Business Moat !!!!

Hidden Gems …

Of all the things that Value Investors fall in love , the most seductive one is “
Business Moat” . For any staunch value investor , few things can be as
fascinating as finding the next gem (business) with solid moat . In simple terms
, moat is all about “durable competitive advantage” of a business. Durable
competitive edge acts as a protective barrier for a business to stall any threat
from competition ( like how “moat” around the castle protects it from enemy) .

High moat means superior economics of business with high pricing power ,
solid return ratios and wide operating margin supported by growing free cash
flow . As a result , such business seldom needs debt for its growth and hence
clean balance sheet with substantial cash reserves making it an attractive and
compelling opportunity for value investors. Strong brand , first mover with
long operating history , diversified customer base , wide distribution network ,
IP based business , high switching cost , annuity / sticky services , low cost
manufacturing or economics of scale are some of the well known sources of
moat . In contrast , businesses which operate in segments such as concentrated
buyers market (OE business) , high degree of technological obsolescence ,
capital intensive sectors ( sucks constant capital to grow) , commodities ,
cyclicals etc possess low or negligible moat . Airlines , Infrastructure , Power ,
Regulated Industries , Capital goods etc come to mind as examples of businesses
with low moat .

Business with high level of moat exhibits in general high degree of predictability
in its revenue & cash flow streams and hence appeals to Value Investors . The
reason being the criticality of predictability of cash flows for ascertaining
Intrinsic worth of the business on which the whole edifice of “Value” stands .
To the uninitiated , the intrinsic value is nothing but the present value of future
cash flows discounted at appropriate discount rate.

So far so good . But will it have any practical use if such solid businesses aren’t
going to be available cheap ( discount to their intrinsic worth) . It appears so if
one goes by the sky rocketing valuations of some of the consumer franchisees in
the market i.e. Unilever , Nestle , Marico , Godrej Consumer , Glaxo , Titan etc.
Not to get dis-heartened , market is not so efficient to price businesses to
perfection esp in the broader market ( small and mid caps) where there are
innumerable businesses with solid moats available at significant discount to
their intrinsic worth . Hidden gems are many for those who are prepared to dive
deeper .

Though there are many segments in the broader market that possess economic
moat , there is one interesting space where the opportunities are multitude esp.
given the nature of large domestic market for industry products i.e. “Industry
retail” . Unlike consumer brand companies ( highly visible and hence high
valuations) , industry retail is about well established brands in the narrow, notso-visible industry ( intermediary) market . Brands with long presence and
niche characteristics in this space command pricing power and customer loyalty
. Businesses with such brands , esp. those with long operating history in their
domain possess superior economics of business with high return ratios , strong
pricing power , durable competitive advantage aided by high free cash flow
generation ( basically very high moat) .

There are many names that come to the mind . But some prominent ones are
Grindwell , Finolex Cables , Amara Raja Batteries , V Guard , ESAB welding ,
Astral Poly , Hindware , WimPlast , Plastiblend , Indag Rubber , Greenply ,
Havells and so on . Some of these are already re-rated by the market , while
most remain undervalued thanks to the inefficient market
Such businesses are not only limited to this Industry retail space . IT software
product space with huge IP edge is another example where some of the well
established companies with Industry leading software product are going for
songs ignored blatantly by the short-sighted market . No prize for guessing one
such company . Check for the company which grabbed the deal from RBI
recently for the core banking solution . That much for efficient market
hypothesis !!!

Happy Value Investing!!!

ArunaGiri. N

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