I only invest in very high quality businesses. Part of this is about the business economics, which can be captured in financial metrics: I like businesses that are highly profitable relative to their costs and how much they need to invest in capital. Another more qualitative part of my assessment is whether a business has an edge.
Quality (as I define it) is about the certainty and consistency of long term growth in profits. Ultimately this is what determines the value of an investment. The most common risk to long term growth in profits comes from competition. Competition is not the only risk. There are also risks from changing consumer demand, technological change and regulation, to name a few. But I think competition tends to be the main one.
A key aspect of quality is therefore immunity to competition, or a competitive advantage or ‘economic moat’, as they are sometimes known. A competitive advantage comes from a unique attribute, or set of attributes, that help a business win or retain customers and that cannot easily be replicated by competitors. It creates an edge over existing competitors, enabling a business to grow its market share, and deters potential entrants. I’ve talked a bit about competitive advantages previously in my post on identifying quality. Here I want to do a bit of a deeper dive.
I have a lot of experience of trying to assess whether businesses have competitive advantages from my day job. It is hard! I’ve found that it often needs to be a bespoke and detailed exercise, tailored to the specific circumstances of the business in question, in particular accounting for how competition works in its particular market. A few other points add to the complexity:
- A competitive advantage is often the result of a combination of several interrelated factors rather than one single one.
- As well as identifying a possible competitive advantage, it is important to assess how strong it is and how long it might endure. Even with a detailed analysis, some judgment and speculation is required to assess how long a competitive advantage might endure into the future.
For investing, it’s not really practical to carry out the same detailed assessment as I might do at work. I do a more shorthand assessment, first identifying the possible sources of competitive advantage and combining them into an overall ‘story’. I then make an intuitive judgment of the credibility of this story, where possible also looking for evidence to support or refute it. For the reasons in the previous paragraph, applying a template framework to each case may not be very accurate, but a checklist of questions can probably be used as a sensible starting point. I haven’t developed this checklist before but I’ve had an initial stab in writing this post.
Below I set out each of the main sources of competitive advantage individually, how I incorporate them into an overall assessment and some examples from my portfolio and watchlist. I’ve structured according to a checklist of questions.
How big relative to the market?
The classic source of competitive advantage is scale. On the supply side, scale can lead to cost advantages if there are economies of scale or fixed costs become a smaller proportion of revenues. On the demand side, scale can allow for a better and more efficient distribution network and more opportunities for cross selling.
As well as bringing advantages, scale is also an outcome of success – the biggest companies are those that have won the most business. This can lead to a ‘virtuous circle’, where past success leads to scale, which leads to an even greater competitive advantage in the future.
It’s normally pretty easy to tell whether a business is largest amongst its competitors. It is one of the first things I look at. I’d tend to pick the market leader unless I had good reason not to. As well as just the size relative to competitors, the operating margins relative to competitors can also give a sense of to what extent a scale advantage is leading to a cost advantage.
Scale can matter more in some markets than others. It particularly matters for businesses where more complex infrastructure is required. Generally, I am less keen on more capital intensive businesses, where these kind of scale benefits can be more relevant, as greater capital intensity means less profit for shareholders. However, where scale is giving business a clear competitive edge, the extra profit this brings can more than compensate.
Cranswick, a pork processing business in my portfolio at the moment, is an example of a business whose competitive advantage comes from scale. It is the largest and most efficient business in an industry where economies of scale are really important. It’s simply not possible for its smaller rivals to match its costs and successfully compete for its business.
More vertically integrated than competitors?
Similar to increased scale, vertical integration (owning more than one level of the supply chain) can lead to greater efficiency as it eliminates ‘double marginalisation’ (the need for both levels of the supply chain to make a margin). Boohoo.com is an example of a business that is able to make higher margins than many of its rivals, despite selling its products at cheaper prices, as it solely produces own-label products and has taken great trouble to make its whole supply chain (from overseas sourcing to online distribution) as efficient as possible.
Is the product or service better quality than those of rivals?
As I like to invest in capital light businesses, technology rather than scale is generally the more important source of competitive advantage. Technology is important as it allows a business to offer a higher quality product or service compared to rivals.
Is the technology sufficiently different or complex?
I look for evidence that a business has higher quality services or products as a result of technology (in a broad sense) that is not easy for rivals to replicate. The key observable attributes of the technology I am looking for are that it is in some way different to what rivals are providing and that it is sufficiently complex to make it hard to replicate. For example, this could be because the business has invested heavily in R&D for a number of years and built an extensive knowledge base.
Intellectual property protection (‘IPP’) in the form of patents can sometimes be a useful way that a business prevents competitors replicating its technology. However, while hearing that a business’s technology has patent protection is nice, it is not something I look for. The trouble is that it is very hard to assess what future competing technologies a particular patent might not provide protection against. I prefer to make a more high level assessment of how a business does things differently to its competitors, and why how it does things is sufficiently complex that others will struggle to copy.
Is there incremental rather than rapid technological change?
A technological advantage in an industry with rapidly and suddenly evolving technology can be short-lived, while a technological edge based on multiple, frequent, incremental advancements is more likely to endure. For this reason, I think it can be better to identify businesses in industries where technological change is more incremental and where the business in question has a track record of consistently innovating as a market leader. This needs to be considered on a case by case basis – an obvious thing to look at is the history of innovation in the market in question. As a rough rule of thumb, my expectations are that products and services with a greater physical element (e.g. engineering type products) would tend to evolve more incrementally than IT when changes can be more of the sudden ‘big bang’ type. Note this is only a rough rule of thumb and there are plenty of exceptions either way. However, I would be wary of putting too much weight on the competitive advantage of an IT business, if it was solely derived from a technological edge.
