SOURCE: Disciplined Growth Investors

Disciplined Growth Investors

July 11, 2013 05:00 ET

Disciplined Growth Investors: Investing in Stocks With a Competitive Barrier

Benjamin Graham and the Power of Growth Stocks: Part 11 in a Series

MINNEAPOLIS, MN--(Marketwired - Jul 11, 2013) - "People who are good at math naturally look for math to explain investment decisions when often the competitive advantage is not revealed by mathematics."
-- Charles Munger

A "competitive barrier" that inhibits new competitors from entering a market can serve as a powerful competitive advantage for the established leaders in that market, according to author Frederick K. Martin of Disciplined Growth Investors. The stronger the barrier, the more promising the company's potential for long-term stock growth.

"At a minimum, effective competitive barriers severely impede a competitor's ability to offer a similar product or service to potential customers," Martin writes in his book, "Benjamin Graham and the Power of Growth Stocks" (McGraw-Hill). "In many cases, these barriers create near monopolies by shutting would-be competitors out of the market altogether."

Warren Buffett has said that the first thing he looks for in a stock is not the earnings report nor the balance sheet, but whether or not the company has a "sustainable competitive advantage."

There are many types of competitive advantages, but competitive barriers can be among the most effective of all. Competitive barriers can be regulatory, asset or scale-based in nature. "Competitive advantage takes one of two forms," explains Martin, "barriers that keep potential competitors out of the market and handcuffs on customers that make them reluctant to switch to an alternative supplier."

In his book, Martin details several of the most common competitive barriers:

Regulatory barriers. Certain laws, regulations or standards created by regulatory bodies can make it very difficult for new competitors to enter a market. The U.S. Food and Drug Administration, for instance, has such stringent requirements for new medications and devices that few start-ups could afford the time and cost to launch a new product. Martin says there are two categories of regulatory barriers: "direct" regulatory barriers, such as intellectual property laws, fees, licensing requirements, and capital requirements, and "indirect" regulatory barriers, such as subsidies, targeted tax breaks and government favoritism. "But regulatory hurdles can also be among the most arbitrary competitive advantages, given that they are dependent on the often fickle and politicized decisions of a small group of regulators," warns Martin. "Investors must be careful to gauge the potential for regulatory barriers to survive changes in political attitudes."

Asset barriers. When a company has sole access or preferred access to proprietary assets, that's considered an asset barrier. Whether it's hard assets, such as diamonds, or intellectual property, such as software code, an upstart competitor would be required to spend considerable time, effort and money to buy their way into the game. "Barriers formed by proprietary intellectual property can come from a variety of sources," says Martin, "including internally developed technology, databases of unique information, cumulative knowledge or learning curve advantages, capital (usually to fund start-up losses), and proprietary processes."

Hard switching costs. What would it cost your company to switch its entire computer network from one operating system to another? The cost of time, equipment and training for a project of that scale could run into the millions of dollars for many corporations. That is why hard switching costs can form a very real competitive barrier. "Measuring the impact on customer captivity from hard switching costs is relatively straightforward," explains Martin. "The more money it costs to switch to a competitive product, the more likely it is that a customer will remain captive."

Soft switching costs. Soft switching costs can refer to barriers little more tangible than basic brand loyalty. But if you've ever tried to persuade a Coke drinker to switch to Pepsi, you should understand the power that a soft switching barrier can sometimes carry. "Even if the hard costs of switching are negligible, the soft switching costs can still provide a barrier that is sufficient to keep customers from fleeing to the competition," says Martin. For instance, banking customers rarely switch checking accounts despite the relatively small price of moving from one bank to another. "The soft switching costs -- the inconvenience of evaluating the alternatives and filling out the necessary paperwork, the hassle of reentering online bill payment information, and other such issues -- tend to far outweigh the perceived benefit of switching for the average account holder," adds Martin. "That is why financial institutions see modest turnover in core checking account customers."

Scale-based barriers. The low-cost producer in a particular market is generally in a strong position to maintain its competitive advantage because of the efficiencies it has developed in purchasing, manufacturing, research and development, sales and marketing, managerial specialization, and financing costs. "Significant scale advantages combined with great execution can present virtually impenetrable barriers to competition," says Martin.

Although a solid competitive barrier is not a lock-tight guarantee of a sustainable competitive advantage, it can represent one important key in identifying stocks with the potential for consistent long-term growth.

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    Evan Almeroth
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