The Sage of Omaha has emphasised time
and again to only invest in companies that has a durable competitive
advantage. The phrase “durability” can be subjective so to clear
the air, a durable competitive advantage is an advantage that should
at least last decades, if not indefinitely, not one that will last a
couple of years or less. Companies that have short-term competitive
advantages may do well for a year or two but without durability, any
success will be short-lived. Beside Mr Buffet's sublime investment
reputation, 3 key reasons come to mind on why we should heed his
advise:
- It's hard to predict how long a company with a non-durable competitive advantage can milk her cash cow before the curtain falls. If you buy such a share, you may well make a quick buck. However, it's very likely that you will sell too early or too late and not optimise your profit. The more you repeat the cycle, the higher the loss in profits.
- Many cases, such companies may not even have enough time to translate their competitive advantage into profit before being ousted by competitors. If the share is not sold by that time, whatever paper profits you may have made can easily turn into losses.
- Due to the nature of companies without a durable competitive advantage, their shares should naturally be sold before the competitive advantage is lost. After selling, you will have to search for new berths to park your funds. In other words, you have to repeatedly look for short to mid-term investments. Buying and selling of shares involves brokerage fees, which does not amount to much for small volume transactions but will mount up quite fast if you carry out a hundred or more transactions every year. More importantly, sniffing out a good share is a time-consuming process.
Isn't it simply better to search for a
company which you can invest indefinitely? How do we find these gems?
One of the key signs to spotting a company that has a durable
competitive advantage is extremely intuitive - a strong branding.
Such companies tend to be one of the market leaders in their industry
if not the market leader. Consumer brands, such as Coke and
McDonald's, are well-known to most people on the planet and evidently
possesses a very durable competitive advantage. Even billionaires
would not think to start a business competing against these
behemoths.
Non-consumer brands may not be as
well-known to the general public but can be easily identified by
people in the industry. Just ask any industry person to name the top
companies in their sector and the names will generally gravitate
towards the same few. Employees of shipping companies will not miss
out Maersk or Hapag-Lloyd.
Patents, government regulations or even
long-term contracts can also bestow upon a company a durable
competitive edge. Pfizer's patents in relation to Viagra allowed it
to monopolise and dominate the male sexual dysfunction market.
Similarly, China's protectionist measures enabled Baidu to become the
top search engine in China. The growth of Singtel into Southeast Asia's top telco also did not come about by chance. Singtel
monopolised the Singapore market until 1997, before the local
telecommunications sector was liberalised. By that time, Singtel has
flourished enough to acquire stakes in other telco companies around
the region.
Quantitatively, a company with a
durable competitive advantage should have one of the largest slice of
the market. Its operating margin (operating margin is the revenue
remaining after paying all operating expenses, expressed as a
percentage) will be higher than its corresponding industry's average.
Such companies tend to invest a minimal amount into research and
development, and as a result, are likely to have a relatively higher
cash flow. A high cash flow translates to a high chance of dividends.
And dividends are great for value investors as that is essentially
how we get money back from our investment!
