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Circle of Competence
ln the Stock Market, no one loses by being extra cautious. People get killed in the market
by venturing into high-risk zones.

Your longevity in the market will not be defined by what you do, but by what you don't do.

If you don't get into high-risk activities such as derivatives. commodities, etc, there is a
high probability that your long term investing journey will be successful.

We stress on having a to-do list when in reality, a "not-to-do" list will serve a better
purpose.

What we should and shouldn't do in the market is decided by our circle of competence

We often jeopardize our long term goals for short term gratifications. To ensure success,
in the long run, we must resist the temptation to venture out in the unknown. Your
discipline to stay within your 'Circle of Competence' decides your chances of success in
most cases.

What is Circle of Competence?

Circle of competence is the collection of businesses that you understand. So every

business that you understand, falls within your sphere and the others fall outside it. A
business falls 'within' your circle of competence if you can understand the following about
it-

a. How does it operate?

b. What is the business model?

c. How it ensures sales and profit growth?

d. How it competes with its peers?

e. What is the competitive advantage?

Most of us own some or the other IT stock like Infosys, TCS or Tech Mahindra. We merely
label them as 'IT companies,' whereas their business model might be completely different.
While Tech Mahindra derives most of its revenue from Telecom sector, Infosys is a leader
in Banking Space. So, these are proxies to Telecom and Banking sector respectively.

Similar is the case with Pharma companies; one company earns from the sale of TB
drugs, the other might profit from Cancer drugs, so, we will invest on the basis of our
assumption of growth in TB vs. Cancer.
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Just because two companies are in the same industry does not mean they are similar.

Both Gillette and Zydus are in the FMCG sector, but while Gillette is into Personal
Grooming, Zydus is behind the brand Sugar-free. Now, can we say that Sugar-free and
Gillette are both similar companies?

It's important to stay within our circle of competence so that we can adequately analyze,
differentiate, compare and then invest in the best possible company. We can't invest in
the best until we have the skill to compare.

Thereby, investing in companies that you understand thoroughly, is the key to success
and is better known as staying within your circle of competence.

The crux of the circle of competence is simple - You have a better chance of succeeding
when you know what you are doing.

"Risk comes from not knowing what you are doing."

-Warren Buffett

Some of you might wonder that if you follow this principle, you will be able to invest in a
very small number of companies. Thankfully, the size of the circle does not matter, staying
within it, does.

We are often demotivated by imagining the number of companies we would have to reject
due to this, but why do you need a large pool of companies? All you need is a good bunch
of 15-20 good companies to invest and you will be sorted for life.

You don't have to be an expert in every company. Or even many. You only have to
be able to evaluate companies within your circle of competence. The size of that
circle is not very important; knowing its boundaries, however, is vital.

-Warren Buffett

Expanding your circle

You might want to invest in companies outside your circle. It's crucial to first acquire the
capability to understand such companies. There is not a quick fix way to do that, but with
experience, constant reading and gaining knowledge through various sources, you can
expand your circle gradually.

Remember - Reading a Jot is the key to Success.

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Economic Moats
ln a capitalist economy, money flows to every opportunity that offers a higher return on
capital. So, if any company is earning higher profits. it will soon face many new
competitors who will be attracted by the high margins.

This aspect of ever-increasing competition leads to subnormal returns for many

businesses. But certain companies continue to earn a higher rate of return for a prolonged
period.

How do they manage to do that? What is that protects them from the competition? How
are they able to break out from the capitalist pattern of money flow?

Economic Moats

lt refers to the 'competitive advantage' a firm has over its peers. It's a structural feature
that helps a firms shield profitability. If there is no moat, competition will eventually drive
the return on capital down to the cost of capital or even lower.

A good business is like a strong castle.

-Warren Buffett

Anything that helps the company in protecting its profitability from its peers is a moat.

Types of Moats

1. Brands

2. Regulatory Licenses

3. Patents and copyrights

4. Switching Costs

5. Network effect

6. Large Distribution Network

7. Cost Advantage

Brands

Having a strong brand helps in the following ways -

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1. Developing trust that helps in repeat business

2. Quality assurance that helps in charging a premium

Not all brands are moats, only a strong brand that helps the company in gaining pricing
power and customer loyalty can be considered a strong moat.

Example- imagine this- If you are in a shop for a low-calorie sugar substitute, do you ask
for a sugar substitute or do you say "Please Give a pack of Sugar-free"? Similarly, we
never ask for instant noodles, we ask for "Maggi." That's the power of having a strong
brand. lt becomes a part of our routine, our vocabulary. It's very difficult for the competition
to displace such strong brands.