Do customers care a lot about quality?
A technological edge can be particularly important in certain markets, for example where end customers have exacting quality requirements. IPG Photonics is an example of a US company I have recently invested in, that appears to be a technology leader in the production of lasers. Using proprietary technology, scale and developed know-how, it is able to produce more powerful fibre lasers at a cheaper cost than its rivals.
Is the business a pioneer in its market?
Another important characteristic I look for is whether a business is a first mover in its market. An important point to note is that by first mover I don’t necessarily mean the first business to come up with an idea. In fact I always avoid blue sky story stocks. What I mean is the first business to implement an idea successfully and profitably. Pioneering businesses, which have come up with a new product or a new way of operating, benefit from a period where the competition is yet to catch up and there is the whole addressable market to play for. Being invested in this high growth phase can often be highly profitable.
More importantly, being first can often come with a number of strategic advantages. The important high level point is that it is strategically much less attractive to be a ‘me-too’ product entering a market. While the first mover has the whole market to play for, number two know that they will be competing with the first mover, who is likely to retaliate to competition when it comes. In addition, the first mover is likely to have competitive advantages over a new entrant, such as existing infrastructure or customer relationships. Being first provides the opportunity to invest in these advantages in order to deter potential entrants in the future. For example, a first mover may have the opportunity to invest heavily in distribution infrastructure to create scale advantages or to artificially create switching costs (more on that below). By way of an extreme example, I am sure readers will be familiar of the story of how VHS was successful, despite being an inferior technology to Betamax, as it was the first to be more widely adopted and a single industry standard was necessary to ensure compatibility.
Of course, being first is by no means a guarantee that competition will not come in the future – but I think it makes sense to treat it as a source of competitive advantage in itself because of the strategic opportunities it tends to provide. It has the benefit of being something relatively easy for the investor to identify.
A classic example of a first mover in my current portfolio is Burford Capital. It is currently achieving excellent growth and is the number one player in the relatively nascent market of litigation finance. While it will undoubtedly face more competition in the future, I believe it is likely to be able to develop its scale, customer relationships, reputation and know-how to an extent that gives it a significant advantage over smaller competitors in the future.
Is it the consolidator of a fragmented market?
Another type of first mover is a business that consolidates a previously fragmented market through acquisitions. These buy and build businesses can make very good investments as there can be potential for very rapid growth. They are especially attractive where the acquisitions can be made cheaply (often the case when buying small unlisted businesses) and when economies of scale or scope can be generated. Keywords Studios is a good example of this sort of business.
Does it have a brand that instils customer loyalty?
Brands are a classic form of competitive advantage often favoured by quality investors (think Buffett and Coca-cola for example). They differ from the previous sources I’ve mentioned as they are not tangible but are demand side factors that exist solely in the minds of customers. They generate loyalty from customers, reducing competition and allowing brand owners to charge higher prices. Most of the time they rely heavily on advertising to generate their brand value.
Brands are pretty easy to identify (that’s kind of the point!) The key things to look for in a brand in addition to the other factors mentioned earlier in this post are how ‘niche’ it is, how premium or clearly associated with high quality it is (which allows it to make greater margins) and what its longevity might be. I don’t have any particular insight here – for me it’s a combination of looking at its track record and gut feel.
An example of a brand I like a lot is Fevertree. It is the clear leader in its niche of premium tonic and is the gold standard for high quality.
Are customers locked in?
One of the characteristics I am most drawn to when looking for sources of competitive advantage is the degree to which customers are locked in. Switching costs that lock in customers can create a high degree of certainty of profit growth that is very attractive.
Switching costs can arise where a business’s services are very integrated into those of its customer, making switching very disruptive and costly. This is common for some types of IT services: Micro Focus, Craneware and Sage all benefit from this type of switching cost.
Switching costs can also be high where product quality and reliability are very important. Customers may often be reluctant to take the risk of trying out new products. This is common in healthcare markets and benefits companies such as Tristel, which makes high-grade disinfectant products.
Customer loyalty can also arise from the need for compatibility between multiple products. For example, Games Workshop has very high customer loyalty as products are connected through their use in its tabletop games.
Are there network effects?
Platforms are businesses that create value by connecting users or groups of users. Often they are used to facilitate transactions, connecting businesses with potential customers. Platforms benefit from network effects, where the value of the platform to its users grows with the number of users. Customers benefit from being able to access a greater number of businesses and vice versa. Network effects creates a competitive advantage for larger platforms over smaller platforms and in some cases this can mean that a single platform is adopted. Network effects can be a very powerful source of competitive advantage. In addition, the business economics of platforms tends to be excellent, as once the platform is set up the incremental cost of growth is very low.
I have a number of platform businesses in my portfolio or watchlist, including Google, Facebook, Rightmove and Just Eat among others.
Do users multi-home?
Probably the most important question driving the longevity of the competitive advantage of a platform is whether users multi-home ie use multiple platforms for the same purpose. Requiring users to set up a profile and enter a lot of personal information can discourage users from multi-homing. Facebook is a good example of a platform that it is hard to see users switching from – it has unparalleled coverage of the global population and users have used it to store huge amounts of personal information. This has led to a pretty much bulletproof competitive advantage. Users of Just Eat on the other hand do not have much difficulty in multi-homing. So while it does still benefit from the advantage of network effects, it is easier to see it being challenged by a rival technology.