Opinion | Why understanding competitive advantage is essential to successful investing

Saurabh Mukherjea

Most well-run companies in the BSE500 earn a return on capital in excess of their cost suggesting that these companies have some sort of competitive advantage. But what investors need to know is whether the said company's competitive advantage will endure. More importantly, would the return on the incremental capital that the company would invest over the next 10 years be higher than the return on capital employed (ROCE) clocked by the company over the previous decade?

Here are three books that shed light on this important subject.

Understanding Michael Porter: the Essential Guide to Competition and Strategy by Joan Magretta

The book discusses three useful mental models  — uniqueness, quantification of competitive advantage and looking beyond the received wisdom on growth and scale.

Magretta says that one should not look for companies trying to be the best or the largest. Instead, look out for companies that are unique and are focused on staying unique. Being the best or trying to become the best does not lead to a ROCE greater than the Weighted Average Cost of Capital (WACC). Sustained uniqueness, on the other hand, does. She says that one should stay away from companies that are trying to be all things to all people; they rarely sustain a ROCE greater than the WACC.

She says that the prices charged by a firm tell you a lot about the firm's offering. Specifically, if a firm is being able to charge premium prices for long periods of time and retain market share, then this has to be underpinned by a distinctive/unique product. One should not look at costs in isolation, because it is relative costs that matter.

The Harvard Business School associate goes on to say that a company's competitive advantage can thus be quantified: if Firm A's ROCE is five percentage points higher than Firm B, then how much of that is because of higher prices and how much is because of lower costs?

The author says that one must not assume that high-growth industries will be attractive to invest in. Growth is not a guarantee of profitability and often puts suppliers in the driving seat — this, when combined with low entry barriers, might attract new rivals.

Magretta also says that the importance of scale must not be overplayed.

Competition Demystified: A Radically Simplified Approach to Business Strategy by Bruce Greenwald and Judd Kahn

In this provocative book, the authors argue that there is only one essential factor in determining competitive advantage — how easy it is for competitors to enter or expand in a specific market. If a company can erect strong barriers to entry through customer captivity, lower production costs, or economies of scale, it can manage these advantages, anticipate competitors' strategies, or achieve stability through bargaining/cooperation.

The authors discuss ways to gain protected positions from which businesses can be run badly but still earn a ROCE significantly higher than the WACC. Here, investors are advised to look for small/local/niche markets without existing competitors.

Greenwald and Kahn place emphasis on supply-related advantages (based on patents, experience, know-how) or advantages related to customer captivity (underpinned by switching costs, search costs, habit), rather than obsessing about demand. They also argue that branding or product differentiation or operational efficiency is not a barrier to entry since this can be copied by competitors.

The authors show that efficiency matters in industries (such as steel, telecom, textiles, etc.) where no company has a competitive advantage. In such industries, the ROCE will often be below the WACC for most, barring the most efficient firm. The best — perhaps the only — time to invest in such sectors is when capacity is shut down thus allowing the most efficient company to enjoy higher ROCEs for a while.

Greenwald and Kahn also show that economies of scale by itself is not a competitive advantage. For scale economies to matter, incumbents must have privileged access to customers, and this involves customer captivity in some shape or form.

Inside the Investments of Warren Buffett: Twenty Cases by Yefei Lu

This book gives access to the financial statements that Warren Buffett would have analysed real time (30 to 50 years ago) before he pulled the trigger on his most successful investments. Two case studies stand out — American Express and GEICO.

In the early 1960s, the credit card was only beginning to take off, courtesy American Express (Amex). However, Amex's mainstay at that point was traveller's cheques. Amex was a well-run firm when disaster hit in 1963 — a subsidiary that earned fees by inspecting warehouses and then issuing warehouse receipts was hit by fraud.

This Amex sub had issued receipts for what it thought was tankers full of salad oil. Instead, these tankers were full of sea water. The banks which had lent money against the warehouse receipts threatened to sue and the word on the Street was that the banks' claims would be around $150 million (in comparison, Amex's net worth was only $78 million). Amex's share price fell from $60 to $35 by early 1964 when Buffett stepped into buy a stake in the firm at around $40 per share (implying a forward price-earnings multiple of 20 times).

Buffett was willing to pay a fair market multiple because his discussions with Amex users (restaurant owners and diners, SMEs in Omaha) told him that the Amex brand had not been dented by the salad oil debacle. In fact, the network effects underpinning Amex (more people wanted to use it if more vendors accepted Amex cards and vice versa) were getting stronger by the year.

Furthermore, in Amex's balance sheet he saw something that would later define his career — there was a time lag between the date on which customers gave money (in lieu of traveller's cheques) and when this money was withdrawn. In between these two dates, Amex could earn an interest of $4-5 million per annum on this "float". Hence if the brand was not damaged then both the fees from issuing traveller's cheques and the revenue from the float would sustain. That in turn would put Amex on a forward P/E of 11.5 times. This insight/conviction underpinned Buffett's investment in Amex.

GEICO was an auto insurer that specialised in insuring government employees who were inherently a low-risk group. However, unbridled expansion across the United States meant that GEICO had ended up writing insurance in several states where the state had capped the premiums at a low level. This had triggered underwriting losses and in 1976, GEICO found itself on the verge of bankruptcy and running out of cash. Its share price had dropped from a high of $61 to $2 by 1976.

By that time, Buffett had been following GEICO for 25 years and he understood three things about GEICO that nobody else did: One, the customer base was inherently low-risk and was not the source of the problem; two, since GEICO sold directly to the customer, rather than through agents, it had a structural cost advantage; and, three, the "float" was massive — because for every 100 people who paid insurance premiums each year, only a third made a claim in that year (implying that if the firm could be stabilised, it would have surplus cash on which it could make an investment return. In fact, GEICO's three advantages were inherently linked to each other and that insight convinced Buffett to recapitalise GEICO  when the rest of the market had given up on it.

Investment lessons learnt

Had I understood this framework properly 10 years ago, I would have avoided investing in Bharti Airtel in 2009 when it was apparent that it was heading into markets where it had little or no competitive advantage. I would also have avoided buying Tata Motors five years ago just because it screened well on the ROCE as I would have understood that, sooner rather than later, the challenge of having to compete with BMW and Mercedes would drag the ROCE of this firm down.

Looking forward, a clearer assessment of competitive advantage will help me stay away from most housing finance companies as it appears that almost none of them have any pricing power or a unique access to raw material/funds even as regulation makes it easier for customers to switch their mortgage provider. I will also stay away from large asset management companies whose funds struggle to beat the benchmark index.

Brand is not a competitive advantage if your product is expensive and does not deliver performance.

In contrast, Indian life insurers seem to have significantly higher competitive advantages — distribution through captive bank branches, opacity around pricing/performance of the product, high costs for the consumer of switching from one insurer to another and significant regulatory barriers to entry.

I am also enthused by an emerging group of small cap industrial companies who make unique products in the B2B context (products where they have a technological edge) and have long-standing relationships with large customers like Dr Reddy's, Cipla, UPL, etc. who are locked into these smaller suppliers.

(Saurabh Mukherjea is founder, Marcellus Investment Managers and an author. Views expressed are personal)