This blog post is an excerpt from my new book, The Defensive Value Investor, outlining how I analyse companies to see whether they have any durable competitive advantages or not.
Competitive advantages can make a company more profitable than its peers. This is good because profitability is effectively the rate of return you get on any earnings which are not paid out as a dividend.
Competitive advantages can also help a company survive the inevitable tough times that come around every now and then. This is especially important for value investors because we often end up investing in companies that are attractively valued precisely because they’re going through tough times.
However, competitive advantages are hard to build and can be even harder to maintain. Most companies simply don’t have any and that’s why so few companies generate high rates of return over prolonged periods of time.
Another reason to look for competitive advantages is to learn about why a company has been successful in the past. Doing this research should complement the previous research carried out when answering the value trap questions.
The rest of this [extract] covers how I look for competitive advantages using another series of questions, this time based on Pat Dorsey’s book, The Little Book that Builds Wealth. It’s an excellent book which sums up the topic of competitive advantages nicely.
Dorsey’s framework is used extensively by Morningstar and consists of four main types of competitive advantage. When I’m researching a company I always like to think about whether or not the company has any of these traits, and to what degree.
I’ll cover competitive advantages in some detail here, but if you want even more detail then Pat Dorsey’s book is a good place to go.
My rules of thumb for durable competitive advantages are simple:
- Prefer companies that have durable competitive advantages to those that have short-term advantages or no advantages
- Prefer companies that have low-cost competitive advantages to those with advantages that are expensive to maintain
I have four questions which are designed to uncover whether or not a company has a durable and defendable competitive advantage. Few companies are likely to get more than one yes answer from the four questions and most will get none.
However, not having a competitive advantage is not necessarily a reason to ignore a company.
For Warren Buffett it might be, because his preferred holding period is forever. In other words, he would rather not sell a company once he’s bought it, in which case competitive advantages are critical if the company is to perform well over decades.
I, on the other hand, am not a buy-and-hold investor. I expect to be invested in a company for somewhere between one and ten years, and over that timescale a durable competitive advantage is less important (although still preferable).
So for me a competitive advantage is a nice-to-have rather than a must-have feature, and regardless of whether or not a company has any advantages, asking the following questions will increase your understanding of its business.
1. Does the company have any intangible asset advantages?
There are three kinds of intangible asset that really matter:
- Brand names
- Patents
- Regulatory licences
In different ways they each help a company to be the go-to destination for a particular product or service.
[The book covers intangible asset advantages with another thousand words or so but in the name of brevity I’ve left that out of this excerpt]
2. Does the company gain an advantage from switching costs?
Switching cost is a term that refers to how easy it is for customers to switch or substitute one product or service for another. The cost here is not necessarily in financial terms, although it can be, but could also include costs such as time, effort and so on.
For example, our local supermarket is a Tesco, so that’s where we get our groceries. If we moved house and Sainsbury’s became our local supermarket then that’s where we’d shop. We can switch from Tesco’s to Sainsbury’s with only the tinniest amount of hassle (such as working out where the baked beans are).
The problem of low switching costs hampers most companies, but not all. One example of a company with very high switching costs is Microsoft.
Millions of people use Microsoft’s products because that’s what they’ve always used and it’s what most other people use. Microsoft users have built up skill and familiarity with Microsoft’s products, not to mention a huge archive of files which work best with Microsoft software.
The bother of switching to a competitor’s word processor or operating system, even if it were significantly better, just isn’t worth it for most people. The effort required to learn the new software is usually just too big a barrier to climb, and in some cases files and software won’t work on anything but Microsoft’s products.
So, for the most part, existing Microsoft users stick with Microsoft even though it may or may not offer the best products.
3. Do the company’s products or services have a network effect?
Some products and services get better as more people use them. eBay, Facebook and Microsoft are all good examples of how the network effect works.
eBay, for example, is an online marketplace for pretty much anything. As more people go to eBay to buy things it becomes a more attractive place for sellers as they will be able to sell a wider variety of goods more quickly than if there were fewer buyers. In turn more sellers will draw in more buyers as there will be a wider variety of goods on sale and competition among sellers will keep prices down.