We never ask for a paracetamol tablet, we ask for "Crocin," which is just one of the
hundreds of other paracetamol brands. But this customer loyalty enables GSK (makers
of Crocin) to charge a premium over other players even though paracetamol is a
commodity.

Brands enable a company to differentiate a commodity and charge a premium for it. Keep
your eyes open for such strong brands around you.

Pros:

This kind of moat is potentially perpetual if nurtured well

Cons:

Maintaining the brand can be costly and tedious

Regulatory Licenses

lt takes a lot of paperwork, capital adequacy and numerous licenses to start a bank. Thus,
we can safely say that there are a lot of entry barriers in starting a commercial bank. This
helps the existing players to thrive as they are protected from new competition due to the
higher entry barriers. Regulatory barriers should be limited to entry only and should not
lead to price control, or else it's not a strong moat because it will affect the profitability of
the existing players.

Regulatory licenses can be nothing short of a gold mine. A lot of business is valued
primarily because of the licenses they hold are hard to acquire. So, they become takeover
targets for companies wanting to enter that space but are finding it difficult to procure a
license. Also, since licenses act as a deterrent for new players, it ensures stable growth.

Example- Credit rating agencies are valuable only because there are just a few in
numbers. Similarly, the value of NSE or BSE is partly because it's unlikely that they will
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face competition from a new player owing to extremely high paperwork in case of starting
a stock exchange, apart from other benefits like network effect as well.

Pros

The competitive advantage is achieved automatically once you receive the required
licenses.

Cons

lt might erode anytime due to government policy changes.

Patents & Copyright

Patent is an exclusive opportunity given to the inventor of an innovative product or service,

to benefit out of his innovation for a certain period commercially.

Ever wondered why some medicines are extremely expensive? That happens because
probably the product is under patent protection, meaning no other company can make
that particular medicine. Pharma sector thrives on this form of moat because once they
develop a new drug, they are protected from competition due to patents, which enables
them to sell the drug at a premium and recover the high drug development cost and also
earn healthy profits.

Multinational pharma companies like Abbott, GSK, Sanofi, Pfizer, etc. are the leaders in
patent-protected drugs. No wonder they are amongst the most profitable Pharma
companies in the world, whereas most Indian Pharma companies are focused on making
generic (out of patent) drugs in a cost-efficient manner.

Think of it this way, if there was only one vegetable vendor in your town, he could sell the
vegetables at a very high price and customers will be forced to buy due to lack of
alternatives.

The only concern is that patents are granted for a limited period and hence, a company
has to innovate continuously to have a healthy patent-protected product pipeline.

Pros

This is the form of a moat that provides not relative, but absolute protection from
competition. lt creates a temporary monopoly

Cons

Limited in duration. lengthy and costly process to acquire patents

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Distribution Network

Some products are dependent on the distribution network for their success. Often, it's
costly and time consuming for a small company to establish a healthy distribution network.

Thus, companies like Pepsi, Coca Cola, HUL, P&G, etc. have a huge advantage of an
established distribution network which helps in ensuring that any new product is instantly
available on the shelves, throughout the country.

Many smaller Companies lose out on market share, despite having a great product
because their products never reach the end consumer.

Pros

Very hard to replicate for competitors, it's a strong moat

Cons

Does not provide protection against regional competitors

Cost Adantagc

Customers are attracted to quality products at lower prices. A company can price its
products lower by keeping a check on its cost. Some companies enjoy a natural cost
advantage such as proximity to raw material, low labour cost in the region, etc. The cost
advantage is specifically important in commodity businesses such as oil, power, iron,
cement, etc. wherein the product differentiation is minimal and the consumer is extremely
cost sensitive.

Pros

Provides you the edge to eliminate competition permanently

Cons

Prone to erode due to various reasons beyond a company's control

Switching Costs

Switching cost refers to the time, cost and inconvenience involved for the customer in
switching to products/services offered by a competitor of the company.

If you have a savings account and current account in HDFC bank, it is very difficult to shift
your bank account to a new bank because your account is linked to dozens of other
services that you don't want to disrupt. It's the reason most people never change their
bank account.
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Thereby, it's clear that switching costs are higher in the case of banks, which acts as a
strong moat that ensures repeated business.

IT companies like TCS, Wipro, etc also enjoy this moat since once their software is
installed in an enterprise and all the employees of the organization are trained to use it,
it's difficult for the organization to start using a competitor's software because all its
employees will require retraining.

Compare that to a multi-brand retail store like Big Bazar. There is no customer loyalty and
a customer will easily switch to a O-Mart if the prices offered are cheaper.

