Moats
How do equity researchers think about economic moats? Like let's say you are evaluating a growing tech company that just IPO'ed or Hershey's or whatever it may be - how do you think about what features of the firm translate into an economic moat?
Many ways to approach this, and the specifics differ between industries. Think of things like: amount of & quality of competition, intellectual property, pricing power & sustainability, brand name, management quality, first mover advantage, regulatory barriers, manufacturing barriers/expertise etc…all these things (obviously I didn’t name everything) can contribute to a moat and some will be more obvious or nuanced than others.
Simple two questions to ask are 1.) how does this characteristic of the business affect the ability of others to compete against the firm; and 2.) is that characteristic differentiated in a sustainable way that is difficult to replicate? If you answered yes to the first question but no to the second question, you have a competitive strength but not a competitive advantage. If you answered yes to both, you have a moat source. In general, moat sources will either be cost or price based. If cost, they can make or do something cheaper than others, and there are attributes that prevent others from copying or at least make it very difficult or costly. If price, something about what they are doing allows them to charge more for their product/service than others. It's a very broad question so I submit a fairly broad/high level answer.
On the quantitative side, the question to ask is what about this business is allowing the firm to earn returns on capital in excess of their cost of capital, or comparatively, a greater economic spread than others in its competitive set. ROIC will generally be the quantitative manifestation of a moat. The important distinction to make is between cyclically high ROIC (firm is most profitable because we are at a favorable or high point in the cycle) and structurally high ROIC (the firm has genuinely better economics than its competitors). This is an oversimplification, but a firm with structurally high ROIC will have stable and/or expanding ROIC over time, while a firm with cyclically high ROIC will have greater fluctuations in ROIC over longer time periods. Mistaking cyclically high ROIC for structurally high ROIC can be very painful when the cycle turns.
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