How to pick stocks (Part 1) - Economic Moats

Finally, i'm more free to continue blogging and write up good articles for readers of my blog. Just finished my exams yesterday and looking forward to my Taiwan holiday trip in one weeks time. In the meantime, i'll be starting a series of posts on how to pick stocks. As an economics student, i'll start of with what is familiar to me which is how to analyse a company's economic moat. Many of you may have already heard this term. Read on to find out more.

Introduction
How to know what companies to invest in? This is a question many people will ask. When choosing which companies to buy, we need to know its competitive advantage against other companies. Investopedia defines economic moats as: "The competitive advantage that one company has over other companies in the same industry. This term was coined by renowned investor Warren Buffett."

An economic moat is like a company building a fortress. By having a competitive advantage, firms can continue to have profits in the long run. As a shareholder of a company, you'll also want the company to continue generating profits and cash flow. In this way, the share price can continue rising and dividends will also increase with it.

Category of Industry Competition
In economics class, we learn that there are basically 4 different industry competition:

1) Monopoly Competition
2) Oligopoly Competition
3) Monopolistic Competition
4) Perfect Competition

Monopoly
From the name, you can roughly know what sort of industry it is. In a monopoly, there is only one firm in that industry and this firm has complete control of the market. It is similar to a familiar board game that we play called monopoly. The objective of the game is to buy up all the properties and gain control of the market. This industry has high barriers to entry through legal restrictions, economies of scale and control of essential resources. In simple terms, it means that if other firms or competitors want to enter this industry, it is almost impossible. Examples of firms in this industries are utilities companies which provides water and electricity. Very seldom do we see listed companies which belongs in a Monopoly.

Oligopoly
An oligopoly consists of around 3-7 firms that dominate the market. Each firm has a big market share with few competitors. However, the competition among these few firms are intensive and firms need to constantly have a strategy to stay ahead of competition. There is often a leader in the market among the few firms and others act as followers. Examples of firms in this industries are Telcos. In Singapore context, they are namely Singtel, Starhub and M1. From these 3 names, we can roughly guess who is the leader in the market with the biggest market share.

Monopolistic Competition
There are large number of firms in this industry (30 or more). They offer similar but slightly different products. With so many firms in the market, each firm only has a small market share. Firms differentiate their products through product differentiation by advertising and building their brand name. Examples of firms in this industry are food and beverage companies. In Singapore, we see many different F&B companies. Most of them own several restaurants and fast food chains. An example is Breadtalk which owns a bakery, food court, restaurants etc. It has established its brand over the years and this is a form of economic moat.

Perfect Competition
In a perfect competition, there are large number of buyers and sellers. There is a standardised product. In simple terms, these are markets like foreign exchange market, commodity market etc.

Understanding which category the firm belongs to is important in determining the firms future profitability and how long it can hold off competition.

Building an Economic Moat
We always need to ask ourselves why is the firm suitable for investing? Are profits still coming in and if so is there a threat that competitors can steal away its customers?

There are ways that firms can build sustainable competitive advantage.

1) Differentiate their products from competitors 
For firms in the monopolistic competition, this is especially important.

2) Building a brand
A brand is a form of product differentiation. People tend to look for brands that they trust to determine the quality of their products. A strong brand attracts customers and prevents competitors from taking aways their customer.

3) Offering similar products or services at a lower cost  
If a firm is able to offer similar products at a lower costs, this creates a competitive advantage for it. Firms that are able to do that creates high barriers of entry and makes it difficult for new firms to enter. Airline companies have been driving down costs by offering budget services. Singapore airlines for example, has a fairly new budget airline Scoot. Their planes are old SQ air buses which are much bigger than other budget airlines. In this way, they can have more passengers on board at a time and the price each passenger pays can be cheaper.

4) Creating high switching costs
Firms which provide services and products such as IT systems can create high switching costs. Especially for banking systems, they are so complicated that banks will not want to risk in changing to other systems. In this case, most likely the firm that provides the service will continue providing it for a long time. An example of a listed company in Singapore is Silverlake Axis. They provided integrated banking solutions to various banks around the world.

5) Locking out competitors
Firms can lock out competitors by having regulatory exclusivity and patents for their products. Casinos require licenses and in a country, very few licenses are given out. A firm that has this license gain a competitive advantage. Las Vagas Sands, a well known casino brand has been having this competitive advantage for a long time and are still doing well until now.

Patents can lead to years of extremely high profits for a firm. Breakthrough medical products have patents to protect them. Pharmaceutical companies with patented products will have almost guaranteed profits for many years.

Conclusion
Firms in certain industry will find it easier to make money compared to other industries. In industries where there are many firms, competition will lower market share and in turn lower profits for that firm. This is not good news for shareholders. We need to identify which industry the firm belongs to in order to critically access the firm's profits in the long run.

In the next series, i'll discuss on how to evaluate the profitability of a company using various financial ratios.

Part 2 is now available. Click here to read: How to pick stocks (Part 2) - The profitability of a business

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