Monday, April 4, 2011

Competitive Advantage

This week I would like to cover what I consider to be one of the more important aspects that a value investor considers when examining firms to be purchased.  But I would like to start it by posing a question I will answer later in the blog:  What do Coca Cola and Kraft Foods have in common that Delta Airlines does not?

When we consider attractively priced firms, we look at both the balance sheet to determine the margin of safety and the income statement and statement of cash flows to determine incoming cash.  You can look at the balance sheet like our castle that will protect us from enemies (other firms) and bad weather (averse economic conditions).  A well capitalized firm will show strong current assets well above current liabilities on their balance sheet.  And then we can look at the cash flows to equity as the strength of our army which can go out, conquer, and bring back resources to our castle.  The condition of both our firm's financial strength as determined by the balance sheet and the condition of the firm's inflowing cash as determined by the statement of cash flows are critical measurements in security analysis.

Yet, there is an additional protection that is not so obvious by just looking at a balance sheet.  You could look at this additional protection as our castle's moat.  What does the firm have that prevents enemies from even reaching the gate of the castle?  To translate this back from our overdrawn metaphor, this is the competitive advantage that our prospective firm has.  A firm can have a competitive advantage for any number of reasons.  Let me go back to my first question.

What do Coca Cola and Kraft Foods have in common that Delta Airlines does not have?  They first two are both protected by a strong moat, while Delta Airlines is not.  But what makes up a competitive advantage?

When you pick a company that you are interested in investing in, ask yourself whether it would be possible to start your own similar company.  If you discover that it is actually quite easy to start a similar firm, then the company does not have a moat.  This is known as the threat of new entrants and it is a very important consideration.  The best investment is a monopoly that can set their price how they please.  Monopolies are not necessarily great for the economy in general, but for the owners of the monopoly, profits are consistent and likely to grow.  Kraft and Coca Cola, while not monopolies, enjoy something that could only be described as monopoly-like.  Starting a soda company is well known to be a horrendous endeavor.  Richard Branson's Virgin Cola failed miserably, despite him being a truly talented entrepreneur.  Food companies like Kraft enjoy a tremendous advantage in the very high level of mass production they are able to gain.  This is known as an economy of scale, which is another potential moat for a company.

Delta Airlines, on the other hand, has no moat.  Airlines can be started relatively easily.  Whether or not they will be profitable has less to do with the scope of their operations, and so existing firms have very little protection from a more efficient, upstart competitor.  An airplane can be leased, filled, and flown.  Branson did precisely that and has made a tremendous success of Virgin Atlantic at the expense of British Airways.  There are indeed hurdles to starting any business, and the more hurdles there are, the better!

It is very important to get good at identifying competitive advantages in firms.  A common effect will be steadily increasing profits (which you should be able to confirm over the prior 10 years of financial statements) as firms with competitive advantage usually can move their prices around instead of having to respond to their competitors oscillations.  It is especially important because there is no number, no quantifiable piece of data that will tell you what this competitive advantage is.  It requires a hands on approach and a keen eye for business.  To me, business and investing are interchangeable terms.

So, exercise for today:  Spend some time considering some products, especially ones with very few competitors, and ones that you probably couldn't do without.  If it isn't obvious, find out which companies sell these products and write down the names on a list along with their ticker symbol.

Then, go to Google Finance, click on Portfolios, and add these stocks to your portfolio.  This list can be the basis for which stocks you are interested in purchasing.  You can watch as their prices oscillate up and down, and when one of them becomes a truly attractive purchase, it is time to explore more to see if it is a potentially great opportunity.  I will discuss financial statements next week so you can see what exactly I'm getting at, and hopefully the picture should be clearer at that point.

But get your list together!  If you're not sure whether the stocks you like have a moat, talk about them in the comments section and we can come to a conclusion together.

More value investing to come next week!

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