There are 3 types of businesses based on moats – great, good, gruesome. Companies which earn 40% RoE, those are great businesses because the moat keeps becoming bigger. In good businesses you start with 20% and it remains 20%. So every time you want to grow the business you have to put in more capital. The real difficult part and this is 95% of the market is gruesome. These are companies with negative moats. The problem is not with the business but the manager trying to grow a bad business. Then it becomes a bottomless pit into which you throw capital. Loss making PSU companies are a prime example, just think of how much money the government has to pump in.
The real test of an economic moat is whether it is sufficient to make money, not only for the company but also for the investor. This is a key thing to keep in mind. Some unit of the company might be making money and will continue to make money but how much of it will flow to the investor. For instance, there is no better moat company than Colgate India but that does not mean it will make money for the investor. To make money as an investor you have to figure out the how the fight between growth and quality will pan out.
When you have a moat, investors fall in love with the moat and pay a high price for the moat. But delta return will only come with growth. So there is both, a quality and a growth trap. Growth trap is when there is no quality but massive growth. That happens with every product. In 2000 all kinds of dotcom companies came as well and so did a lot of real estate companies. Unitech's value went up from Rs.200 crore to Rs.80,000 crore in 3 years. Then it collapsed 300%. That is a growth trap and it happens in every market cycle.
Maybe, it is likely to happen with e-commerce start-ups. People will get sucked into it and it will continue. Hence, the moat has to be broad both in growth and quality. Once the moat has been assessed as high-quality, you need to add it to your portfolio at a reasonable price. As far as the moat is concerned, investors can only make as much money as the underlying companies make. So you need growth, quality and reasonable price. No serious amount of wealth can be made without a thick moat around the business. My mantra for investing is moat with high-quality growth at an attractive price.