This positive feedback loop between the number of buyers and sellers is why eBay has been so successful. Once a critical mass of buyers and sellers was reached, eBay’s competitors found it impossible to compete without an equally large pool of buyers and sellers.
4. Does the company have any durable cost advantages?
Being able to sell products or services for less than your competitors, while maintaining decent levels of profitability, is of course a great advantage. But as with most competitive advantages it’s a difficult trick to maintain over time.
It’s no good simply cutting costs to boost profits in the short term as that will likely undermine the company’s long-term prospects.
It’s also no good simply investing in newer, more efficient technology that enables the production of widgets more cheaply than competing widget manufacturers. If one company can do it then others can do it, and it wouldn’t be long before every widget manufacturer had invested in the same technology to gain the same advantage.
At that point they’d be back to competing on price, producing very little in the way of profit and a terrible return on their new technological investment (although of course the consumer would benefit from cheaper widgets).
Durability is what really matters and durable cost advantages come in four flavours:
- Cheaper processes
- Better (and cheaper) locations
- Unique low-cost physical assets
- Greater scale
[As with intangible asset advantages, the book also covers cost advantages with another thousand words or so, and again I’ve left that out in the name of brevity]
Answering these competitive advantage questions is the final step in my company analysis process, after which I’ll make a decision as to whether I’ll invest or not, and at what price.
Finally, if you’re really interested in competitive advantages then the chapter which covers them in my book is a good starting point, but to get a much deeper understanding I would urge you to read Pat Dorsey’s book as well.
Microsoft is in my top 10, and in addition to the switching cost, it has a huge growth in cloud service provision, which in itself is not impossible to switch out of, however, it’s more attractive to add it to your existing contract, rather than say buying Amazon, Google or IBM for cloud service, if you are an existing Microsoft user.
Ebay’s popularity has allowed it to grow for the reasons you stated and I appreciate that it’s only really included by way of example for illustrative purposes, but before anyone rushes out to buy eBay, it’s popularity is shrinking for a couple of reasons :-
I think a lot of people are tired of bidding and just want to buy. “Buy it Now” is obviously a feature of eBay, but so is it at Amazon et al — that are growing much faster than eBay.
eBay introduced a nasty new policy 18 months ago which allows a buyer to send anything back at the sellers expense without giving a reason – this is an unfair practice, which while eBay incurs no cost itself, it’s really alienating sellers and driving many away – this together with onerous fees.
Bought eBay myself, to get hold of PayPal, but when the company split, I sold eBay, kept PayPal.
PayPal, competitive advantages:
1. First mover advantage and scale
2. 189 Million users already and 10 Million merchants signed up.
3. “One touch” — has boosted conversion by 50% and will be difficult to displace
4. Secure Wallet offers a big screen for users and helps prevent fraud — others will find this difficult to compete with.
LR
Hi LR, thanks for adding those points.
Regarding eBay, as you point out, having a powerful network effect doesn’t mean a company will dominate forever. All companies make mistakes at some point either proactively or inactively, which even the almighty FANG companies should take note of.
Companies with a durable competitive advantage :-
Renishaw
Advanced Medical Solutiuons
Anpario
ARM
Diageo
just a short list but worth a comment if anyone is looking in on these
LR
My primary financial measure for competitive advantage is ROCE. If a competitive advantage doesn’t translate into consistently high ROCE (relative to peers) then perhaps it isn’t so advantageous after all.
Perfect measurent, no point having a competitive advantage if it doesn’t provide a decent economic return. I’ve become a little more draconian in my conservatism and selected ROA as a primary measurement in addition to ROCE.
ROA for the little list is :-
Renishaw — 19.3 — one of the highest i’ve seen
Advanced Medical Solutions — 12.8
Anpario — 10.7
ARM — 17.17
Diageo — 9.47
Obviously these are moving targets, but it’s at least a decent base to start with and something to monitor as you hold the stocks.
LR
Thanks for the taster John!
I notice Roger Lawson (ShareSoc) has reviewed it: https://harriman-house.com/press/full/2923/
I think I’ll drop a few father’s day hints to my children, who knows I may get lucky & not have to spend my own money for it:-)
“I may get lucky & not have to spend my own money” – Spoken like a true value investor!
