Return on Invested Capital: Part Three – Competition & Competitive Advantage

In capitalism, competition is unrelenting. I don’t intend that as a generic statement of economic theory. It is a reality of an ecosystem in which entrepreneurs naturally gravitate to open niches, seeking to exploit profit opportunities, and in which established competitors attempt to suffocate upstarts that threaten their market share.

While unrelenting, competition is never perfectly efficient. Profit opportunities will always exist (and at times the window can be quite large), but as the opportunity becomes more publicized and better understood, strong competitors move in, the rules of the particular market become established, and a sort of homeostasis sets in. The profit potential either decreases (e.g., price wars deflate margins and force out the less efficient players) or certain actors establish competitive advantages that protect their market share and rates of profit.

It is truly Darwinian, and it is the environment in which a high-ROIC business must compete and try to continue producing the earnings that made it such a high-ROIC company to begin with.

So, the investor must ask himself: how sustainable is this company’s earnings? I find that companies popping up on my high-ROIC radar tend to have one of the following three characteristics:

Characteristic One: Durable Competitive Advantage

This is the gold standard. When you find a business with an ability to grow earnings at a high rate of ROIC, while simultaneously fending off the competition, you have a bona fide compounding machine. And if the price is right, back in the truck and load up.

Here is a shortlist of competitive advantages (ideally, the company has multiple combinations of these): strong brand equity, high product quality, pricing efficiency, corporate culture, customer loyalty, network dominance, control of distribution channels, patent rights, etc…these are all examples of very identifiable moats behind which businesses can make it exceedingly difficult for competitors to steal market share.

It is rare, however, to find such high quality businesses on sale. But it does happen from time to time when either the company has a fixable slip-up that causes earnings to fall temporarily, or the market fails to understand some part of the company’s business and punishes the stock price, or the larger market is subject to panic selling and equities take a hit irrespective of their quality.

Sir John Templeton loved to buy in the last of those circumstances. The time to buy, he was known to say, is when there is blood in the streets. He would research companies, identify the price at which they would be a compelling value, and place standing orders with his broker to make a purchase if the stock ever hit that point. He put it on cruise control. Sublime!

While I think an investor could build an impressive portfolio over time by waiting for these opportunities, the following sorts of high-ROIC companies can offer better returns and offer it more quickly…but not without challenges.

Characteristic Two:  Good-But-Not-Great Advantage

The measure here is whether there is sufficient advantage to keep the bigger dogs at bay long enough to string together multiple periods of increasing earnings on a low base of capital. If it can hold out long enough, the markets will get excited by the business performance, and its price will rise.

Let’s be clear, these are not Berkshire-Hathaway businesses.

For a business to enter Warren Buffett’s circle of competence, he must believe he understands what the economics of the business will look like a generation or more into the future. I won’t take umbrage with Buffett’s philosophy (who can?), but I understand that he has an image to protect: Berkshire as the retirement home for all the best cash-generating businesses.  Active trading would not help this image. And so while he almost always buys at great values, he often sticks with stocks that he knows are astronomically overpriced. (See KO in early 1998.)

The rest of the value investing world has slightly lower standards (and considerably less new cash flowing in each year that we must put to work in some way, shape, or form). While I don’t recommend short-term trading, our time horizons can be considerably shorter than “forever.”

When assessing a high-ROIC company, I want to feel confident that I understand its competitive position (or, to be more precise, its ability to generate a certain level of earnings) over the next few years. And I want to feel confident even after making excessively conservative estimates about the company’s future.

Make no mistakes, this is tricky and can involve a tremendous amount of work. You must consider the company’s ability to increase its revenue, manage its cost of sales, control its expense structure, hold-off competitors, protect its capital, and make shareholder friendly decisions.  

To invest in these sorts of opportunities, I want to see a reasonable (better yet, conservative) path to a minimum 15% compounding returns, and I want to produce a strong argument that the downside potential is limited. I see plenty of businesses that look exciting when you play with their earnings potential, fantasizing about the possibility of high multiples and excellent investment returns. But for the vast, vast majority, it’s too hard to see their competitive advantage. So I bail out. I’ll trade plenty of upside potential to protect against downside risk that I can’t understand or handicap.

I’ve borrowed no small part of the philosophy from Joel Greenblatt. I mention that as segue to the following (known to be one of his favorite investment warnings):

“Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”

Characteristic Three: Flash in the Pan

Plenty of companies can show up on high-ROIC screens that are flashes in the pan. They will show the ROIC but it’s an illusion brought on by unsustainable, one-time earnings growth or by a temporary reduction in costs or expenses or by a change in their capital structure.

Either way, you should catch these by looking at multi-year ROIC records and by digging deeper with your analysis to understand what the company’s true competitive advantages are.

Last thoughts on ROIC before returning to Overstock.com:

To paraphrase Joseph Heller, just because you’re paranoid doesn’t mean you shouldn’t be. Be assured that other companies will gun for the low-investment, high-return opportunity your idea represents. Those competitive pressures are unrelenting without some sort of moat. If you don’t understand how your company can protect its earnings for at least a few years, just turn around and walk away.