Before an investor can buy great companies at low prices, she must first understand how to identify a durable competitive advantage. Although a thorough understanding of a business and its customers is necessary to fully vet a competitive advantage, this article focuses on evidence of a durable competitive advantage as it is likely to appear in a company’s operating results.
Dead giveaway
Although many investors search for companies with high margins or efficient working capital management, the two biggest clues that a company has a durable competitive advantage are (1) a high return on capital and (2) stable market share. Both attributes should have been maintained for at least a decade, preferably several decades, for it to be likely that the company has a durable competitive advantage.
Return on capital is the amount of money a company earns for each dollar it invests in the business. So, if a company buys a plant for $10 million and it earns $1 million in profit each year, the company earns a 10% return on capital.
You do not need to be an expert in any field to determine the difference between a high return on capital and a low return on capital. If someone earns a 25% return in the stock market each year for a decade, anyone can recognize that is a high return. A low return is something like a 5% annual return. Businesses are no different than any other investor; they simply aim to invest their money at the highest possible rate of return. A 25% return on capital is high, a 5% is low. Just like in the stock market.
The reason a high return on capital is evidence of a durable competitive advantage is that everyone wants a high return on capital. Everyone wishes that they could earn Buffett’s returns, but they can’t. Village Super Market, Inc. (NASDAQ:VLGEA) wishes it could earn returns on capital as high as The Coca-Cola Company (NYSE:KO), but it is not insulated from competition to the extent The Coca-Cola Company (NYSE:KO) is. If there were a way for Village Super Market, Inc. (NASDAQ:VLGEA) to break into the soft drink business and earn high returns, it would. But it cannot because The Coca-Cola Company (NYSE:KO) has durable competitive advantages that prevent it from doing so.
The second giveaway is stable market share. A company that has stable market share does not necessarily have a durable competitive advantage, but all companies that have durable competitive advantages have stable or growing market share.
Examples
Ford Motor Company (NYSE:F) is an example of a well-known company that does not have a durable competitive advantage. Over the last decade, the company has averaged a return on capital close to 0%. In 2012, its return on capital was 2.5%. In other words, shareholders would have been better off if, instead of investing in new plants and equipment, Ford had simply put all excess cash in 30 year U.S. treasury bonds. Most investors earned a higher return on their capital over the last decade than Ford Motor Company (NYSE:F) did, so it is hard to believe Ford has any semblance of a competitive advantage.
Moreover, Ford Motor Company (NYSE:F)’s market share has dropped precipitously over the last decade; it had close to a 25% share in 2000 and now has a 15% share. A company losing market share is, by definition, without a competitive advantage.
Contrast Ford Motor Company (NYSE:F)’s results with those of Coca-Cola and The Western Union Company (NYSE:WU). For each dollar these companies have invested, they earn about $0.22 in profit. In other words, these companies earn Warren Buffett-like returns on investment. They may not be engaged in the process of buying great companies at low prices, but the businesses they are engaged in allow them to earn the same returns as if they simply handed their money to Buffett to manage.
Meanwhile, The Coca-Cola Company (NYSE:KO) has maintained a 40% share of its market for at least a decade — and that share may grow as PepsiCo diverts more of its attention to its snacks division and less dollars are invested in its carbonated soft drink business.
The Western Union Company (NYSE:WU), too, has maintained its competitive position despite periodic assaults by its smaller rival, MoneyGram. Western Union’s 500,000+ agents is significantly more than MoneyGram has. Agents have a strong incentive to stick with one company because recurring customers expect to be able to send money to the same endpoint each time they use the service. So a Western Union agent would not risk switching over to MoneyGram because he would lose all of the endpoints where MoneyGram and The Western Union Company (NYSE:WU) do not overlap. This results in captive agents, which secures Western Union’s position as the preeminent cash transfer company.
The Coca-Cola Company (NYSE:KO) has enormous brand equity and an unreplicable global distribution network. The Western Union Company (NYSE:WU) has an unmatchable network of agents on the ground in some of the most remote places in the world. These companies will continue to earn outsized profits decades into the future, even as competitors try their best to steal market share. That’s because Coca-Cola and Western Union have durable competitive advantages.
Bottom line
The two dead giveaways of a durable competitive advantage are high returns on capital and stable market share. The Coca-Cola Company (NYSE:KO) and The Western Union Company (NYSE:WU) exhibit these attributes, while Ford Motor Company (NYSE:F) does not. Although a deeper inspection of the businesses is warranted in order to make a final assessment of the durability of a competitive advantage, these two factors are near impossible to maintain without one.
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends The Coca-Cola Company (NYSE:KO), Ford, and The Western Union Company (NYSE:WU). The Motley Fool owns shares of Ford Motor Company (NYSE:F).
The article Two Metrics That Will Boost Your Investment Returns originally appeared on Fool.com.
Ted is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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