I am a CA by education and have been buying stocks since 1980. During those days, books on investing were almost zero. I didn't know about Warren Buffett till 1994 and got to know about his annual reports at the same time. Sanjoy Bhattacharyya first told me about him and gave me a few physical copies of the reports. After I read through them, it was as if a light switch had flipped on. Buffett advocated focusing on the economic moat rather than earnings per share. That seemed like pathbreaking wisdom. Ever since, I became his disciple and have been trying to understand what he does in depth. One of his favourite quotes is, "Great companies are like wonderful castles with deep dangerous moats."
I have read a lot of books on investing since then but I haven’t lost track of the concept of an economic moat. And what is business anyway? It is an input-output machine. We might love labeling them as consumer, pharma, metals, infra etc but basically it is an input-output machine. You input capital in the beginning, that is deployed for 10 years or whatever period you decide and then you get an output. Whether the return on capital employed is 15% or 20% decides how good the business is.
A lot of people think they can make a lot of money from loss making companies. If the company doesn't make money, you are never going to make money either. That approach has kept me in good shape. Over the long-term it is hard for a stock to earn a better return than what the underlying business is earning. If the business earns a 6% return on capital over 40 years and you hold it for 40 years, you are not going to make more than 6%. Even if you buy it at a dirt cheap price, that will be the case. Conversely if the business earns a 25% return on capital over 20-40 years, even if you pay an expensive price, you will end up with a lot more money.
These are things which will never change. That brings me to why we should keep looking for businesses with economic moats. Professor Bruce Greenwald in his book on value investing says that economic moat refers to its sustainable competitive advantage. This advantage leads to a return on capital which is significantly higher than the cost of capital.
Let me illustrate. Say that the cost of operating is 10%. Don't sweat about cost of equity, cost of capital, whether the risk free rate is 7% and all that stuff. Just assume the cost of operating is 10%. Let’s say the cost of equity risk is another 5%. So, if any company is generating more than 20% in a competitive environment, there is some magic going on in that company. That magic is the moat. Once you see that magic sustaining for 5-15, then the company has some advantage. And you need to find such a business. Anyone can earn 7% in a bank deposit but the excitement is in figuring out how does a business earn 20%?
This is the first of a three-part series. You can read the second part here