No competitive advantage – now what?

No competitive advantage – now what?

For a firm to grow in value, it must earn returns in excess of its cost of capital. Typically we expect that firms will achieve this by developing a competitive advantage difficult to replicate by competitors and exploiting said advantage for all it’s worth. But what if the firm has no competitive advantage?

This is largely the case for most businesses that operate in competitive commoditised markets. Returns may not necessarily be stable year to year but over time, should approximate an industry’s cost of capital (which will be a function of risk).

Economic profits (defined as returns above the cost of capital) can still be earned under these rather depressing set of market dynamics. Typically this is achieved by investment in operational efficiencies that lowers production costs and as a result widens the gap between marginal revenues and marginal costs. It’s still a requirement that competing firms are unable to replicate these efficiencies or else economic profits will not persist for long.

If pulled off successfully, not only will the firm’s shareholder enjoy economic profits, but also a sizeable barrier to entry where new entrants with higher marginal production costs will either have to tolerate below average returns or leave the market.

So how can we apply this theory to finding great investments or avoiding potential disasters?

CSL Limited (ASX: CSL) is a firm we have owned since shortly after The Montgomery Fund’s inception in 2012. CSL develops and produces biopharmaceutical products derived from blood plasma, a derivative of blood donations collected from human donors. These products are used to treat chronic medical conditions such as haemophilia and immune deficiency syndrome.

One of CSL’s drivers is its production scale. This was generated through many hundreds of millions of investment dollars over many years. Whilst competing firms can produce similar derivatives, they tend to do so at higher costs. Combined with an oligopolistic market, high barriers to entry and intellectual property, the firm’s returns on capital (circa 20 per cent) have been well above cost for many years.

On the flip side of the coin, the mining boom through circa 2007 to 2012 delivered large returns for incumbents who had invested in relatively efficient operations (such as BHP Billiton Limited). However, as iron ore prices fell over the following years those returns have waned and firms with a higher cost of production have almost been driven out of business (some completely).

The market tends to have an obsession with the daily ups and downs of share prices, of which we’d say is akin to obsessing over coin flips (or betting your hard earned savings on a spin at the roulette wheel). In our view, a detailed analysis of the above yields better investment decisions and hence better returns over the long term.

As a bonus, market turmoil presents opportunity rather than cause for stress.

Scott Shuttleworth is an analyst at Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.