Moats and Floats – Investment lessons from Warren Buffet’s letters. Moats: For those who are familiar with the letters that Billionaire investor writes to his company’s shareholders, the concept of moat is known as the competitive advantage enjoyed by a business entity over its rivals in the same industry. For example, if CoCo Cola has certain competitive advantages over its rival PepsiCo then these advantages can be termed as Moats in buffet’s language.
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How do they help the business firms?
Moats act as an entry barriers against the new firms that are trying to enter into thr industry in which the entity is operating. They also act as shield against the competitor’s moves to expand in the market by gaining more market share in the industry. Example: Brand value of established businesses and Trusted and long associated distribution network and scale of operations etc.
Moats in investing:
Strong and sustainable moats that can stay on for as long as at least 10 years can assure the investor of growing and assured value of the moated firms he would want to invest. However, moated firms are always overpriced in the stock market. So, before picking up the moated stock, it’s always advised to study the fundamentals and sustainability of moats of the firms.
Floats:
This is another term coined by Buffet in his letters to the shareholders. According to Buffet, float is the money that a business freely receives in advance from the customers. It is said to be free because the obligation to serve this money by way of interest arises much later in time say one or 2 years later. This would be easier to understand from the perspective of an insurance business. Insurance companies receive the premium money upfront but the claims would be settled later on.
In his letter to shareholders (in the year 2002) Buffet has said
“To begin with, float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an “underwriting loss,” which is the cost of float.
An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money. Moreover, the downward trend of interest rates in recent years has transformed underwriting losses that formerly were tolerable into burdens that move insurance businesses deeply into the lemon category.”
Floats in investing:
Floats if invested well by the companies generate positive return with no cost except the liabilities that are to be settled in future. So, always look for the companies generating positive cash flows from the operating activities. Also, take into consideration parameters such as Return on equity and interest coverage ratio, Cash conversion cycle and such other financial ratios to judge the company’s performance before making any decision to buy the stock.
Bottom line:
Investment in carefully considered moated companies has always endured well. However one should evaluate the sustainability of these moats from time to time to make sure that they remain intact. Companies with floats can be best considered for investing after due examination various other financial rations that enable the investors to know how effectively the company with float is managing its funds.
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