Often when looking at a stock, the investor tries to assess potential expansion of the industry it operates in or the effect that industry will have on society going forward.
According to Warren Buffett this is erroneous thinking. The key is to determine "the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."
The supermarket space in Australia falls under the definition of an oligopoly, which means the number of sellers is few. Woolworths (ASX: WOW) has over 1,000 supermarkets in Australia and New Zealand and is the dominant player in the industry. Nearest rival Coles accounts for 60% of the total revenue of its owner Wesfarmers (ASX: WES), but has slightly less (80%) retail space than Woolworths.
There are four different types of economic moats of varying advantage and durability. The strongest type of moat is defined as the cost advantage moat. Let's assess whether Woolworths has this elusive and very valuable attribute.
Woolworths has a cost advantage via the economies of scale derived from its 1,000 supermarkets. It has centralised back office operations and logistics supply networks, which allow the negotiation of favourable supply agreements.
Aldi is one competitor, owned by two German brothers with very deep pockets, but despite a decade long presence in Australia (stores have increased to over 200) there has been negligible impact on Woolworth's market share. This is partly attributable to the market growing but is mainly illustrative of the durability of the competitive advantage held by Woolworths.
Another indication of a cost advantage moat is whether margins and profitability have improved over time. A short answer is that Woolworths has increased its dividend fourfold over the past decade. Its return on investment (ROI) has hovered around 30% over that time and its earnings per share (EPS) have increased from 50 cents to around 183 cents. This performance has been achieved with significant headwinds in the form of the GFC, the general slump in retailing, the entrance of both Aldi and Costco to the market and the resurgence of Coles.
Speaking of Coles, when a company is managed poorly but only declines at a relatively slow pace, a strong moat is in place. Such a decline was in evidence with Coles under successive management teams prior to coming under Wesfarmers' guidance.
Other stocks that have cost advantage moats are CSL (ASX: CSL), which also has a patent-related moat, and Coca-Cola Amatil (ASX: CCL), which has an additional moat courtesy of its brand name.
Foolish takeaway
There is little doubt that Woolworths has a cost advantage moat. This ability to undercut rivals by providing goods and services at lower prices while increasing margins is shared by the other dominant supermarket in Coles.
Moats come in many forms and in all cases management must remain vigilant to maintain the advantage. Thankfully for shareholders of both Woolworths and Wesfarmers, cost advantage moats are very hard for competitors to navigate.
Both companies are very low risk investments and should be core holdings for the medium- to long-term investor.
