How can a fund house's equity research process help distributors find answers to how they can preserve and grow their business, despite regulatory upheavals? Amazing - but, there is actually a lot that distributors can learn about shaping their own business models, by analyzing and adopting the principles that drive Motilal Oswal's research and fund selection process. Read on as Aashish gives us a detailed and highly lucid explanation of the economic moat theory that his firm applies in stock selection and how he has adapted learnings from the same theory to share insights on how you can ring-fence your business from regulatory upheavals and competitive pressures and maintain a robust growth momentum.

The last couple of years have seen many debates about the future of mutual fund distribution and that of distributors. All discussions are centered on the changing regulatory landscape and associated insecurities and fears amongst distribution community about retaining their investor base and hence the very business built painstakingly over the years. In this article, I would like to submit some thoughts for your consideration on how you can strengthen your business and overcome these and many more challenges that may come your way - by focusing on building your own economic moats. Building these economic moats, I humbly submit, can help tackle many of these questions that may be in your minds about what you can do to ensure that your investor base remains intact and in fact continues to grow - irrespective of external influences that may keep coming up.

What is an economic moat?

At Motilal Oswal Group, we have a tradition of documenting the evolution of our investment philosophy through a series of annual studies called the Wealth Creation Study, the Chairman of MotilalOswal AMC, Mr.Raamdeo Agrawal being the renowned founder. The latest one released in December 2012 was on "Economic Moat - Fountainhead of Wealth Creation".

This strategy is reflected in all the holdings of Motilal Oswal's MOSt Portfolios PMS offerings like the Value Strategy (10 year track record Large Cap) and the Next Trillion Dollar Opportunity (5 year track record Mid Cap).

As an Equity House we have the following core elements of our investment philosophy:

1. We are Value biased. When it comes to "value" though we are not necessarily looking for deep value or special situations or value as signified by low PE companies. When we seek Value, we are looking to identify companies whose Earnings Growth is either being under-estimated by current market valuations or who earnings growth is not being given due credit for its sustainability. This is where the concept of Economic Moat to forecast sustainability of earnings is absolutely key.

2. Secondly, we are strictly Buy and Hold - we do not like to sell once we buy. This is because of a number of reasons - our competition is with the index. The index has a survivor bias and hence the index itself is buy and hold. So we need to be long term buy and hold investors if we wish to beat the index. Holding any form of cash leads to opportunity loss and buy and sell decisions have transaction costs and in a PMS structure also taxation costs. Here again buying sustainable competitive advantage via companies with economic moats is a must for us.

The best example that can be illustrated in our portfolio is a name like "Nestle". Take a specific case of their "Maggi" noodles. One entire generation of people I have seen starting from my childhood has grown up seeing Maggi Noodles 2 minutes etc. concepts on TV for the last 20+ years. Most people don't know that for the first 10-15 years Maggi Noodles as a brand did not make money, they made losses but they kept investing single handedly in the brand and in the instant food business. Today it is one of their most successful brands in the Indian portfolio. Once Maggi Noodles became successful, many a competitor came with their own version of 2 minute noodles and none of them succeeded. How can you expect them to succeed when an entire generation of crores of Indians has been brought up thinking that Noodles means Maggi!!! And do you know, Nestle globally has 100s of such brands world over, their entire portfolio hasn't even been exposed in the Indian market - they are doing it one by one. Twenty years of advertising and teaching a concept to one full generation of crores of Indians, is a sustainable competitive advantage no competitor will be able to take away from Nestle. The market keeps complaining that at 37 PE Maggi is expensive. Is 37 PE expensive or is virtual dominance of instant food market in a bulge bracket middle class country being under estimated - you tell me??? And when was the right time to buy and when will it be right time to sell Nestle??? That's why Buy and Hold and for that reason Economic Moats are key to good stock picking.

While I made a mention of this study in my last wealthforumezine interview, it is Vijay who encouraged me to create this article identifying sources of sustainable competitive advantage in the distribution / advisory practice for mutual funds.

So what is a "Moat"? Wikipedia says "a moat is a deep, broad ditch, either dry or filled with water, which surrounds a castle, other building or town, historically to provide it with a preliminary line of defense".

