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What Sets This Company Apart From The Rest? |
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Value Investing is all about finding great businesses trading at a discount to its intrinsic value. But just what are the hallmarks of a great business? For Warren Buffett most companies that he is interested in investing in have what he calls unbreachable moats. In simple words, he looks for companies with a sustainable competitive advantage. The larger the advantage, the wider the moat. This moat would protect the business from competition. And if the company is able to use its competitive advantage to widen the moat over time, then it is the perfect business to be in. So how does a company go about building a moat? One way to do so is by building a brand. A brand that has consumer recall. It would take years and lot of investment for another company to challenge the authority of a good brand. Take the example of Coca cola. It is one of the most well known brands in the world. This brand gives it pricing power. Despite the number of soft drink manufacturers who have been in existence, none has been able to dethrone Coke as a leading soft drink brand. The second would be in terms of economies of scale. Let us take the case of a company, which can increase its operations without costs rising at the same pace. Basically, the fixed costs would already have been taken care of. And the rise in variable costs would not be much. Thus, whenever this company increases sales, the benefits of this will directly flow into margins. Such a company enjoys a moat because another player looking to enter will need to make a huge investment. And that is only possible if this new player has deep pockets. Patents are another great way of building a moat. One example in this regard would be the pharmaceutical sector. Once an innovator company comes out with a new drug, competition can only enter in once the patent on the drug expires. Thus, the revenue and margin potential during this period tends to be huge for a pharma innovator company. Switching costs can also be a barrier of entry and can deter competition. When you buy a laptop or a computer, more often than not it comes loaded with the Microsoft operating system. Have you even thought about changing the operating system? The answer would most probably be no. Why? Because there is a cost involved. This is what is called a switching cost. High switching costs make it costly for a customer to switch from one product to another. Or from one company to another if a company is able to create this moat, then it ends up having a customer following without the threat of competition. One such example is Solar Industries. The reason it made it to our 'Buffett would buy' list at the beginning of 2013 is its leadership position in the lucrative, niche business of industrial explosives. The other advantage that the company had came from government regulations. The industrial explosives sector is one of the very few industries that require industrial licenses. This creates a strong barrier against new players planning to enter this industry. And we were right. Post our recommendation, the stock went to generate returns of more than 100% before closed the position in August 2014.
So now you know that the first thing to look for while picking stocks is the competitive advantage that a company enjoys over its peers. But there's more. Look out for my next email where I will talk about the second important factor that you need to have in mind in the stock picking process. Now, even as you wait for the next article, I want to tell you something about what I do at Equitymaster. I am a Senior Analyst and an avid follower of Warren Buffett and his value investing philosophy. And right now, I am managing two portfolios that I believe will you give you a chance to invest like the legendary investor himself and build long term wealth. To know more about this, please click here. » Next: Should You Care About The People Running These Businesses? |
