Saturday, June 16, 2012

This Buffett test helps distinguish Coke from Kodak

'Moat' is a very popular term that legendary investor Warren Buffett uses to define a great business. Literally, 'moat' means a wide and deep pit dug around a castle for defence against attacks by enemies. In investing parlance, this translates into a business that has a strong competitive advantage.

But competitive advantage is not a measurable parameter. So how does one find stocks with a strong moat? There is this one acid test that you can use while evaluating a prospective stock. Ask this one simple question. If you were given billions of rupees, would it be possible for you to replicate the success of this business? Would you be able to put a significant dent to the company's business and profitability? If the answer is in the negative, then you have just found a great business with a very strong moat. Some of Buffett's greatest wealth creators such as Coca-Cola, Gillette, Geico and Wrigley (the list is long) had passed exactly this test. Each of these stocks had some robust in-built moat that gave them a substantial advantage over their competitors.

Moats can be in the form of various things. For instance, in the case of auto insurance firm, Geico, the moat was low cost. In other cases, the moat can come through superior product quality, strong brand image, better quality services, patents, real estate location and so on.

The next important question- Is the moat is durable enough? For one, do not confuse temporary advantages with moats. In some case, the companies may lose their competitive advantages with shifts in the industry. Think of Xerox and Eastman Kodak. What you should be looking for is a company like Coca Cola whose moat can widen over time.

No comments:

Post a Comment