It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price
- Warren E. Buffett
Evolution of the word moat-
In the early days, the term "moat" certainly was used for a different purpose than how it is used now in terms of investing.
Moat is basically a deep wide trench surrounding a castle filled with water and is used as a defense against attack. The above picture depicts an example, for more clarity on the subject revolving around moat.
A wild thought many of the readers would have got, as to why am I writing about castles and moats in a finance related blog? Well.. it has a lot to do with most of the successful blue chip companies and those consistent compounders of your portfolio :). A famous quote by Mark Twain that is very apt for the financial markets and which is very relatable to all the market participants is that " History Doesn't Repeat Itself, but It Often Rhymes".
How moat has been a successful protection to castles of the early age, certain familiar jargons such as "competitive advantage", "monopolistic position", "recession proof" are those artistic qualities of companies which have created a "moat" surrounding them as a defense against new competitors in the market.
The phrase "Moat" was coined for the first time by Warren Buffett.
Moat is that competitive advantage, that one step ahead which certain companies take in order to retain market share and consistently increase it. These are the companies where one has to see themselves invested in.
Below are certain examples of companies that have the benefit of moat in their business model and how they have been beating their peers and have remained steady and growing in terms of market share and share prices as well. (Consistent compounders as they call it!)
Exhibit 1: Backward Integration- RIL
Time And Time again backward integration has been the key moat for most of the successful companies in India. Sometimes the most simplest strategies provide the best returns! Popular example being of Reliance Industries Limited.
Dhirubhai Ambani always relied on world class technology and large scale development when it came to backward integration. Quoting his own words "My desire was motivated by the fact that we were not able to produce and supply a quality fabric to the export market. It was a question of integrating backwards. If I had a ready product then I would not be at the mercy of other units in the industry, and I could ensure the quality of the products myself". The vision of the Ambani Family is in sync with their empire's name Reliance, being self-reliant and not dependent. Over time, Backward integration would become a core Reliance Strategy a theme for all strategic planning and execution.
Late until the 1970's Reliance was only involved in the manufacturing of synthetic yarn and textiles. Dhirubhai Ambani had the foresight to step backwards into the manufacturing of Purified Terephthalic Acid (PTA) which is a raw ingredient chemical for polyster fiber used in textiles. Later on they started a new venture of the name "Only Vimal".
Now the moat a business creates around them by backward integration is: Control on prices of raw material, manufacture final products at cost effective rates and quality of your choice, helps in effective inventory management which is key in any business which requires high inventory, SKU's(Stock Keeping Unit) and regular creativity and change in products such as the Retail sector.
Exhibit 2: High brand equity and strong distribution network- Asian Paints
The market share that Asian Paints owns that is more than 60%(decorative paints) is something commendable. The paint sector is mainly controlled by 2-3 market players making it "power concentrated on a few hands". Now with the entry of Grasim Industries, rising crude oil prices are bringing some knee-jerk reactions to this sector. Not to mention, nearly 50% of raw materials is used by paint companies are crude oil derivatives and are 30-35% of the total raw material cost in this industry. Inversely, successful companies such as Asian and Berger Paints have been successful in the past in painting this increased cost on the end consumer hence not effecting the margins and top line of their companies.
On the 12th of November 2021, Asian Paints made an announcement that the prices of their products would increase by 8-9% and on 5th December it increased by another 6%. So in total an increase of 15% in price of products. Having a high brand equity and goodwill, and a customer centric brand, consumers have little to no choice other than Berger or Asian Paints. This added benefit of passing on the increased raw material price to the end consumer is something that Asian Paints enjoys. This is known as operating leverage.
Now the chances of the price of raw material coming down is high in the following quarters, but the price of the end products coming down is less. So in the longer run, the increased margin benefit will help in increasing their bottom line.
Asian Paints has more than 60,000 dealers across the country and have gained their trust over the years and they also have a excellent supply chain management.
To have a efficient inventory management and good supply side, instead of having high inventory, they increased frequency of restocking rather than stocking at one go. Interesting fact: Restocking every three-four hours, which works out to 3-4 times a day and an average of 28 times a week.
Asian Paints have had this supply side management from 1970! Now how did they do this?
An interesting fact being, they bought a super computer in 1970 worth Rs 8 Crores. This studied the consumer's buying habits based on past habits(data). The super computer and it's data is so efficient that the probability of it being right is as high as 97%! And it can also forecast future demand in terms of paint colour, can size and quantity as well.
In this way Asian Paints has been successful in retaining it's market share and being no.1 consistently.
Exhibit 3: MM- Monopoly Moat: Fine Organics
Fine Organics Industries Limited (FOIL) -
Fine Organics has a strong moat in oleochemicals due to high entry barriers, high return ratios, customer stickiness and Good research and development capabilities.
Oleochemicals are derivatives derived from natural sources such as plants and animal fats. It is mainly used in production of cosmetics, lubricants and other chemical products.
(To learn more about oleochemicals: https://www.youtube.com/watch?v=GlLZGHOEqBA)
As derived naturally it is also known as green additives. FOIL are one of the largest oleochemical manufacturers in India.
MOAT Advantages:
Manufacturing and extraction of green additives is highly complex and only very few companies have the proprietary technology. Hence making it a very niche market.
Very high R&D Expenses- Only large scale manufacturers can afford the costs.
The products of FOIL in end products are used in a very minimal quantity 1-2%, but these additives are extremely crucial for the products. This in turn ensures customer stickiness ( low frequency in changing of suppliers in the view of customer).
The chart too depicts a strong structural story for FOIL. Consistent compounder of wealth for investors!
Hence, we've tried to elaborate on the essence of a Moat and how it can effectively help a company stand out and help investors make stellar returns by investing in those companies that have a moat in their business model.
Shivam M. Dave
Such a well- articulated write up. Very informative!
Excellent analysis shivam, very nicely explained particularly about the backwards integration of ril. I was also impressed by that during my early investor days. I have always avoided companies going for unrelated diversification, where majority of the company's have gone bankrupt. Keep it up. Regards, naresh kumar bhatt.