We seek to own shares of companies with durable competitive advantage. If maintained, a company should consistently generate cash at a rate in excess of its cost of invested capital, generating economic profits. Competitive advantages ward off continual threats that pressure profitability. Compounding economic profits over time creates wealth. The magnitude of compounding is so surprising that Einstein said that it was the eighth wonder of the world.
What can one expect from long term ownership of this type of company? We evaluated the stock performance of a list1 of companies derived from the Value Line universe of companies between 2003 and 2012 that had an average Return on Equity of 20% or higher and no single year below 15%. Just over 4% of the companies in the universe of over 2600 passed this high standard of economic excellence. Of the group, over 75% of the stocks outperformed the S&P 500 during the entire ten year period. However, these great stocks underperformed quite often (4 out of 10 on average) in any single year. Additionally, about two thirds of the outperformers also experienced at least one consecutive two year period of underperformance. This analysis shows that companies with top tier business performance tend to outperform the broader stock market over long time periods and underperform quite often in any single period of a year or two. The challenge for investors is identifying companies early in the period of posting top tier business performance and determining if stock price underperformance is normal gyrations or a market recognizing a deterioration of competitive advantages.
How do we spot competitive advantage? Our first step is to evaluate the past financial performance of a large number of companies across various industries. A record of good returns on invested capital using low amounts of debt is difficult to accomplish in a competitive landscape. Overwhelmingly, these high returns have been generated by companies using little or no debt and operating in surprisingly straightforward business models. The screening process at Redmond Asset Management searches for similar financial characteristics that identify durable competitive advantages. Our screening process filters out at least 85% of the stocks listed on major U.S. exchanges so that we can target those that meet our standards of economic excellence and possibly become the top tier performers over the next decade.
From this select group we delve deeper into the company’s financial statements and industry dynamics. We assess the likelihood that the attractive returns will continue into the future, at a rate near historical growth or better. Sometimes, we find a company that has a good history but recently stumbled. We assess the likelihood that it regains competitive advantage with improved growth.
Once we identify a company that demonstrates potential to achieve or maintain competitive advantage, we compare the current valuation to our conservative expectations. Using price multiples (price to earnings, sales, cash flow and sometimes book value) as guideposts, we evaluate the possible outcomes and compare the investment attractiveness to our current strategy holdings and determine if it fits in the existing portfolio.
Types of Competitive Advantage:
Cost Advantage – A firm obtains cost advantage when it achieves a lower cumulative cost of performing value activities than its competitors. Starbucks is a firm that uses its efficient distribution network and large size to exert buying power upon its suppliers to sell coffee at low prices. Starbucks has economies of scale. Proprietary institutional learning is another driver of cost advantage. Manufacturers that have figured complex processes and innovative factory layouts over many years of experience are more efficient than competitors. This learned efficiency lowers overall costs. Several other types of cost advantages exist, and are not always apparent or known by the investing public. We use the trail of excess cash as circumstantial evidence.
Differentiation – A firm differentiates itself from its competitors when it provides something unique that is valuable to buyers beyond just offering a low price. There is a constant push for companies to establish and advertise unique qualities of products or services. These qualities range from fast and reliable delivery of service to better engineered or higher purity products. Customers tend to pay more, sometimes lots more, for certain things by brand name (think Tiffany blue), and not for others such as paper plates. A culture of innovation underpins many forms of differentiation. New and better products create increased demand and command higher prices, even in price-sensitive markets. 3M has remained relevant because it has consistently innovated across a wide range of products, including Scotch cellophane in 1930 and more recently a unique mirror film for concentrated solar power. Differentiation leads to superior performance if the price premium paid exceeds any added costs of being unique.
For many commodity-based businesses it is quite difficult, if not impossible, to maintain high profitability – a market must remain “tight” for a meaningful period of time. The airline industry is a good example of what we seek to avoid. It takes a few years to build large airliners, so when capacity is tight like it has been recently, airlines can raise prices and earn higher profits. During this period each airline sees that it can earn even more money if it has more planes. Historically, the industry has misjudged what competitors would do and too many planes were built, creating overcapacity, lower prices, lower profits and even losses. It remains unclear if history will repeat itself within the airline industry.
In the short run, the stock market often pays too much attention (overprices) or substantially not enough (underprices) to durable competitive advantages. However, the market tends to properly price them over the long run. The recent stock market correction has perhaps given too little credence to select companies within the energy, healthcare, and biotechnology sectors, and companies with exposure to China. Recently we have bought or held stocks in these areas with a willingness to possibly underperform in the near term and an expectation to outperform over several years. We continually evaluate the competitive positions of our holdings and make adjustments to compensate for unexpected shifts.
What are durable competitive advantages for a money management firm? First, we believe that our disciplined bottom-up stock picking process results in a differentiated portfolio of companies with attractive business fundamentals. Second, our long term ownership mentality enables us to take advantage of price declines, lowers your transaction costs and capital gains taxes. A third competitive advantage that we would like to recognize is you, the client. Overwhelmingly, our client base has exhibited great patience. The quality of capital that professionals manage is a significant factor that determines success or failure. A client base focused on short-term results will undoubtedly influence decisions focused more towards the present than the future, which corrodes a perfectly sound long-term process. Here, we are fortunate to have a clientele that is focused on the long-term.
As we approach our ten-year anniversary this December, we want thank you for your support over the years. Many of you have been investing with members of our team for much longer and were with us during the financial crisis of 2008. Your patience was a meaningful factor in enabling us to weather the storm and stick to our disciplines. We welcome our newer clients and look forward to earning your trust by weathering future storms with you. Your committed capital and sustained confidence in how we manage your money are among our firm’s most important durable competitive advantages. Thank you for contributing to our past success. We value our partnership with you and your family.
1Cleven, John. “A Fortune article from 1988 is put to the test…in 2013.” Web blog post. CAPS Community. The Motley Fool, May 2013. Accessed October 2015.