And so what's an Economic Moat? Investopedia says "the term economic moat, coined and popularized by Warren Buffett, refers to a business' ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms".In other words, Economic Moat is something which can bring in Sustainable Competitive Advantage to a business.

5 common sources of economic moats

What are the common sources of an Economic Moat for companies?

1. Low Cost Producer: Companies that can deliver their goods or services at a low cost, typically due to economies of scale or captive sources of raw materials, have a distinct competitive advantage because they can undercut their rivals on price. E.g. steel companies with captive power generation, iron ore mines and coal mines.

2. High Switching Costs: Switching costs are those one-time inconveniences or expenses a customer incurs in order to switch over from one product to another. Typically applicable in case of telecom companies, banks etc.

3. The Network Effect: The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use it. For example - Visa / Master Card networks or Facebook or LinkedIn.

4. Intangible Assets: Some companies have an advantage over competitors because of unique nonphysical, or "intangible," assets. Intangibles are things such as intellectual property rights (patents, trademarks, and copyrights), government approvals, brand names, a unique company culture, or a geographic advantage. Seen widely with pharmaceutical companies and IT companies or auto and other manufacturing companies during India's license raj.

5. Efficient Scale: When a company serves a market limited in size, new competitors may not have an incentive to enter. For instance, for a niche market, the demand would only be large enough to support one dominant firm and thus potential competitors have little incentive to attack.

Applying economic moats theory to financial products distribution

How can we apply this theory of economic moats to the business of distribution and advice on financial services? Needless to say IFA friends must investigate closely where they can bring in sustainable competitive advantage from each of the five sources listed above - any strength to be built that can protect them from losing clients and their earning power in the face of competition and regulatory change. Competition can be from other IFAs or other distribution channels.

A preliminary investigation tells us that the 1st and 5th source is not relevant to our typical individualistic distribution business. It is more relevant for a manufacturer in our industry or relevant for distribution only if we were to take a more capital intensive route. So I am making an attempt to identify some sources of sustainable competitive advantage our IFA friends can build in their business from points 2, 3 and 4. They can choose anyone one area and then invest their efforts and resources in creating their Economic Moat via this chose area.

To begin with - the area of maximum scope appears to be the one centered on building Intangible Assets.

1. Economic Moat No. 1 : Intangible Assets

It's very easy and tempting to conclude that Intangible Assets should mean developing softer aspects of the business like relationships. I am assuming here that we are talking of relationships with customers that are genuinely built through the business and we are not talking of doing business with people who we already had relationships with. I think "relationship" is the most over-hyped and over-rated aspect of managing business. What are the sources of a strong relationship being built through the business? You cannot start building relationships for the sake of building. Relationships are built only after reliable delivery or coming true on quite a few "moment-of-truth" experiences. Hence, let's be clear that relationships are built because of sustained delivery on business parameters and unless we have some proposition to deliver through our business, relationships will be set for failure.

The other great temptation amongst our IFA friends is to conclude that, "I provide good service" is a USP and a great source of Intangible Assets. But who doesn't give good service? And who survives in today's competitive world without giving good service? No one!!! Good service is not a source of sustainable competitive advantage, the harsh reality is that it is a hygiene factor - taken for granted by today's consumer. And is good service about delivering forms and account statements? Can it be a lot more? Can it be backed by alignment with some strong solution providers or technology partners?

So what actually are the sources of an Economic Moat that can be created in our business via Intangible Assets?

1.1 Intangible Asset # 1 : Knowledge

Let me tell you before I start - the most important one is Knowledge!!! I can share every secret of mine and all my knowledge with you, but I would be wary of telling you what I am READING!!! Because that's more than my knowledge, that's the source of my knowledge!!!

1.2 Intangible Asset # 2 : Process

Does your client have the same experience dealing with you each time you meet him or her? Does he or she see the same you acting in the same predictable calm and composed manner with a lot of listening and concentration or do you behave differently each time depending on who the client is and how the markets are behaving or what product you are interested to recommend? Do your views on products, asset classes and markets keep changing or you steadily present each product, asset class and market condition only as a mere instrument of full-filing his or her needs?

