Most long-term business investors look for high-quality businesses. But what exactly makes a business of high quality? Unfortunately, many investors fail to ask themselves this very simple question. High quality businesses are usually a result of a sustainable competitive advantage. Let’s take a look at a few key competitive advantages. Going through this exercise helps focus investors’ attention on the businesses that are most likely to offer extraordinary long-term opportunities.
People and organizations purchase goods and services for several reasons, primarily for need, convenience, improvement or pleasure. Those purchased for improvement or for pleasure compete not on price, but on value added. However, those purchased for need or convenience typically compete on price. The lowest-cost producer has an immediate advantage over higher-cost competition. This allows the low-cost provider to enjoy higher profit margins and allows it to drop prices and profitably take market share from competitors.
All goods and services are sold and distributed through some identifiable infrastructure. The companies that control these distribution networks can act as toll booths and collect fees whenever goods and services pass through. While pricing in monopolistic infrastructures of basic living needs (water, sewage and electricity) is heavily regulated, pricing is moderately regulated when there are few alternatives (transportation and communications), and lightly regulated when there are many alternatives. The best returns on capital are likely to be found in distribution networks established by demand rather than a lack of alternatives.
The profitability of inventions and innovation depend on the ability to prevent others from copying ideas. This is most clearly evident in health care and technology industries, where many end products are completely dependent upon patent protection. While businesses that depend on patents and technology can have relatively short-lived success, businesses that use patents and technology to add value can enjoy long cycles of success.
Some businesses are monopolistic or oligopolistic. Neither of these, in and of themselves, inherently leads to superior results. It also depends on the nature of the products or service, or the level of regulation. An example of this is in the aforementioned regulated utilities industry. Monopolies and oligopolies can form due to special geographic characteristics that limit availability of goods or services. Again, the best monopolies and oligopolies are those formed by demand because they are more natural, rather than forced, and are less likely to be regulated.
Entire businesses can be built from a collection of data or from someone’s ability to think. While information is becoming more readily available for collection in the information age, intellectual capital (people’s brains) is more difficult to copy. Because data can be reproduced and ideas can be copied, information and intellectual capital is most valuable when it can be controlled or when it is time sensitive. This is evident in the ability of highly skilled managers to collect information, evaluate it, and become the first mover with a new competitive strategy or business model. In select businesses, such as investing, the same intellectual advantage can be applied over and over.
A captive audience is extremely valuable because the cost of gaining someone’s attention is very high and the cost of gaining their business is even higher. Not only is a captive audience expensive to gather, but it is extremely valuable once it is in place. Because so much time, money and energy are spent trying to engage potential customers, businesses with captive audiences enjoy a certain type of leverage. These businesses can instead focus their attention on business improvement and potentially cross-sell new products to their existing captive audiences. A captive audience can be built through successful branding or through some unique physical location or relationship.
Sustainable competitive advantages don’t necessarily exist in a vacuum. Some businesses enjoy more than one of these key advantages. For example, Coca-Cola (NYSE:KO) controls a majority of its distribution infrastructure, operates in a soft drink oligopoly, and has a captive audience. Google (NASDAQ:GOOG) has access to key search technology, operates in a search oligopoly (nearly a demand monopoly), attracts and retains top intellectual capital with its unique corporate culture, and has a captive audience as it offers one of the most frequently used services in the world.
Sustainable competitive advantages can become even more deeply entrenched when combined with other favorable characteristics such as high switching costs, convenience, key relationships, scale, and habit formation through frequently recurring consumption and purchase decisions.
This is just a brief overview, but it is often helpful to revisit the most fundamental elements of investing, especially in the face of uncertain times.
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