I was read a book “Warren Buffet’s management secrets”, written by Marry Buffet & David Clark. In they have mentioned that companies with**“durable competitive advantage”**come in three basic business models.They have been mentioned in the order of priority, the reasoning(priority) is givenalongside.
1). They sell a Unique service- These businesses own apieceof customer’s mind and have pricing power.Theydon’thave to incur huge R&D cost and huge CAPEX to keep the business running and so have the best margins among the the various business models.Its margins are really healthy and relatively more sustainable.
Eg: CRISIL when a company thinks of rating or grading it thinks of CRISIL. It incurs very small portion of its revenue in training its employees,it basicallyacquirestalent(so, it saves on R&D cost),it doesn’t have to incur huge CAPEX to maintain factories as itdoesn’t have any.
2). They Sell a unique product- These businesses own apieceof customer’s mind and have pricing power. They sell a stable product and don’t have to incur huge R&D cost to upgrade the product. They use the samemachinery and hence incur CAPEX only when themachinery wears down completely.This model isinferiorto the first one as at some point of time it has to incur CAPEX and because it is selling a product it has to cope with the fluctuation in raw material prices, thesethreatensits margins and the margins are relatively less sustainable.
Eg: whenever we think of cool drink we think of Coca-Cola or Pepsi. These companies have been selling almost the same product for more than a 100 years now( no R&D cost). TheyincurCAPEX only when the machinery completely wears down(occasionally).
3). They are low cost buyer and seller- Here the margins are traded for volumes. Here the advantage is buying at the cheapest price and selling at lowest prices to induce customers to buy from you.**This is the mostinferior one as maintaining lowest price is the main focus. Hence the margins here are not very healthy and not very sustainable.**But still these are far better than businesses with mediocre economies.
Eg: when we think of finding the best deal we think of Wallmart. Owing to its size it hasenormous bargaining power with suppliers and sells at heavily discounted prices. It enhances its ROE through increased asset turnover.
It would be great if the valuepickr community could help me further refine this idea by coming up with examples and adding other kinds of business models which may beperceived to have a durable competitive advantage.
However, whether such advantage is durable or not depends upon how the future unfolds. Monopolies are normally not possible- and oligopolies are prone to destructive competition for claiming market share. Occasionally brands, for which consumers are willing to pay a higher price, do confer some amount of competitive advantage. Low cost delivery does confer a competitive advantage if the delivery model cannot be replicated easily. However, as business environment keeps on changing- competitive landscape also changes leading to loss of competitive advantage.A consistent high ROE shows existence of some amount of competitive advantage.
Companies with competitive advantage is rare. In Indian context there are some companies- oligopoly (CRISIL, ICRA), Brands (Nestle, Gillette, Jubilant food), Local monopoly (Adani Ports), Technological advantage (Bosch), Economy of scale (Maruti, ITC, HLL) etc. Many a times factors are overlapping. The problem with these stories is that these businesses are not available at steep valuation- and if for some reason competitive advantage dissipates for some reason, can lead to disastrous investing result.
Searching for competitive advantage in small cap stocks can be useful, as these stocks are available at fair price on various occasions. Some of the stories in that sector- Venky (economy of scale), Thangamayil (High asset turnover with decent margin), Treehouse (localised monopoly), Kaveri seeds (technological advantage)… they can be analysed more deeply.
Buffet says “we invest in companies with durable competitive advantage in industry which are expected to remainstable” (ie: the companies with stable products because stable products mean stable profits)
He bets on Kraftfoods, he says “even after 50 years children will dip cookies the same way we did when we were kids” and this gives him the comfort to stay invested in such companies.As he says “i don’t look at the price,as long as the underlying business and their prospects are good i stay invested”.More often than not he is right. But as a human being he also hascommitted his share of mistakes eg: The Washigton post (the newspaper business). Here he failed to factor in the threat ofsubstitutes(one of poter’s five forces). With the advent of online news the industry as a whole faced stiff competition and this hampered theprofitability.
He further says if a company has a decent operating history of 50 or more years, it is an indication that the company may be having durable competitive advantage.
I am not sure that companies like Maruti and Bosh(Incurs huge R&D and CAPEX on regular basis due to the nature of the industry in which they operate), Adani ports have durablecompetitive advantage. Yes they do have barrier to entry and some of them have monopoly at present. But, would it be right to say that they have a durable competitive advantage?I mean can they sustain theirprofitability in an economicturmoil? I doubt.
