How to identify businesses with a competitive advantage?

how-to-identify-businesses-with-a-competitive-advantages

Competitive advantage – We invest in the stock market so that when a share price goes up. And our capita gets appreciated, and make returns. Hence, we get the benefit of investing in the business. But the main problem we face is how to choose a good business. And whenever this is discussed, all big investors suggest their competitive advantages.

What are competitive advantages?

An interesting story of Warren Buffett. When he used to invest earlier, he used to say that he invested in fair companies at wonderful prices. Meaning he used to invest when he used to get discounted prices. And changed his strategy after meeting Charlie Munger. And started investing in wonderful companies at fair value. Warren Buffett invests in those companies that have economic moats, and Competitive advantages. And says a company that has a Competitive advantage, it protects it from new competition. Hence, this way the new competition won’t be able to replicate the same way. And the existing company will see long-term profitability. The company can keep increasing its market share this way. From which you can understand that how these are important for companies.

How to identify competitive advantages?

If the company has given good, and excess returns, and till when they can maintain the excess returns. Then it can give us a hint of a Competitive advantage.

What is Cost of Capital?

Whenever I start a business, it starts giving returns only when I invest in it. Which I bring from different sources. So that it can become profitable, and can give me good returns.

Where will I bring that capital?

I have two ways.

  1. Either I buy debt from a bank or a financial institution.
  2. I give away equity/ownership from the company in return for capital.

Now if I take up debt or a loan from a bank. I would have to pay 7% as interest. But on the equity side The cost of that is a questionable aspect, and can be discussed in detail.

What is the cost of equity?

Investors like us invest and expect a return. And that return depends on many things like the most important being risk.

For Example

When you invest in a small company, your cost of equity is more. Because there is a higher chance of returns. When you invest in a big company, your cost of equity is lower. So the cost of equity is the shareholder’s expected return from his investment in a company.

All factors impacting the cost of equity

The first is Financial leverage, Meaning how much the company has taken debt. As the debt rises so does the cost of equity. Because the company’s obligations rise to pay a fixed interest.

The second is Operating leverage which is the fixed cost. The more fixed cost more is the cost of equity.

The third is Discretionary spending, meaning the products without which people can make do.
For example, if we see pharmaceuticals, jewelry. Out of which pharma business is the one you cannot stay without. Hence is less risky, whereas if you don’t buy jewwlry you can make do for a couple of months. And has more cost of equity due to the higher risk.

The fourth is the Risk-free rate, these are the return rates get if you invest in govt. bonds. So the higher the return rate, the higher the cost of equity. Now, why would you invest in a company that gives you a 7% return? And the govt. bonds have low risk as compared to companies. So the cost of equity rises if the bond rates do.

Now you might have understood the cost of equity, the cost of debt is the interest the companies have to pay. And if I add these two up, it results in the cost of capital.

For example, if the return on capital employed (ROCE) of a company is more than the cost of capital. The business is profitable. So this was the way you can identify competitive advantages through the financials.

Qualitative analysis that leads to competitive advantages

The first is economies of scale.

There is a lot of fixed costs required to set up a business. And crores are deploying to set up a factory, and start productions. The variable cost is lower which is the cost of goods to make the product. So if the fixed cost is higher than the variable cost, It acts as a barrier to entry for new players. Because the one who was able to set up, and has less variable cost can make their products on a lower rate. Due to which these manufacturing companies have an inherent advantage.

The second is the network effect.

Its use is that the more people use it. For example, if we see Zomato, the more the people use it more restaurants get to add, the more business they do. Similarly, Facebook is such a big company due to its network effect.

The third is switching cost

Which is incurred when you switch from a service or product to the other. And in the businesses where switching cost is high. It is difficult for the customers to switch services/brands. For example, if I want to switch from Wipro to another IT services company. The cost would be high. Because I would have to train the people and see to the new software. The higher the switching cost more the competitive advantage.

The fourth is Brands.

We talked about the niche. But there are many companies that operate with negligible differentiation.

how-to-identify-businesses-with-a-competitive-advantages

For example, you want to buy wheat, there are many companies with no such difference in the product. But here branding helps. More the trust you have on the brand, more the retention you will have with the brand. And this branding helps companies to retain their customers.

The fifth is cornered resource.

For example, pharma companies have patents that help them make differentiated products. So an asset that gives an edge, and helps differentiate gives you a competitive advantage.

The sixth is counter positioning or called disruption

For example, a company is running smoothly, and a newcomer enters with product differentiation. After which the existing start to think about whether h should change his business or work the same way he is. So in this many big companies have made mistakes which have hurt them.

Let me explain with the example of Kodak. Kodak was doing well in the camera segment. But new products enter like digital cameras. But kodak does not change its business which disrupted their business the whole camera industry. Due to which the existing companies become irrelevant. Hence you need to see that, how the company you have invested in changes with time. And you should closely monitor disruptions like these in a company you have invested in.

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