Seven economic moats company stocks must have to win over rivals

Just as moats defend territories from invaders, economic moats give a company a distinct competitive advantage over its rivals.

By ET Bureau | Feb 09, 2015, 08.48 AM IST

Seven economic moats company stocks must have to win over rivals

Warren Buffett coined the term economic moat. Just as moats defend territories from invaders, economic moats give a company a distinct competitive advantage over its rivals.

1. Monopoly

What does it mean? In this situation, there will be only one supplier or service provider. The profitability will be very high here because the company can charge as much as it wants.

Monopoly situations are mostly the result of government policies.

Examples: Coal India (present) and MTNL (past).

Impact: Though a major advantage while it lasts, a breach of this moat can lead to massive wealth destruction like in the case of MTNL.

2. Entry Barrier

What does it mean? Incumbent players are at an advantage in any industry where new players face high entry barriers. This may be due to high cost of entry (eg telecom industry, oil refineries, etc) or because of regulatory restrictions (eg cigarette).

Example: ITC

Impact: Near monopolistic situation helps ITC maintain very high margins in its cigarette division.

3. Brands

What does it mean? When products become more complex and the probability of adulteration and fraud increases, customers tend to stick with their trusted brands. It becomes difficult for new entrants to compete with companies that have developed strong brands over decades.

Example: Asian Paints

Impact: The paint major could convert a commodity into brands and thereby generate better margin for decades.

4. Technological Advantage

What does it mean? New entrants are unable to challenge the high-end research and technological advantage of these companies. They acquire large number of patents making it illegal for others to replicate their products.

Example: Bosch

Impact: The largest automotive component manufacturer in India retains its edge over competitors due to the highend research by its German parent.

5. Cost Advantage

What does it mean? Very low cost of production helps a company increase its market share by under-cutting competitors or generate higher profits when it is selling at the market rate.

Example: Shree Cements

Impact: Shree Cements has the lowest production cost among all other cement producers and reported an EBITDA/tonne of Rs 933 against the industry average of Rs 692/tonne.

6. Switching Costs

What does it mean? Customers stick with a product or service provider because shifting to a competitor is expensive. Developing a new IT infrastructure and training its employees is costly. That explains why Infosys and TCS get around 95% of new business from existing customers.

Example: TCS

Impact: TCS continues to benefit from its first mover advantage in the US.

7. Network Effect

What does it mean? In some situations, customers get into a place just because other people are already there (eg. Facebook and Linkedin).

Similarly, traders want to be on the stock or commodity exchanges with maximum turnover. This "virtuous cycle" propels the largest player to a monopoly kind of situation.

Example: Facebook

Impact: Facebook's continuing growth.

(In all charts, stock price and index values have been normalised to 100.)

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