How to Check if a Moat Exist? (Moat Analysis Framework)
It is quite strange that a medieval defense strategy employed in the fortifications of forts in England has come to occupy such a central stage in value investing stock analysis.
Come to think of it, if you could picture England as a giant castle and The English Channel as the surrounding moat, you could quickly deduce that once England united the other nations on its island there would be few world powers who could launch massive territorial conquest on its shores especially since amphibious operations always tend to favour the defending side. (Perhaps this enabled them to expand their empire since not much needed to be done on homeland security front).
As explained in our posts before, Moats are long-lasting competitive advantages a company might have owing to its business model that enable it to resist the onslaught of competition for a great number of years.
The evolution of Moat:
In the period around 1950-1960, when great companies such as Walmart and Nike were still startups, the greatest struggle the entrepreneurs faced was the problem of securing a starting capital. Most of the times business in that time had to open a line of credit from banks but the problem was that the banks were highly regulated and only were willing to lend to those companies which had already established their operations and achieved some reasonable scale to their businesses. This gave an advantage to existing businesses since the system stifled the growth and emergence of new competitors.
Come the 70s, the world began to see the rise of venture capital and private equity firms namely Sequoia and Carlyle in the US. These companies were able to pool in money from investors and redirect them to fund the capital of emerging entrepreneurs of Silicon Valley and elsewhere.
In time (that is the last 4 decades), the high capital requirement as a barrier to entry has steadily eroded away and have enabled upstarts and disruptors to challenge incumbent businesses across different sectors.
The other trend (which will get even more relevant in the future) has been the evolution of technology at breakneck speed which has fundamentally brought down the cost of entry into many businesses at the cost of well-established firms.
Since companies face a greater risk to their business models now more than ever, it has become imperative for investors to select the companies with the most resilient business models for their portfolio. Only then it is possible for investors to generate steady returns without painful volatility.
The process of finding moats can be quite arduous and confusing for investors who are starting out, especially when a lot of companies seem to be running profitable operations for extended periods even without any apparent moat. Although moats often come in various forms and sizes, it may sometimes be very difficult to identify and to judge their quality for many companies. In such a scenario it helps to have a decision-making framework to act as a force multiplier in the investor’s toolkit.
Moat Analysis Framework
The following moat analysis framework should provide a good starting point for our readers in their analysis. You may feel free to develop this into a more comprehensive and robust framework based on your experiences and understanding of different industrial sectors.
(Please note the framework was developed by Ensemble Capital, an asset management company in the US, it draws greatly from the experiences of the firm’s analysts and books including “The little book that builds wealth” by Pat Dorsey and The Investment Checklist by Michael Shearn)
(Source: Intrinsic Investing)
Levin is a former investment banker and a hedge fund analyst. He is an NIT Warangal graduate with around 5 years experience in the share market.