Issue 4 of Stock Selection Criteria
Today we are going to learn what many consider probably the #1 most important criteria when it comes to selecting stocks. And that is the economic moat of a company. The economic moat is a term popularised by Warren Buffett who once said “In business, I look for economic castles protected by unbreachable moats.”
The traditional meaning of a moat is a deep ditch that surrounds a castle and is usually filled with mud in order to protect it from invasion by enemies. In investing, an economic moat refers to the durable competitive advantage of a company. Essentially, it is what will enable the company to continue making larger and larger profits and continue to convince customers to buy from them as opposed to their competitors.
Economic moats can be of several types and they are as follows:
Supreme Brand - Some companies have a very strong and powerful brand which continues to attract customers all the time. An example is Coca Cola.
Economies of Scale - Some companies are able to provide a very competitive price to customers because they can buy their raw materials in bulk and get a cheap price on them hence lowering their costs. An example could be Walmart.
Patent- Some companies hold a patent on a technology which is very lucrative and makes them a lot of profits.
Trade Secret - A trade secret is something that is kept secret by a company so as to not allow competitors to copy their products. An example is McDonald’s secret recipe. Or Coca Cola’s secret recipe. These cannot be easily copied by you and me and hence, companies like McDonald’s and Coca Cola have continued to make good profits over the years.
Network Effect - Network effect refers to the fact that some products tend to be used by more and more people over time simply because their friends are using it. An example is Facebook. Facebook continues to have an increase in its user base as well as its profits because the more people there are who use Facebook, it is likely that even more people in future will be using Facebook so that people can meet and connect with friends.
High Switching costs - Some companies continue to make good steady profits simply because it is difficult and/or too expensive for their customers to change to a competitor. An example could be Microsoft. It would be too time consuming for companies all around the world to switch their office computers to using a Macbook. It would be seen as an unnecessary activity. “We’ve been using Microsoft all this while so why should we switch?” As a result, Microsoft continues to make good profits and pay good dividends.
Government Regulation - Some companies are protected by government regulation. Some industries need a government licence in order for someone to setup a business. Examples can include public transport systems or pharmaceutical companies or even construction companies. Some companies may have the license from a government to perform certain construction work over the next few years. Such contracts can make the company a lot of money and enable the stock price to increase.
Monopoly - Some companies have a monopoly meaning that they are the only company offering a certain product or service to large numbers of customers. For instance, there is usually only one public transport system in a city or country. It doesn’t make sense for there to be two trains building two different railway tracks and competing for customers! Sometimes, these companies trade on the stock exchange and can be good candidates for stock selection.
Alright, with that wealth of information, here’s the mini-homework for today - take the stock(s) you shortlisted in yesterday’s lesson and determine what moat it has if any. The more number of moats it has, the better. We are also looking for a moat that can last for several years if not longer. A good resource to determine a company’s moat is the company’s investor page. Just google the company’s name and look for the page on investor relations. For example, here is Facebook’s investor page. As you go through the tabs, you will learn how Facebook has a strong position across different networks and even owns Instagram and WhatsApp!
Remember that determining a moat is very subjective. There is no right or wrong answer and different people can have different opinions. So do not over-think it! It is possible that the company you selected may not have any moat. If so, you need to make a decision whether you are still comfortable investing in that stock or would you rather invest in another stock?
Good luck with the homework and remember, if you have any questions, help is just a click away in the Facebook Group.
Watch out for tomorrow’s e-mail where we will learn about identifying risks associated with a company.
Legally Required Disclaimer: All information provided is solely for education and is not a recommendation or advise to invest. The course provider will not be liable for any losses, financial or otherwise incurred. This course will contain examples of several stocks in order to enhance the learning experience. No recommendation or advise to invest in these stocks is intended. Every step has been taken to ensure accuracy of the information but not assurances of the accuracy are made and the author will not be responsible for any inaccuracies. Investors may wish to seek professional guidance before investing.