You all might have noticed that I have talked about return on equity or to buy businesses that give good return on equity and sustainable competitive advantage. But no one really responded or asked me what I mean with this competitive advantage until we posted our last post and asked you to find out competitive advantage.

So, this post is all about competitive advantage and please feels free to raise any questions if you have as this is a very vital topic with reference to our method of investing.

As mentioned before, if a company has a history of stable high return on equity then predicting the future earnings becomes very easy. But if you look at the history of Indian market or any market you will notice that there are very few companies or we can say you can count on your fingers such companies.

Many of the companies who reported great returns in 2011 are witnessing a free fall from the cliff in the current year. One of my very close critic friend told me that, “it is the future that will determine your returns. You can’t drive looking in the rear view mirror instead of the road ahead.” I am glad that he shared this great insight with me as even I believe that past years performance will be of no benefit to you or me if we didn’t own those shares!

Buffett once observed:

“If history supplied all the answers, the Forbes 400 would consist of librarians.”

 

It is very important to understand what forces are producing those high returns today of any company. As investors we should always ask ourself: “what could come along and change them?”

Competitive advantage is that part of investments where you don’t require calculators, spreadsheets and equations. You just need to sit back and think: ‘why is this company’s business so good?’

It is not sufficient to simply invest in any company with a high return on equity. Majority of businesses listed on Indian stock market comprises of very few assets that have no barrier to enter into the market and give stiff competition and drive the returns in that sector lower by offering goods and services at lower cost. Conversely a business infrastructure like Reliance which is difficult or highly impossible to replicate but with low returns is same time not worth to invest with. The key point is then to invest with only those companies which give high returns and have a reason that they will continue doing that.

The competition in the market as per theory is the key variable that erodes the return on equity. When IT industry was evolved then there were only few companies in that sector and today if you look then there are countless companies doing business in that industry. But still Infosys and TCS are the companies still giving their shareholders those high returns. The competition has not eroded their returns. Why? They might have developed something intangible that causes businesses to prefer their services then giving same business to any new entrant. They might be doing something special which is difficult to copy or replicate. In other words they might have built such assets like reputation that cannot be easily obtained or duplicated.

The competitors may simply not understand what this superior company does so well. This difference between superior and ordinary companies Buffett refers as economic ‘moat’.

The best business to own are those with little or no debt, bright prospects and high rate of return on equity, driven by sustainable competitive advantage.

The most valuable differentiator or competitive advantage of any business allows the business to simply raise the price each year without loosing any business at all. In other words best business can afford to charge higher price. This is one of the big things that investors, advisers and market commentators miss – because they talk about trading stocks rather than thinking about businesses.

If you don’t believe my point that there are any such businesses that can afford to raise its price without loosing any business then let me ask you all to do this small practical exercise. Go to your local super market and jot down the names of the products that you think have a pricing power. What I mean is, no matter what the price is you would buy that product only. I still remember when I was a little boy my mother never bought any other éclair chocolate other than Cadburys brand. She always bought Amul Butter than any other butter available in the market. She always preferred to buy Kissan Jam then any other brand and my first cycle was Hero cycles which was really costly compare to other brands.

It doesn’t matter whether you call it economic goodwill, competitive advantage or ‘moat’ around the business. If a business has an X-factor and can charge customer more than its competitors for the same product or service, it is more likely to produce high, durable rates of return on equity.

Conversely, it is true for any company which can offer its products and services cheap and can still maintain healthy returns on equity like Wal-Mart and Costco in United States.

To help you with this subject let me go in more detail and talk about sources of competitive advantage. There are many sources of competitive advantage and they are as follows:

Reputation

The very first source is the reputation for quality or desirability that encourages people to pay more. The best example in this category I can think about is of the Apple products. Why people are willing to pay more for iPod and iPhone than any other cheap MP3 players and mobile phones available in market.

Regulation or government policy

Another source of competitive advantage is government policies and regulations. The examples I can think about is about oil drilling licenses etc. it is very hard or almost next to impossible for any new entrant to get those licenses which Reliance Industries and ONGC enjoy. We can also add those government contracts which IGL owns for supplying gas in metro Delhi and its buses as example.

There are two separate opinions in the parliament house and also within the country in regards to FDI policy in retail sector. Small business owners are getting agitated and they are talking about loosing their competitive advantage if these big boys enter into retail market. My personal opinion as a business analyst is that if these big boys enter into the retail sector then the small businesses that do not have competitive advantage will have to work creatively to build that to sustain their businesses.

Exclusively access to intellectual property

The companies which have exclusive ownership of intellectual property like many pharmaceutical companies like Divi’s Lab, Glaxosmithkline that manufacture their products using that intellectual property.

We can also add extension to this competitive advantage source the companies which has exclusive rights to access natural resources like companies in mining and minerals sector etc.

Brands

Even brands are citied to the source of competitive advantage and are most valuable to generate business. We have forgotten word ‘photo copy’ instead we say ‘Xerox this’. If you want paracetamol we ask for ‘Crocin’. The owners of these brands have that competitive advantage on their rivals.

Vast fortunes are invested in building these brands, but generally accountants can’t value them as they are not found in the Balance Sheet.

I can list down hundreds of such examples with their competitive advantage but all those companies, however, also run the risk of changes to the width and depth of their competitive advantage. Each source of competitive advantage has its risks. People could simply switch their allegiance. For example recently ‘Zandoo Balm’ has taken over ‘MOOVE’ or when Coca-Cola was relaunched in India took over Thumps up. The rules and regulation can wipe out the whole competitive advantage of any company, like Ester Industries. The reform in Gutka packaging made Easter Industries loose its competitive advantage.

Good management is also one of the sources of competitive advantage. It is very important that management treat its shareholders as the owner of the company. They should also take sound decisions about allocating capital – paying dividends or keeping the money to expand – much as they would if they were 100 per cent owner of the business themselves.

Most of the investors are consumers and they really understand what derives consumer behaviour. You could tell in an instant that Airtel is better than MTNL or Reliance mobile service is better or these days’ people are talking about IDEA. But there is another reality that you will make some mistakes – everyone does – but if you stick to businesses with high rate of returns on equity, little or no debt and you can identify its competitive advantage then you will minimise, to a great extent, the most important risk – that of permanent loss of capital.

Hope this post will help you out understand what competitive advantage is. We would like to invite you all to share few competitive advantages which you have identified of the companies from your portfolio.