Telecom operators too enjoyed this moat before Mobile Number Portability came into
existence

Pros

Aids in increasing wallet share from the customer in the long run

Network Effects

This is perhaps one of the strongest moats wherein the value of a product/ service
increases with the increase in the number of users. Facebook is valuable because of the
high number of users on its platform.

A Facebook user is unlikely to switch to any other social network because the value of
Facebook is derived from the fact that all of the individual's friends and family are on it
too.

Think about it - which are those products/services that you consume, just because
everyone else is consuming them as well? MS Office, Google search, Google Maps,
Youtube, Facebook, lnstagram, Twitter are some examples with powerful network effects.
The value of these platforms increases with every new user signing up on the platform.
They are valuable because your friends and family are using it as well.

But these companies are not Indian, so, are there any Indian examples? We prefer to use
Paytm over Airtel money or mobikwik because everyone else is using paytm. Goibibo is
trying to do the same by giving you Rs 50 of promo cash every time your friend books a
flight on its app. So, it's trying to connect users on its platform through mutual incentives.

Amongst the companies that are listed in the stock exchange - Mahindra Holidays, Info
edge, Infosys, etc. have decent network effects.

This moat is usually found in companies that are data-driven. Another example could be
Microsoft office. You are forced to use it because everyone else is using it and you don't
want to run into compatibility issues.
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Pros

Gets stronger and Stronger with each addition in customer base.

Conclusion

We will be discussing each of these moats in the upcoming chapters with dozens of
examples and case studies. Exciting Chapters are ahead. Its important from now onwards
that whenever you are looking to buy a stock, you identify if your potential investment
enjoys any of these above-mentioned moats. Proceed with the investment decision only
if your answer is yes.

Economic Moats (Contd.)

ln the last chapter, we discussed some examples of a moat, that protects the company
from the competition. ln this chapter, we will discuss some other aspects of moats.

Moats- Revisited

Anything that saves the company from competition and generally speaking, anything that
helps the company maintain and sustainably enhance its business. is a moat.

The strongest wealth creators in the world have been companies with the strongest
moats. Today, we will discuss some Indian and global companies and their moats.

Why are we discussing Moats?

Often, we are too caught up with finding cheap stocks. Whereas, in reality, we should
look for 'good' stocks that are cheap. The first essential criteria is the company being of
'good quality' fundamentally, and only then the price matters. Wealth is not created by
buying garbage at garbage prices; it's created by buying quality at bargain prices.

Now that we have established that Quality is of an essence, we need to realize that often
it's not always apparent from a glimpse of the financial statements. Moreover. our
understanding of quality would be limited to how strong the company was in the past if
we solely rely on financial statements to determine quality whereas moats help us in
determining the likelihood of the company remaining isolated from the competition in the
future.

Investing is a planned activity, no one makes money from the past track record of the
stock. Moats helps us in evaluating the future of the company. The strength and
sustainability of the moat give us a reasonable idea of the future of the company. It's your
window to the future.

Sustainability of Moat
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The sustainability of a moat is more important than the presence of a moat. While some
companies may look like companies with moats in the short term, their competitive
advantages can be eroded in the future. When this happens, the company and investors
both suffer. How do you know whether a moat is sustainable? For that, you have to study
what the company does. If its product or service is such that it will never go obsolete and
it's a strong brand that no competitor can challenge, or if it's in a regulated industry and
that regulation is unlikely to go away, then the moat is likely to be sustainable.

"Just as moats around medieval castles kept the oppositìon at bay, economic
moats protect the high returns on capital enjoyed by the world's best companies.
If you can purchase their shares at reasonable prices, you'll build a portfolio of
wonderful businesses that will greatly improve your odds of doing well in the stock
market."

- Pat Dorsey

Structural Advantage

Most wide-moat companies have some structural advantage over competitors. lt means
a position in the company's business model that wouldn't go away even if the
management of the company changes. Basically, you want a company that is not
dependent on its Star CEO.

Buy a company that even a monkey can run, because someday, a monkey will run
it

- Peter Lynch
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Customer Stickiness
Everyone loves to go out for dinner with their family on weekends. Do you visit the same
restaurant every week? If you are like the majority of us, chances are that you like to
shuffle you dinner destinations.

Why do we do that? Why do we visit a different restaurant every now and then, even if
the last restaurant we visited served delicious food? That's because an evening out with
family also involves doing something new or have a new experience. So, it's our quest
for "something new" that drives us to visit different restaurants periodically.

Now think about these products-

a. Tata salt

b. Amui Butter

c.Nescafe coffee

d. Crocin

Why we only trust these four brands in their respective categories? Why don't we try any
other paracetamol tablet apart from Crocin or Calpol (which by the way is manufactured
by the same company)?

