The term “economic moat” is one which was coined and popularized by Warren Buffett. Like a moat around a traditional castle, the phrase refers to the ability of a business to defend its profits from its competitors, and where possible, expand its market share. If a company is able to dig a strong and sustainable moat around its business, it might just possess the competitive advantage needed to drive equally strong profits around it. And strong profits, over time, often lead to great share price returns. Ok, where can I find a moat? To help us…
The term “economic moat” is one which was coined and popularized by Warren Buffett. Like a moat around a traditional castle, the phrase refers to the ability of a business to defend its profits from its competitors, and where possible, expand its market share.
If a company is able to dig a strong and sustainable moat around its business, it might just possess the competitive advantage needed to drive equally strong profits around it. And strong profits, over time, often lead to great share price returns.
Ok, where can I find a moat?
To help us find sources of economic moats, we can turn to Morningstar’s book “The Five Rules for Successful Stock Investing”. In the book, its author Pat Dorsey (previously, the Director of Stock Analysis for Morningstar) highlighted five different sources of economic moats.
One of the sources for an economic moat is the ability of a company to be a low cost leader. More explicitly, this means that the business has the ability to offer a similar product or service at a lower price.
The train of thought follows as such: If a business is able to achieve the lowest cost efficiency for its operations, it will attract more customers, which in turn will allow the company to increase its profits and further push costs down. If this virtuous cycle can repeat, the low cost leader stands to incrementally gain market share while widening its moat.
Some examples, please!
Japan Foods Holding Ltd (SGX: 5OI) operates 44 Japanese food outlets in Singapore, specialising in Japanese ramen. According to Masayuki Yamashita, Director-General of Food Industries Affairs Bureau (for Japan’s Ministry of Agriculture, Forestry and Fishery) there are 880 Japanese restaurant outlets in Singapore as of Oct 2013.
Needless to say, that’s a lot of competition.
However, Japan Foods has been able to hold its own despite the competition. In the financial year ended 31 March 2010 (FY2010), the company had 28 outlets in Singapore; by FY2014, the number of outlets had jumped to 44. Below is the trend of its gross margins for the past five financial years.
Source: Morningstar, company presentations
The improvement of the gross margin over the past five years shows that Japan Foods has been actively managing its cost structure. For instance, in 2012, it invested S$450,000 in its own noodle making facility to bring better control over the cost of one of its key ingredients.
On top of that, the expansion of its restaurant network also brought better pricing from bulk buys of its raw materials. The increasing number of brands under its corporate umbrella has also allowed it to secure better terms in rentals as the company brings a variety of new flavours which attract customers. Finally, the stronger Singapore dollar also benefitted the company.
Japan Foods’ gross margins also compares favourably with another two Singapore-listed Japanese restaurant owners, Neo Group Ltd (SGX: 5UJ) and Sakae Holdings Ltd (SGX: 5DO). In their last completed financial years, Neo Group, which runs the Umisushi-branded stores, sported a gross margin of 39% while Sakae Holdings had a gross margin of 72.2%.
With this competitive cost structure, Japan Foods has been able to grow its revenue by 43.7% and its net profit by 58.7% in the five years from FY2010 to FY2014. Japan Foods currently trades at a price to earnings ratio (PE) of 14.7 and paid a dividend of 2.6 cents for FY2014.
Foolish Bottom Line
The identification of a strong moat helps us identify companies which might thrive over the long term. As lifelong students of the investing game, we should be watching the actions of the company over the long term – through the lens of an “economic moat” – to see if its moat is indeed widening, or shrinking.
We should also note that while a strong moat is a desirable trait, the owner of the moat should also be able to derive economic results out of it. After all, the term is “economic moat” and not just “moat”. Accordingly a business with a moat, but no customers, could be just a lonely abandoned castle.
Be sure to stay with me, as I explore other forms of “economic moats” in search of Singapore’s strongest companies.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.