How to identify businesses with competitive advantages | Economic moats | Competitive advantages - YouTube

Friends we invest in the stock market so that when a share price goes up, our capital gets appreciated and we make returns

Hence, we get a benefit of investing in that business, but the main problem we face is how to choose a good business

and whenever this is discussed, all big investors suggest seeing their competitive advantages

So what are these, how to identify, for which we have brought this video

where we talk about these competitive advantages, I Jagdeep Singh welcome you and let's start

So let us try to understand what are these economic moats and competitive advantages

Before starting on these, I would like to tell you an interesting story of Warren Buffett

When he used to invest earlier, he used to say that he invested in fair companies on wonderful prices

meaning he used to invest when he used to get a discounted price

And changed his strategy after meeting Charlie Munger and started investing in wonderful companies at fair values

Warren Buffett invests in those companies that have economic moats and competitive advantages

and says a company that has a competitive advantage, it protects it from a new competition

and hence this way the new competition won't be able to replicate the same way, and the existing company will see long-term profitability

And the company can keep increasing its market share this way, from which you can understand that how these are important for companies

So the next question is how to identify these competitive advantages in a company, can you do so by looking at its financials

If the company has given good and excess returns and till when they can maintain the excess returns can give us a hint of a competitive advantage

Now before getting to know excess return, we need to understand the cost of capital and what is it

Now whenever I start a business, it starts giving returns only when I invest in it

which I bring from different sources so that it can become profitable and can give me good returns

Now the question is from where will I bring that capital, I have two ways

Either I buy debt from a bank or a financial institution or I give away equity/ownership from the company in return for capital

Now if I take up debt or a loan from a bank, I would have to pay 7% as interest but on the equity side

the cost of that is a questionable aspect and can be discussed in detail

Now, what is the cost of equity? Now investors like you and me invest and expect a return

and that return depends on many things like the most important being risk

For example, when you invest in a small company, your cost of equity is more because there is a higher chance of returns

and when you invest in a big company, your cost of equity is lower, so the cost of equity is

the shareholder's expected return from his investment in a company

Now I will tell you all the factors impacting the cost of equity

The first is financial leverage, meaning how much the company has taken debt

and as the debt rises so does the cost of equity, because the company's obligations rise to pay a fixed interest

The second is operating leverage which is the fixed cost. The more fixed cost more is the cost of equity

The next is discretionary spending meaning the products without which people can make do

For example, if we see pharmaceuticals and jewelry, out of which pharma business is the one you cannot stay without

and hence is less risky, whereas if you don't buy jewelry you can make do for a couple of months

and has more cost of equity due to the higher risk

The next is the risk-free rate, these are the return rates you get if you invest in govt bonds

So the higher the return rate, the higher the cost of equity. Now why would you invest in a company that gives you 7% return

and the govt bonds have low risk as compared to companies, so cost of equity rises if the bond rates do

Now you might have understood cost of equity, cost of debt is the interest the companies have to pay

And if I add these two up, it results in the cost of capital.

Now, for example, if the return on capital employed of a company is more than the cost of capital, the business is profitable

So this was the way you can identify a competitive advantage through the financials

Now we will see the qualitative analysis and see from where a company generates competitive advantages

The first is economies of scale, there is a lot of fixed cost required to set up a business

and crores are deployed to set up a factory and start productions

and the variable cost is lower which is the cost of good to make the product

So if the fixed cost is higher than the variable cost, it acts as a barrier to entry for new players

because the one who was able to set up and has less variable cost can make their products on a lower rate

due to which these manufacturing companies have an inherent advantage

The second is the network effect, its use is that the more people use it, it will expand

Now for example, if we see Zomato, more the people use it more restaurants get added, the more business they do

Similarly, Facebook is such a big company due to its network effect

The next is switching cost which is incurred when you switch from a service or product to the other

and in the businesses where switching cost is high, it is difficult for the customers to switch services/brands

For example, if I want to switch from Wipro to other IT services company, the cost would be high

because I would have to train the people and see to the new software, the higher the switching cost more the competitive advantage.

Now the next is brands, we talked about the niche, but there are many companies that operate with negligible differentiation

Now for example, you want to buy wheat, there are many companies with no such difference in the product, but here branding helps

More the trust you have on the brand, more the retention you will have with that brand

and this branding helps companies to retain their customers

The next is a cornered resource, for example, pharma companies have patents that help them make differentiated products

So an asset that gives an edge and helps differentiate gives you a competitive advantage

The next is counter positioning or called disruption

Now for example, a company is running smoothly and a newcomer enters with product differentiation

after which the existing starts to think whether he should change his business or work the same way he is

So in this many big companies have made mistakes which has hurt them and let me explain with the example of Kodak

Kodak was doing well in the camera segment, but new products enter like digital cameras

But Kodak does not change its business which disrupted their business the whole camera industry

due to which the existing companies become irrelevant, hence you need to see that

how the company you have invested in changes with time.

And you should closely monitor disruptions like these in a company you have invested in.