Thursday, December 23, 2010

Behind The Competitive Advantage

Companies with strong ROIC and strong ROE numbers may have competitive advantages. On the other hand, there could be many reasons for high returns which could trick the investor into believing a competitive advantage is present. Therefore, it's important for the shareholder to identify the competitive advantage before accepting it as true.

Rising (or falling) commodity prices could make companies which sell (or buy) commodities look like they have an advantage. Temporarily strong markets, or temporary weakness in competitors can also have the same effect. These occurrences will result in elevated returns for extended periods, occasionally for several years. Managements for these companies will of course take credit for such uncontrollable but favourable circumstances, and will claim that the abnormally high returns are due to their effectiveness in securing a competitive advantage for the company. Therefore, the shareholder must investigate the situation and apply his own business sense to determine if the advantage is for real.

Unfortunately, there is no formula one can apply to determine if a competitive advantage exists. Investors must use good judgement, conduct diligent research, and educate themselves by reading the examples of successful investments of the past. Competitive advantages come in all shapes and sizes. For example, Cisco Systems, discussed on the site a few weeks ago, may have an advantage due to its high market share, allowing it to spread its R&D spend over more units, resulting in a quality per cost advantage. Apple (AAPL) may have an advantage in its processes that allow it to consistently innovate and design new products for the consumer.

Philip Fisher's book Common Stocks with Uncommon Profits helps guide the investor in thinking about whether a company in question has a competitive advantage. This is a book that Buffett learned from as well, as he transitioned from Ben Graham stocks to companies with competitive advantages. The book is summarized here.


tscott said...

Do you think Acme has a competitive advantage? It had great returns for 6 years prior to the recession, but will it come back? I feel that a decrease in the unemployment will translate to returned profitability but that could be a number of years away.

Saj Karsan said...

I believe that they do, but I could be wrong.