managed to pay them and most importantly how he competed with Adidas and Puma from his home garage. If you re-call Apple was a turnaround story and Steve Jobs was its main character. Apple was everything for Steve Jobs and so was Microscoft for Bill Gates. I can keep on listing many such stocks but I think you get the idea, the promoter moat is supreme and if you ever find yourself invested in such a company know that your money is 100% safe, money is about to pour in, it may take some time and a few business ventures but eventually the ship will sail because the sailor bows before no headwinds.

Conclusion

The most important thing a moat ensures is that you can’t replicate what a business already does without incurring a sizeable cost. The wider and deeper it becomes the tougher it is to replicate what a business does. Even a moat can’t guarantee business success, it all depends on how a business can leverage these moats after building on to them. Moats just increase the chances of survival and growth altogether a business with no moat might end up in the grave.