Two Metrics That Will Boost Your Investment Returns
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Warren Buffett made the bulk of his fortune by paying low prices for companies with durable competitive advantages. Though he is universally considered to be one of the greatest investors of all time, few investors follow in his footsteps by purchasing great businesses at low prices. The allure of popular companies like Apple, Tesla, and Lululemon distract investors from the opportunities where money is really made. If, instead of buying the hot stocks of the day, investors focused on buying companies with durable competitive advantages, their returns would look a lot more like Buffett's.
Before an investor can buy great companies at low prices, she must first understand how to identify a durable competitive advantage. Although a thorough understanding of a business and its customers is necessary to fully vet a competitive advantage, this article focuses on evidence of a durable competitive advantage as it is likely to appear in a company's operating results.
Although many investors search for companies with high margins or efficient working capital management, the two biggest clues that a company has a durable competitive advantage are (1) a high return on capital and (2) stable market share. Both attributes should have been maintained for at least a decade, preferably several decades, for it to be likely that the company has a durable competitive advantage.
Return on capital is the amount of money a company earns for each dollar it invests in the business. So, if a company buys a plant for $10 million and it earns $1 million in profit each year, the company earns a 10% return on capital.
You do not need to be an expert in any field to determine the difference between a high return on capital and a low return on capital. If someone earns a 25% return in the stock market each year for a decade, anyone can recognize that is a high return. A low return is something like a 5% annual return. Businesses are no different than any other investor; they simply aim to invest their money at the highest possible rate of return. A 25% return on capital is high, a 5% is low. Just like in the stock market.
The reason a high return on capital is evidence of a durable competitive advantage is that everyone wants a high return on capital. Everyone wishes that they could earn Buffett's returns, but they can't. Village Super Market wishes it could earn returns on capital as high as Coca-Cola (NYSE: KO), but it is not insulated from competition to the extent Coca-Cola is. If there were a way for Village to break into the soft drink business and earn high returns, it would. But it cannot because Coca-Cola has durable competitive advantages that prevent it from doing so.
The second giveaway is stable market share. A company that has stable market share does not necessarily have a durable competitive advantage, but all companies that have durable competitive advantages have stable or growing market share.
Ford (NYSE: F) is an example of a well-known company that does not have a durable competitive advantage. Over the last decade, the company has averaged a return on capital close to 0%. In 2012, its return on capital was 2.5%. In other words, shareholders would have been better off if, instead of investing in new plants and equipment, Ford had simply put all excess cash in 30 year U.S. treasury bonds. Most investors earned a higher return on their capital over the last decade than Ford did, so it is hard to believe Ford has any semblance of a competitive advantage.
Moreover, Ford's market share has dropped precipitously over the last decade; it had close to a 25% share in 2000 and now has a 15% share. A company losing market share is, by definition, without a competitive advantage.
Contrast Ford's results with those of Coca-Cola and Western Union (NYSE: WU). For each dollar these companies have invested, they earn about $0.22 in profit. In other words, these companies earn Warren Buffett-like returns on investment. They may not be engaged in the process of buying great companies at low prices, but the businesses they are engaged in allow them to earn the same returns as if they simply handed their money to Buffett to manage.
Meanwhile, Coca-Cola has maintained a 40% share of its market for at least a decade -- and that share may grow as PepsiCo diverts more of its attention to its snacks division and less dollars are invested in its carbonated soft drink business.
Western Union, too, has maintained its competitive position despite periodic assaults by its smaller rival, MoneyGram. Western Union's 500,000+ agents is significantly more than MoneyGram has. Agents have a strong incentive to stick with one company because recurring customers expect to be able to send money to the same endpoint each time they use the service. So a Western Union agent would not risk switching over to MoneyGram because he would lose all of the endpoints where MoneyGram and Western Union do not overlap. This results in captive agents, which secures Western Union's position as the preeminent cash transfer company.
Coca-Cola has enormous brand equity and an unreplicable global distribution network. Western Union has an unmatchable network of agents on the ground in some of the most remote places in the world. These companies will continue to earn outsized profits decades into the future, even as competitors try their best to steal market share. That's because Coca-Cola and Western Union have durable competitive advantages.
The two dead giveaways of a durable competitive advantage are high returns on capital and stable market share. Coca-Cola and Western Union exhibit these attributes, while Ford does not. Although a deeper inspection of the businesses is warranted in order to make a final assessment of the durability of a competitive advantage, these two factors are near impossible to maintain without one.
Coca-Cola's wide moat has helped provide its shareholders with superior gains in the past, but the company faces some new threats to its continued market dominance. The Motley Fool recently compiled a premium research report containing everything you need to know about Coca-Cola. If you own or are considering owning shares in the company, you’ll want to click here now and get started!
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola, Ford, and Western Union. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!