Why don't we buy any salt other than Tata Salt? The reason is simple - these products
are habit based products, they derive their value from consistency and not novelty.
Products that are valued for their consistency such as Coke, Nescafe, Lays, Colgate, etc.
are a far more successful business than products that rely on providing a unique
experience or the novelty factor.

Clothes is a category in which fashion changes quickly, everyone wants to look different.
Hence, companies incur huge R & O costs and a lot of dead stock in their quest to meet
the fashion trend.

Therefore, we see this huge competition and dozens of companies struggling with denim,
Shirts and Trousers segment. No one is a clear winner; no one is making huge money.
Inversely, you don't look for fashion or innovation in inner wears; the essential factor is
the comfort and experience with the brand.

Thereby, jockey suits you perfectly and sells like hotcakes.

Rule 1 : Look for products that sell because of customer habit and consistency

Would you buy Gold from a jeweler who is not reliable? No

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Would you buy a T-shirt from a shop owner who you do not know? Maybe

Why was the answer different for two questions? Two reasons -

1. Value or Price of the product

2. Importance of the Product

If the thing that you are buying is very cheap and/or the inferior quality of the product
won't cause much harm, then you won't be fussy about the product or seller quality.

But, if either the product is very expensive, or if its inferior quality will harm you materially,
then you will think twice before experimenting with a new brand or seller.

Remember that it's not important that the product should be costly and only then you will
be careful before buying it. After all, a paracetamol tablet costs less than Rs 1. Yet, we
are cautious about its quality and brand because its inferior quality might cause huge
harm to you.

This is also the reason why car companies are struggling to snatch market share from
Marutì, it is such a trusted brand, in such a high priced product segment (cars), that no
one wants to experiment with their money by buying a car from a new company. Since
we incur a huge cost while purchasing a car, we tend to play safe and stick to the brand
that's tried and tested.

Rule 2 : Look for Brands that sell because of their actual or perceived superior
quality and or trust.

ln the previous chapters, we have discussed about switching costs i.e. the cost involved
in switching from one product to another. Look for products/services that have a large
user base and high switching costs. For example - HDFC bank has a very large user
base. The bank has an intense relationship with its clients because of up-selling and
cross-selling of products. A typical HDFC bank customer will have the following links with
the bank -

1. Savings Account (Own & family)

2. Current Account (if he is a business owner)

3. Credit card

4. Bank Locker

5. Life insurance

6. Mutual funds
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7. Home/Car loan

Imagine a customer who has availed so many products/services of HDFC bank. Do you
think he will switch because some other new bank down the block is offering 1 o/o higher
interest? He will think of all the complexities & paperwork involved and will probably
decide against it.

So, HDFC bank has a very large customer base, who are likely to stick with it for a long
period. So, we can be sure that HDFC Bank will show stable or growing earnings for the
foreseeable future.

Rule 3 : Look for companies with large customer base along with high switching
costs

So basically, the three rules teach us to hunt for companies that have the advantage of
customer stickiness around them. If customers are such that they will keep returning to
buy the products/services of the company, you as an investor are also assured of a
smooth earnings growth and the markets pay a premium for stable earnings growth.

Look for companies with -

1. Habit forming products/services

2. Valued because of the consistent consumer experience they provide

3. Enjoy huge goodwill/trust

4. Companies having a large and "sticky" consumer base.

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1. Which of these brands does not enjoy the advantage of customer stickiness?

r A. Maggi
•
r B. Tata Salt
•
r C.SBI
•
r
• D. Airtel

2. Which of the following is not a moat for a company?

r A. Patent and Copyrights

•
r
• B. Network effect
r
• C. Low cost of production
r D. High Product diversificatìon
•
3. The company Pidilite Industries enjoys economic moat due to ?

r
• A. Strong brand recall
r B. Regulatory license
•
r C. Switching cost
•
r D. None of these
•
4. A business is said to fall within your circle of competence if you understand it.

r
• A. True
r
• B. False
r c.
•
r D.
•
5. The business model of companies operating in the same industry will always be
same.

r
• A. True
r B. False
•
r c.
•
r D.
•
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6. Which of the following creates a short-term monopoly for pharma companies?

r A. Patent
•
r B. Brand Value
•
r C. Low price than competitor
•
•
r D. None of these

7. Despite having great products and excellent marketing strategy, it's difficult for
Patanjali to compete with other FMCG giants like HUL and P&G. The reason for this is
--- ?

r
• A. Economies of large scale
("
• B. Huge distribution network
r C. Regulatory barrier
•
e: D. None of these
•