Common Sense Investing Part 4: Rule 3 for Successful Investing.

Rule 3: Business must be Durable Competitive and should possess an Economic Moat

Durable Competitive Businesses and Price Competitive Business

Durable competitive businesses are businesses where the products offered by the company are purchased based on the quality of the product and the price of the product is not given much of importance.

Price competitive businesses are businesses where the products offered by the company are purchased based on the price at which they are offered and quality is not given much of importance.

Lets understand this by considering the examples for Cadbury and Jet Airways.

Cadbury is a durable competitive business, the product offered by Cadbury, chocolates are bought for their quality and taste without price being a concern, therefore Cadbury is a Durable Competitive Business.

Where as in case of Jet Air ways, Jet airways is an airline company and the people while booking plane tickets always look for the best deal and opt the one which offering the service for a lower cost. Here the service offered by the company is availed on the price at which it is being offered but not on the quality of the service, hence these businesses are Price Competitive Businesses.

Economic Moat

The term Economic Moat, coined and popularized by Warren Buffett, refers to a business' ability to maintain competitive advantages over its competitors.

Economic Moat is sustainable competitive advantage of the company by having a well-known brand name, pricing power and a large portion of market share.

Examples:

Beverages: Coca Cola

Baby Care: Johnson and Johnson

Oral Care: Colgate

Animation & Entertainment: Walt Disney

These companies possess an economic moat through well-known brand names and high market share
Importance of Company being Durable Competitive and having an Economic Moat 

The most important advantage of the company being durable competitive and having a moat is that the company will be able to maintain consistent profit margins. Due to inflation there will be general rise in the prices, if the business is durable competitive and has an economic moat it will be able to increase the prices of the goods offered without any significant effect on its sales.

For Example, in case of Cadbury,

In 2012, Cadbury offered 12g Diary Milk for 5 rupees, but in 2015 Cadbury offers 6g diary milk for 5 rupees, Cadbury has cut the cost of production significantly to maintain consistent margins instead of increasing the price. Since cadbury is a durable competitive business it wont be having any affect on its sales.

In case of Airline Companies which is a price competitive sector, in 1995 the average Ticket Cost was 475$ where as in 2015 the average ticket cost is 375$ inflation Adjusted, the airline companies have to contract their margins due to high competition which leads to very low profitability in spite of good sales.

In a Nut Shell

• Businesses can be classified into Price Competitive and Durable Competitive Businesses.

• Price Competitive Businesses offer goods or service which will be purchased based on the price at Which it is Offered for.
• Durable Competitive Businesses offer goods or service which will be purchased based on its quality and Price will be given Less Importance.
• Economic Moat is ability of the business to maintain Durable Competitiveness through Good Brand Names and Large Market Share.
• Only Durable Competitive Businesses possessing an Economic Moat can increase their product price to adjust to inflation without sales being affected.

Video Explanation