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5 concepts to know when analysing stocks

Larissa Fernand  |  21 Apr 2015Text size  Decrease  Increase  |  

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Larissa Fernand is the editor of the Morningstar India website.


1) Economic moat

A company with a very profitable business is like a castle that is constantly under attack by competitors. Without a strong defence, competitors will soon imitate the company's products, charge lower prices, steal market share, and erode profit margins to the point where the business is merely average, at best.

An economic moat -- a term coined by Warren Buffett -- is what keeps competitors at bay. It is a sustainable competitive advantage that allows a company to earn excess returns on capital (that is, returns on invested capital greater than the cost of capital) for a very long time.

We define a wide moat as a competitive advantage that is almost certain to last at least 10 years, and probably 20 years or more. A wide-rating is very hard to attain and very few companies globally have a wide-moat rating.

The standard for a narrow moat is lower -- it only needs to be more likely than not that the competitive advantage will last for 10 years. The vast majority of companies have no moat. So even if they are earning excess returns now, it is not wise to expect them to persist long into the future.

Morningstar has identified five potential sources of an economic moat. To read about them, click here.

While it makes for an excellent investment strategy, investing in a wide or narrow-moat company is no guarantee of success. Valuation does play a very critical role. So don't overpay for quality companies. Buying them when they are trading at a discount to fair value is a really important consideration.

2) Moat trend

Economic moats aren't stagnant over time. Rather, competitive dynamics are constantly shifting as technology develops, regulations change, competitors exit or enter a market, companies gain scale, and so on. This is where our moat trend ratings come in.

If the underlying sources (or potential sources) of a company's competitive advantage are improving over time, the company has a positive moat trend.

If the underlying sources (or potential sources) of an economic moat are weakening or a company faces a substantial competitive threat that is growing, then it has a negative moat trend.

For example, the switching costs and network effects that historically benefited Microsoft's Windows operating system are being steadily eroded by the growth in smartphones and tablets, where Google's Android and Apple's iOS dominate.

Closer to home, Sydney Airport (SYD) has a narrow moat rating given it is a regional monopoly, encompassing Australia's most populous city.