From the kind of companies which buffet has in his portfolio i would like to make ageneralization, which may be useful in deciding if the company can has a Durable Competitive advantage. Apart from the banks and insurance companies he own companies that sell products that form a very small portion of the consumer budget,which in economic termsimpliesto a great extent that the product has an inelastic demand, which gives the company the additional levy to pass on the increase in input cost to thecustomer, there by keeping its margin safe.
Buffet’s companies- chocolate, chewing gums etc. are generally not available in Indian listed space. A few, like jubilant food are steeply priced. But, it is one area where one should be focused for any opportunity. In general we can look for following characteristic in a business:-
1). At least 2 positive competitive factors, out of four outlying factors. Further, risk of destructive competition must be very low among existing players.
2). The business must not require continuous capital infusion.
3). The business must be scalable.
4). Return on retained earning must be very high on sustained basis, i.e. high return on reinvested capital.
I think point 1,2 & 3 is understood by the market very early and there is not much scope of finding inefficiencies there. Point 4 is very important place to look for companies with competitive advantage. The phase of high return on reinvested capital comes in the life cycle of a company (with competitive advantage & good management) comes when initial capital spending is complete. Harvesting phase is just about to begin in the life cycle of a company. At this phase, return on reinvested capital is start getting high and the phase may continue for some years- for companies with durable competitive advantage for much longer.
Let us examine the case with some example- I suggest Treehouse. I feel it is a value stock with 10 times price to sales, 32 times earning and 10% ROE!! I feel it is a value stock because earning on reinvested capital is likely to be very high for at least next 4-5 years. I came to this conclusion despite presuming that its present OPM (57%) is not sustainable and must come down drastically as the company matures. But such mental models are based on so many guesses that it is better to keep that model in one’s mind only.
The problem with this approach of investing is that it is very difficult to explain these in words… it is largely a mental model. The way you visualize the future of company. It is not something which can be easily explained in terms of book value or eps.
I agree with you that looking for sustainable competitive advantage in small stocks can be useful. As they have potential to grow faster and their size works in theirfavor. But, here we are not talking about “sustainablecompetitive advantage” the term coined by Michel.E.Porter, rather we are talking about "durablecompetitiveadvantage"coined by Warren Buffett. There is a differencebetween the two.
The “sustainable competitive advantage” by Porter considers how the Porters 5 forces(power of customers, power of suppliers, competitive intensity, threat of new entrants and threat of substitutes) exist in the industry and how are they expected to be in the future. They give a very good insight into the industry structure.
whereas the “durablecompetitive advantage” by Warren Buffett considers few quantitative measures from financials of**companies in industries that are expected to remain stable over a long time **and few qualitative factors like the age of the company, brand loyalty etc.
essentially both are used to predict the future but the inputs that go in are different. Coming to the concept of monopoly, buffett does not go by thedefinition of monopoly in Economics. When he says “Consumer Monopolies” he means that when ever you have to buy chocolate you think of Dairy Milk and there is only one producer in the world that produces dairy milk and that is Cadbury. Effectively Dairy Milk occupies theconsumers mind in such a way that, heperceives it to be a different product. He treats chocolates produced by other companies which may have the same composition, taste etc to be **substitutes **rather than competitors. Yes the competitivescenario may change or the other and the company might loose its Consumer monopoly, but that happens mostly in industries which are prone to technology, but here is where Buffett is a genius! he picked up companies in industries which were least prone to technological change like Kraft foods, Procter & Gamble, Coca-cola etc which have made him what he is today. In hindsight one can always say he could have made more money investing in Microsoft, IBM etc, obviously he could have. But these companies never fit in the type he talks about because these are prone to change. Itdoesn’t mean they would have made bad investment it just means predicting their future would have been tough.Sorry for late reply i thought of studying about Buffettthoroughlybefore replying. When i read for the first time i too got confused between the two competitive advantage terms, but with more readings my doubt got clarified.
A brilliant write-up on the business model of Amazon (through charts). Hope you like it. Comments are welcome.
(Note: I am adding this comment here as I am not sure where else it belongs. If the site administrators think this is the wrong thread to use, please guide me to the correct one)
