Identifying Competitive Advantage
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There are thousands of companies that are publicly traded. Weeding out the poor-performing companies and focusing on the excellent ones is key in a successful investment strategy. To that end, I have certain criteria that I find useful in identifying competitive advantage in companies.
Companies with durable competitive advantage are able to withstand the short-term market volatility, economic downturns, and one-off company-specific issues. Targeting such companies as a starting point for investment analysis goes a long way toward excellent return on investment for the long-term.
Within our investment analysis to identify companies with a competitive advantage, we assess trends relative to key financial metrics such as ROE, ROIC, and D/E ratios. We largely leverage Seeking Alpha Premium to conduct much of our analysis on any stock, as it provides real-time quotes and robust financial information going back as far as 10 years for many publicly traded companies. It's also very helpful to gain ready access of comparison to key peers within a respective industry.
Assessing a company’s branding is more often than not an exercise in familiarity and common knowledge. It’s typically easier to make such an assessment based on products as opposed to services, but a strong brand goes a long way toward identifying competitive advantage.
Think of companies with branded products or key services that people or businesses can’t do without. Typically there are either no available substitutes or very poor substitutes for their products. On the retail front, certain stores pretty much have to sell such products to remain in business. And on the business front, certain products or services are necessary for other companies to remain in business. Microsoft provides such products, and so does Apple, Adobe, and Crocs Shoes.
In my experience, part of assessing a company’s brand power is having an understanding of the products or services provided. In general, understanding the businesses you invest in are also key to making a determination of how sound an investment is. If a company up for investment consideration is thought to have business economics with a durable competitive advantage but you don’t understand the business, do some research online or read related books in effort to gain an understanding.
Exhaust your resources in trying to determine the brand power of a company before investing. Within a specific industry, don’t throw your money into a company that’s #3 or #4. Instead, seek to determine the #1 brand with respect to certain types of products. Think Nike for sportswear or Apple for mobile phones.
Typically the company’s products will endure on the market for years, and consumers or businesses will be continuously in need of them. In turn this will lend to durable competitive advantage for the company and high returns for investors.
High Return on Equity
A great secondary screen is to analyze a company’s return on equity. In doing so, look for high values of ROE over the long-term and as compared to peers. According to The Motley Fool, the average a return on shareholders’ equity over the last fifty years has been about 10%.
So, any ROE above 10% is considered potentially good. This figure tends to vary by industry or sector, however, so it’s important to evaluate return on equity on a relative basis. Research by NYU Stern, for example, indicates that the U.S. Advertising industry has an average return on equity of 13.57% while the same metric for Newspapers & Publishing is only 5.15%.
Be on the hunt for companies with above-average Returns on Equity. To properly assess ROE, one must compare this metric to that of relevant peers. For example, Nike is currently holding a ROE of 37.3%, which on the surface is very good compared to the market as a whole. But a more focused comparison is warranted versus Adidas (ROE 11.8%) and maybe Skechers (ROE 22%) and others.
Return on Equity should also be analyzed historically over time in the last 5-10 years.
High Return on Total Capital
While high rates of return on equity are super useful for gauging any competitive advantage within a company, we also need to assess Return on Total Capital (or ROIC). A company’s ROE metric can be skewed high as a result of large dividend payments or share repurchases.
So, analyzing return on total capital as well is a great safety net. I look for companies with consistently high rates of return on total capital and consistently high rates of return on equity.
Consistently High Earnings
Consistency is indicative of durability. Screening out companies for durable competitive advantage should entail consistently high return on total capital, high return on equity, and high earnings.
The keyword, of course, is consistently. There are always going to be one-off occasions where earnings decline due to some sort of temporary issue. But long-term trends should reflect consistently high earnings. Per share earnings should never fluctuate wildly but should historically show a strong and upward trend.
One thing about the stock market is that Wall St likes to kind of box companies into their projections. If a company doesn’t meet or beat expectations set within projections, the market will overreact and punish the stock price.
In such cases, these market overreactions oftentimes present buying opportunities. It’s important to thoroughly understand what caused the earnings decline before investing though.
As long as the earnings miss or the decline is due to a temporary solvable problem, the stock market’s overreaction is indeed a great opportunity to buy in at a potentially wonderful price.
Pricing power is also going to be evident in identifying competitive advantage. This attribute is strongly related to companies’ brand power. In periods of inflation, a company’s profit can surely be killed unless it has the ability to raise prices. Inflation causes prices to rise across the board.
For a business, that means rising prices for labor and raw materials. The cost to produce goods or services is higher for companies under such circumstance, and in some instances the cost may exceed the prevailing market prices of its products.
There’s no way a company can survive without the ability to raise prices.
A true sign of a durable competitive advantage is the ability for a company to raise prices (to an extent) at will.
It can raise prices right along with inflation without suffering any decline in demand. So profits remain flat or growing no matter how inflated the economy becomes. As such, a company with strong pricing power offers investors the ability to increase value in lock step with inflation.
Ability to Reinvest in the Business
If a company has a true competitive advantage in its space, it shouldn’t have to maintain operations at high costs.
Most of the retained earnings experienced by a company should instead be free to either expand operations, invest in new business, and/or repurchase its own shares. All three options should have a favorable impact on forward earnings.
How retained earnings is utilized is a sure sign of the quality of management of a company.
Low Levels of Debt
Most companies with a strong, durable competitive advantage will be relatively free of long-term debt. This is because they generate lots of cash, so they truly have no need for large amounts of debt. An exception may be assuming a level of debt for the purpose of an acquisition.
In this case, as long as the company generates enough in earnings to adequately pay off the debt within a reasonable amount of time, it shouldn’t be an issue. Such instances would need to be analyzed on a case-by-case basis.
In general though, if a company is maintaining large amounts of long-term debt on its balance sheet, it may not survive those temporary issues that cause the market to beat up its stock. Identifying competitive advantage in companies reflects the financial power to withstand temporary issues or disruptions to business.
To aid in this assessment, an analysis of earnings relative to levels of debt and corresponding interest payments will reveal a company’s ability to service and pay off its debt. Companies with durable competitive advantage typically have long-term debt at levels of fewer than 5 times current net earnings. All of this data is readily available via Seeking Alpha, our go-to investment analysis tool.
Lastly, a company with a track record of repurchasing its own shares is a shrewd strategic initiative and a big help in identifying competitive advantage. Such an initiative requires a considerable amount of cash, and the ability for a company to use its own cash to repurchase shares is a strong sign.
Be wary, however, of companies that borrow debt just to repurchase shares. This tactic is more often associated with meaningless financial engineering.
But when a company has ability to buy back its own shares using its own cash, it is in effect acquiring its own assets and increasing future per share earnings for all remaining investors. Share repurchases will lead to an increase in per share earnings, which in turn will lead ultimately to an increase in the market price of the stock, which will lend to wealth creation of shareholders.
In evaluating companies for potential investment in their stock, identifying competitive advantage within those companies is key to investing money successfully. Use the above criteria as somewhat of a checklist to weed out poorly competitive companies and focus on those with competitive advantage.
Other key characteristics reflective of competitive advantage not covered in detail include scale, the network effect, cost advantages (typically driven by scale), and high switching costs. Look for these types of things in leading companies considered for investment.
From there, additional investment analysis and great timing will afford great money investment opportunities. As long as a company continues to maintain excellent business economics, holding on to that investment while letting retained earnings increase the underlying value will aid in creating wealth for you as a shareholder.
Any of the companies researched and identified for investment on this post are generally going to meet these criteria.
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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions. I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.