Hi John – really like your paper / book but have a few thoughts. First I believe (as I think we have discussed) that you are “short-changing” the whole area of intangibles? I believe there are several more that should be considered and would suggest Mary Adams book on “Intangible Capital: Putting Knowledge to work in the 21st Century.” I would also suggest that ROCE can be a bit misleading (and I do realize its one of many measures) but “book based capital” today understates the true value of an entity from a shareholder view so something like a “market adjusted EPS” might be better? Also, I believe that sustainable organizations should be focusing not on maximizing profitability but on optimizing it – which is more the managed approach of balancing long and short term. Thus I would not want to see earnings at the top of a benchmarked list unless that list itself excludes those organizations without long and stable track records (that is part of your approach anyway?). Finally I would like to think that you might benefit from evaluating the work of The Maturity Institute in the UK in their work of human capital as I believe that in the longer term there will be a correlation between effective management of human capital and long term sustainable earnings ad growth?
“” I would also suggest that ROCE can be a bit misleading”””
Nick, in what way do you consider ROCE misleading?
In many ways, companies vary in their view of value — many claim the value is off balance sheet and tied up in IP (pharmaceutials for example), or valuable patents, or locked in human knowledge.
At the end of the day, it seems to me to boil down to how much cash you get out from the cash you put in, and more importantly the consistency of this over time. Measuring ROCE in cash terms seems the hardest thing for creative accountants and theorists to fudge.
I always find EPS open to significant manipulation, since it is the convenient wrong measure for management remuneration. For that reason you often find debt loaded each year to prop up EPS, or acquisitions conveniently timed to mask a fall in the underlying business.
Until management remuneration is changed, EPS always will be a subjective measure of value.
LR
Hi “LR” I agree with your comments about EPS and manipulation. My concern over ROCE – assuming one is using balance sheet value, is that based on the last 25+ years of trends and research, corporate balance sheets today represent less than 25% of an organizations true value. In pharma companies that you mention it is even less so measuring return on this is not a comparable or really meaningful measure.
Nick, so in essence the ROCE of a pharma company for example is rather flattering, in that a lot of it’s R&D/IP or Patents lie off balance sheet. I guess one can only really measure the growth in cash. If that’s not happening and earnings and revenue are falling (e.g. Astra Zeneca) it’s highly likely that the value of the off balance sheet items are worth even less than are imagined.
A lot of that off balance sheet “worth” is very speculative, and in the case again of Pharma, given that there is about a 7% successful conversion rate for drug pipelines.
It’s really not surprising that the likes of Ben Graham considered only the tangible elements of assets in coming to a conclusion about a companies conservative value.
Good thoughts indeed and this is part of the overall challenge of assessing both profitability and value in the “knowledge economy.” The point on “conversion” rate is also interesting and again part of the challenge. This search for finding better ways to assess and evaluate organizations is a very worthwhile endeavor (and as always as you say “cash in king” at the end of the day!)
Hi Nick
The intangible asset piece of this article is a bit short I must admit, but I had to cut something out otherwise I’d end up posting the entire 4,000 word chapter, which would be a bit OTT.
However, I’m always on the lookout for new ideas so thank you for the book suggestion. I’ll add it to my reading list.
On ROCE, yes I would agree that like any financial metric it can be misleading, so I see it as being suggestive of a company having a competitive advantage, rather than hard proof.
As for maximising profitability, I think that is just as bad as maximising short-term EPS. A company could try to maximise ROCE by underinvesting in capital assets, which of course would be bad for the long-term value of the company.
What companies should really be focused on is maximising shareholder value, but since we can never measure shareholder value (as it depends on cash returns many years into the future) investors and managers tend to (or at least should) focus on a range of indicative or suggestive factors, such as ROCE, EPS and so on. So like you, I wouldn’t like to see an excessive focus on EPS, ROCE or any other single measure, but would rather see management focusing on capital allocation decisions to drive long-term future cash returns.
And thanks for highlighting The Maturity Institute, although I’m not sure how much of their research I could fold into my relatively quantitative approach. Still worth a look though, I’m sure.