Is your interaction with your client part of a continuous process or are these discrete meetings starting with "Aursir, kyahaalchaal?" Do you have meetings as and when you or your client call each other or do you have a set calendar which says - One update meeting per month, one scheme performance review in six months and an asset allocation review once in a year! Is this documented and signed between you and the client in form of a service level agreement? Do you ask your client how his life is progressing towards the life goals that are documented in his or her asset allocation profile? Is the son appearing for IIT-JEE this year? If they ask you about markets why don't you ask about progress towards life goals and implementation?

1.3 Intangible Asset # 3 :Advisory Practice

Can you develop and follow your own asset allocation model customized by client? Each time your client gives you a cheque, is it in favour of a new product or is it in favour of a pre-selected set of schemes which will flow as per the predetermined asset allocation?

If you meet your client once a month can you carry important new events and clippings along with you to explain and demonstrate linkages with the investment behavior? Can you give book reviews to your clients each time you finish reading a book?

Do you experiment? While there is so much fear of a "Direct Plan" and losing clients to it have you experimented with any client telling him or her to invest in a direct plan, maintain the portfolio on any of the free portals and then charging a fee based on achievement of investment goals? Have you educated your clients on low cost products like the "Direct Plan" or ETFs, so that the high expenses of MF can be saved and instead of "getting" commission you can "charge" a fee.

All your clients put money into bank deposits; we all see that as our competition. Have you tried to maintain a tracker of deposit rates for all the banks in the vicinity and advising your client which bank to place deposits and to what benefit? Why don't you get involved in that decision too? Why don't you make the competitor your tool to success?

Can you be contrarian in your advice? When everyone was putting money in Gold, did you tell clients to not shun equity? If you go with the flow, when will you be rewarded for taking a stance? Do you tell your client what valueresearchonline.com or moneycontrol.com or myiris.com is already saying for free by analyzing past performance or do you tell your client about emerging ideas and upcoming stars that are likely to do well in future? Do you talk different stuff with your own independent views or do you talk what the newspaper and internet says? Are you passing news or providing your own views?

2. Economic Moat No. 2 : High Switching Costs

I think if worked upon well, this is an area of activity which can be built upon in our business. And not really financial costs, there are huge intangible costs and huge mental resistance to switching service providers like Chartered Accounts, Financial Advisors, Doctors et al. This is purely because the service provider over a period of times knows your entire personal history and your preferences, likes, dislikes, general dispensation, attitudes etc.

2.1 Use platforms to raise switching costs

While I did touch upon service, it is indeed difficult to build service as a source of Economic Moat in our business. It is possible if you partner with a technology provider or a platform that enables you to give consistently good service to your client. While we all think that allowing the client to use a bank account of his or her choice, juggling with different bank mandates and printing reams and reams of account statements of mutual fund folios is good service, in reality tying up with a platform that would open separate investment related bank accounts and demat accounts actually enables you to have greater control and ability to provide good service to the client. It enables you to take charge of tax computation and tax planning also. At the same time it creates huge switching costs and resistance to change from the client's end thereby creating a moat for you. Aligning with some platform which provides technology for good service and offers you a multi-product multi-provider solution with ability to create own asset allocation is the need of the hour.

3. Economic Moat No. 3 : The Network Effect

This is difficult to build in our business but the key benefits of setting up a network amongst clients or garnering clients from a common network are two - ability to manage scale and getting a positive word of mouth.

How can one do this? If you can categorize your clients by risk profile and return expectations into say 3 broad buckets and cast them into common groups you can do the following :

1. Have common meetings for areas of common interest - for example doing monthly discussions on equity markets for high risk clients.

2. Create separate asset allocation models for each bucket of clients and then monitoring performance of just the three models and their constituents instead of monitoring performance for every client.

3. Involve clients in the decision making process - ask them during meetings what their views are, have them debate and participate.

4. Induct new clients by inviting them to network meetings

5. Create a social media page for each network and have people share their ideas on comments on the network

There are many positives to building a network and this can again make it very difficult for your client to leave.

To conclude

So this is the long and short of it - my attempt to suggest ways of creating an economic moat around your business practice. Should you succeed even 60% at any one or some of these areas, I don't think any competitor or regulatory change can shake your position!!! In fact any major competitive or regulatory change should enable you to attract more clients into your fold - into your way of working!!!