Choosing the businesses with strong economics- Part 2: finding durable competitive advantaged businesses

October 30th, 2008

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Today, we will continue from our previous article, Choosing the businesses with strong economics- Part 1: avoiding poor economics businesses. After learning what type of businesses to avoid, you will now learn which type of businesses that makes ideal investment candidates.

The legendary investor, Warren Buffett favours businesses with durable competitive advantage. As The New Buffettology, explains, a business with

… durable competitive advantage typically sells a brand-name product or service that holds a privileged position in the stream of commerce that allows it to price its product or service as if it faces little or not competition, creating a kind of monopoly. If you want this particular product or service, you have to purchase it from one company and on one else. This gives the company the freedom to raise prices and produce higher earnings. These companies also have the greatest potential for long-term economic growth. They have fewer ups and downs and they posses the wherewithal to weather the storms that a short sighted market will overreact to.

As we mentioned before in Two uncertainties of valuing a business- risk & earnings,

To be a successful investor, you will do better to avoid businesses that you find difficult to come up with accurate earnings estimates.

Therefore, businesses with durable competitive advantage are the ones that can be valued more accurately.

Before we go elaborate on durable competitive advantage, we need to devote a paragraph to explain how businesses make money. Businesses become successful in two ways: (1) having the highest profit margins and/or (2) selling the highest volume of goods/services. Ideally, the businesses that you invest in have both characteristics. If not, either one of them will do. But avoid those that have neither.

Businesses with durable competitive advantage are most likely to be the ones with high profit margins and inventory turnover. They have:

  1. Competitive advantage– they are the only ones producing a unique products/services. This means that unlike price-competitive businesses, price is not the most important consideration of their customers.
  2. Durable– Not only must they just have a competitive advantage, that advantage must be durable as well. That means they must be able to keep that advantage in the long term without needing to expend great amount of capital and energy to maintain it.

There are some businesses that have competitive advantage that are not durable. Consequently, vast sums of shareholder wealth have to be expended to maintain it instead of returning them back to the shareholders. Intel is an example of such business. No doubt it has a competitive advantage and a monopoly on computer chips in the market. But it has to spend billions of dollars in research and development and come up with new products continuously to maintain that monopoly.

In the next article, we will discuss how do we go in for the kill to invest in our chosen business.

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