The competitive advantage period
If I were to begin by saying that investments (at fair prices) in businesses with strong economics and long term sustainable competitive advantages have tended to yield better than average returns in the past, would I be saying something controversial? Well I guess that depends on where I say it… but on this blog at least it shouldn’t raise many eyebrows.
But let’s explore a bit more, the theory suggests that a firm’s competitive advantage will allow it to make higher than usual levels of profits even in a competitive environment. Without this advantage profits will tend towards more normal levels. So how long will this period of competitive advantage last? That’s the million dollar question.
Now it’s all well and good to come up with a definition, but the tricky part is in estimating how long the competitive advantage period (CAP) can last for. One way as proposed by Myuran Rajaratnam et al [1] (not the Rajaratnam that you may be thinking about), is to define the probability of a competitive advantage lasting one year and then run the following equation.
This will provide an estimate of the competitive advantage period (ECAP). However this estimate is only as good as your guess at the probability so we haven’t really got that much further. In addition, small errors in our guesses can lead to large differences in ECAP. Mathematically though, this is sound.
Another way is to restrict oneself to a circle of competence. For example, if you are an expert on fast food outlets, you will have a better sense at how long a firm can hold its competitive advantage as well as the signs of its erosion.
You may be interested to see how this phenomenon evolves in reality. I’ve popped below a chart which shows the convergence in the returns of Coca Cola to its weighted average cost of capital over a 20 year time period.
I’ll leave the reasons behind the convergence up for debate. However this does have major implications for most value investors. Firstly it emphasises the importance of continuous monitoring of investments to ensure the original investment case remains intact.
Secondly it impacts our valuations. Typical discounted cash flow models would suggest that profits after a specified high growth period will only grow by say, the inflation or the GDP growth rate. Our insight into competitive advantages flips this on its head as it states that after the CAP is over, the firm may grow, but that growth may not increase our valuation of the firm if it returns no more than the cost of capital.
Looking forward to your comments below.
[1] Rajaratnam, M., et al. A novel equity valuation and capital allocation model for use by long-term value-investors. J. Bank Finance (2014), http://dx.doi.org/10.1016/j.jbankfin.2014.02.014
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Keough
:
Are these returns for Coca-Cola Amatil?
Or the Coca-Cola Company? Or Coca-Cola Hellenic?Or Coca-Cola Enterprises?
Andrew Legget
:
I have tried to solve the DCF issue by simply allowing some companies to have terminal growth above that of the economy as a whole in certain situations (or by allowing a form of excess return on equity in the terminal state which is lower than what they would earn in the growth stage but above that of the cost of capital).
I think compeittive advantage and the measuring, predicting and valuing of such items is an area of investment with great opportunity and a challenge i have decided to take on in my spare time (which is not as much as i would like). I am currently trying to undertake (when time permits) various experiments to see what works and what doesn’t. I do feel that there are possible soutions to this puzzle and believe i have some good foundations but it is something i will need further practice and research on to complete. So far some of the output has been pleasing.
For people looking at competitive advantage, my first tip is to first try and define what it is. If you don’t know what you are looking for than it is pretty hard to find it and people can have different ideas as to what a competitive advantage looks like.
I, for instance, don’t believe that all competitive advantages are created equal and that there can be a fine line between competitive advantage and a symptom of that competitive advantage. It is like one of those russian dolls where you keep drilling down and finding another thing to consider inside the first, second etc.
For the most part i find one of the most useful tools is to measure certain performance statistics against the companies peers. There will be times when a company is doing something so much better than competitors that there has to be something in there to explore. So you try to find out what that might be. I am also experimenting with a screening ratio to try and make a generic quantifiable tool to spot these and save time delving too much into a company if you don’t need to. A few other ideas i am working on i believe will help this as well but are much more advanced and need considerable more thought and effort.
Good post Scott, i sometimes think you guys at Montgomery are listening into my thoughts the amount of times i will be thinking about things and then see an article that is similar to my thoughts. Perhaps i should go grab my tin foil hat.
Con Berbatis
:
The percentage returns in your commentary are similar to those reported in the French economist’s T Picketty’s acclaimed book: ‘ Capital in the twenty-first century’ , Cambridge Mass,USA : Harvard University Press, 2014.
Refer to :
Croke C. On the path to inequality. Review in The Weekend Australian April 19 2014: 18-19.