SOURCE: Disciplined Growth Investors
MINNEAPOLIS, MN--(Marketwired - Jun 26, 2013) -
"If you don't have a competitive advantage, don't compete."
-- Jack Welch
If you want to invest in stocks that could churn out a rising stream of income for years to come, author Frederick Martin of Disciplined Growth Investors suggests you look for companies with a sustainable competitive advantage.
A competitive advantage can help boost a company's intrinsic value because it helps ensure the future growth of the company. Current growth rates alone are not enough to judge a company's long term growth potential, Martin explains in his book, "Benjamin Graham and the Power of Growth Stocks" (McGraw-Hill). "Focusing solely on the prospects for growth while ignoring the quality of the underlying business model can be a dangerous investment proposition."
It's not just the growth itself that determines the value of the stock, but the type of growth that really matters. Without a competitive advantage, there's no assurance that current growth will lead to future profits. As Benjamin Graham wrote in "The Intelligent Investor," "Obvious prospects for physical growth in a business do not translate into obvious profits for investors."
In other words, not all growth is good growth. To prove his point, Graham referred to the airline industry of the 1940s and 1950s as a potent growth industry that routinely yielded disappointing returns for the airlines and their shareholders. In fact, airlines have continued to struggle despite rising demand for air travel. The industry lost nearly $40 billion between 1971 and 2009.
Yet during that same period, one new competitor in the airline industry was able to generate $6.6 billion in PROFIT! Competing in the same industry with the same cost of goods, Southwest Airlines consistently made money while the airline giants teetered from one financial crisis to another. "We can boil down Southwest's superior financial results to one critical difference," writes Martin, "the strength of the business model. Southwest's business model was highly defensible; the others' were not."
A DEFENSIBLE BUSINESS
Martin considers a "defensible business model" to be "the defining characteristic that sets great growth companies apart from the pack."
But what, exactly, is a defensible business model?
It is the moat the company builds around itself to ward off competition and ensure continued viability by relying on any one of a number of sustainable competitive advantages.
"From an investment perspective," explains Martin, "the key characteristic of a company with a defensible business model is that the model enables the company to increase its intrinsic value at a much faster rate than companies with weak business models."
The more solid the sustainability of the business model, the greater the chances the company will continue to grow. Since intrinsic current value is based on future growth, companies with a defensible business model command a premium in the market.
How do you identify companies with a defensible business model? The first step is to look for a sustainable competitive advantage.
SUSTAINABLE COMPETITIVE ADVANTAGE
"At its most rudimentary level, a sustainable competitive advantage is a durable and unique set of capabilities and industry dynamics that give the company a superior chance of winning with customers," explains Martin.
There are several types of competitive advantages, including competitive barriers, operational excellence, return on investment, and tidal waves of opportunity.
Investors sometime confuse competitive advantage with competitive "strategy." Once you recognize the distinction between the two, it will be easier to identify companies with a true sustainable competitive advantage.
"A sustainable competitive advantage is structural in nature," explains Martin. "It is not merely an endless series of tactical moves (such as price discounts or duplicable cost reductions) that allow a company to temporarily stay one step ahead of the competition, nor is it a unique long-term operating strategy. Sustainable competitive advantage is embedded in the underlying business model."
"Competitive strategy," he continues, "is a choice. It speaks to how a company elects to compete in the marketplace. For instance, certain firms in an industry might strive to be the low-cost producer, while others may adopt a strategy geared toward offering premium products and services to a select group of clients. The permutations of competitive strategy are limitless; the expression of competitive advantage is not."
A well-executed competitive strategy may enable a company to seize a competitive advantage where none existed before, but that possibility would be much harder to predict than simply identifying and investing in companies that already have a sustainable competitive advantage.
Look at the leading companies across nearly every sector of the economy and you'll see that they all have a well-established competitive advantage that serves as a barrier to the competition.
Competitive advantages typically take one of two forms, says Martin, "barriers" that keep potential customers out of the market, and "handcuffs" that keep their customers tied to their company.
Here are several indicators of a competitive advantage to consider in identifying promising growth stocks:
- High and stable market share
- Steady market share gains
- Low frequency of exit or entrance of industry competitors
- Persistent pricing power
- Materially higher operating margins than direct competitors
- Loyal customers and low customer churn
- High repeat purchases
- Brand transferability to new categories
- Strong consumer routine or habit
- Long product cycles
- Robust domain expertise
- Proprietary manufacturing or business processes
The next column will identify the hallmarks of operational excellence and the forces behind "tidal waves of opportunity."