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Investors must go for cos with economic moats: Nirmal Bang

Investors must look for companies with economic moats as these are sustainable as well as create wealth and grow in diffucult times, says Nirmal Bang research report.

August 31, 2013 / 04:17 PM IST
 
 
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Last few years of downturn and subsequent recovery in the equity markets has taught us an important lesson in investing. When it comes to investing in equities, long-term wealth is created only by investing in the most durable and sustainable companies that actually create wealth year after year and have the ability to manage and grow in difficult times.


The ability to manage in difficult times or in a downturn in industry and economy is far more important because what may be earned, say in 10 years during good times, can easily get wiped out in a year in times of volatility. Most Indian companies have failed to perform in these difficult years and thus have eroded huge wealth of investors.


In good times even the most poorly managed companies manage to grow. However, the difference is only felt during bad times when vulnerability of these companies is exposed.


It is still not too late to avoid these traps and the best way is to look for companies which have sustainable or a durable business model. Even if one compromises on returns, which is possible given that many times quality companies trade at higher valuations, the loss of capital could be avoided. We have already seen this happening as many companies with weaker business models have seen huge erosion in market capitalization.


By knowing the pitfalls, most wise investors including legends like Warren Buffett have made their fortunes through investments in durable companies. In fact, Buffett has emphasized a lot more on quality of the company summarized in his theory of economic moat. Studies have shown that companies with high economic moat provide better returns while avoiding risk of losing capital.


Buffett has always advocated that the biggest risk in investing is the risk of losing capital. He says that the number one rule in investing is to never lose money and the number two rule is to never forget rule number one. This is why he and other legendary investors seek companies with growing economic moat.


What is economic moat?


The term economic moat was first coined by Warren Buffett. Economic moat is nothing but the key advantage a company has, which ensures durability and growth of the business. These are structural advantages that the company enjoys, which enable it to sustain, grow and generate enough returns over a longer period of time to reward the invested capital.


Companies which have economic moat in their businesses have an edge or competitive advantage over competitors, which enables them to compete in the market and grow without much threat to the business.


Explaining this further, Buffett says, "Great companies to invest are like wonderful castles, surrounded by deep, dangerous moats where the leader inside is an honest and decent person. Preferably, the castle gets its strength from the genius inside; the moat is permanent and acts as a powerful deterrent to those considering an attack; and inside, the leader makes gold but doesn’t keep it all for himself. Roughly translated, we like great companies with dominant positions, whose franchise are hard to duplicate and has tremendous staying power or some permanence to it."


Why economic moat?


The basic premise of investing in equities is that over the long term the company being invested in should grow and make money so that its shareholders can make money. As investors we all like to see a company grow. This is particularly true for long-term investors, who invest in companies with a 5-20 year horizon.


For such investors it is very important to understand how sustainable the business model of the company is. Many companies come and go. Many go bust within years of their inception and many have a short shelf life. For an investor to make money, durability of the business is very important.


Importantly, over a period of time it has been observed that companies face competition and businesses are often attacked by rivals. Industries which make good returns attract more and more players in the long run and within a short period of time it is crowded by many players including strong and marginal ones.


High competition leads to erosion of margins and return on investments. Under these conditions what was supposed to be a promising company becomes a worthy investment. "The dynamics of capitalism guarantee that competitors will repeatedly assault any business 'castle' that is earning high returns. Business history is filled with 'Roman Candles,' companies whose moats proved illusory and were soon crossed," said Warren Buffett in his 2007 letter to his shareholders.


Ideally a company with a strong economic moat should be able to protect its profits from being attacked by different forces and business dynamics. We have seen competition eroding the sustainability of companies from sectors like telecom and construction. The essence of economic moat lies in its ability to protect companies and allow them to create wealth in the long run.


Growing economic moat


Management gurus say that true companies compete with themselves rather than with competitors. This way they keep on climbing the ladder. In the process they lose some initial advantages but they create more to retain the staying power.


Many companies make the mistake of stopping to think when they reach a certain level. They think as if they are invincible and start taking competition lightly. The self created illusion of static economic moat starts ruling over the minds of people running the business and those who are associated with them.


It is widely believed and accepted that competitive advantages by themselves do not assure protection of the business from external forces. It is only the growing competitive advantages or deepening moat that works in the long run to sustain business and grow.


TVS Motors lost to its competitor Hero. Now, Hero is losing partly to Bajaj Auto. In the telecom space, MTNL lost to private players like Bharti Airtel and others. In capital goods, BHEL is losing to Chinese competitors and other private players like Larsen and Toubro and Thermax.


Moat or Trap?


A constant economic moat or economic moat which is not growing could actually be a trap, which can engulf many investors before it actually fades. Globally many investors have fallen into this trap.


When Kodak was losing to its competitors in the digital photography space, many failed to see this shift and because of their illusion about the strong brand, best franchisee business, etc they kept on buying its shares till it became evident that it was actually a trap in the name of economic moat.


This is why investors are advised to constantly review the economic moat of a company and ask if it is seeing substantial growth. If a company is growing, it will be reflected in its overall performance.


A large market share, a strong brand and a hot product or service alone do not qualify to be called as an economic moat. These should be well-protected and should have the ability to sustain in the long run.


Source: Nirmal Bang's Beyond Market


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Disclaimer: The views and investment tips expressed by investment experts/broking houses/rating agencies on moneycontrol.com are their own, and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.

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