“The key to investing is not evaluating how much an industry will impact society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. Products or services that have wide, sustainable moats around them are those that offer rewards for investors.” – Warren Buffett
In the investment world, we hear a lot about investing in companies with a moat, or a form of long-term competitive advantage that is hard for competitors to beat.
Why do we hear so much about this concept? One of the main reasons is that Warren Buffett loves to talk about it, so a lot of people have tried to figure out what exactly he means by a moat. After all, there is no actual way to measure an idea: it is a qualitative measure that is impossible to measure in most cases.
A moat can be a strong brand—Coca-Cola or Disney, for example—or it can be the intellectual property of, say, the patented drugs of a pharmaceutical company or biotech company.
But we may have focused on the wrong scale all along.
Instead of looking for trenches, we should have been looking for market power. In his book Mutual Funds’ Bets on Market Power, Stefan Jaspersen recently explored the question of whether companies whose products have fewer competitors have an advantage. Using a database of product competition among US companies, he showed that companies with less product competition tend to be older, have higher valuations, have lower liquidity, and are followed by fewer analysts.
In short, they are mostly small to medium sized businesses that operate in small markets where a few highly specialized companies compete with each other. Because these niche markets are not widely followed by investors, there are few analysts who keep up with their companies. As a result, news about what is happening in such markets tends to travel slowly.
All of these factors should determine which companies have fewer competitors to obtain higher stock price returns over the long term. However, the study also found that from 1999 to 2017, companies with little market power had practically identical returns to peers with high market power. But fund managers who invested in companies with high market power outperformed the average actively managed equity fund by 1.56% annually.
How is this possible? The trick is that the market force is not stable. The number of competing products changes all the time. Fund managers who are aware of a company’s market power because they monitor competition and the efficiency with which the company converts R&D investments into actual sales, for example, tend to invest in a company if its market power is high or high and sell if its market power is low or declining.
In effect, fund managers invest in companies that operate in less efficient markets with fewer competitors and thus have the potential to gain a larger share of the market and increase their profit margins. This creates an advantage for the fund manager independently of the fund’s style.
And who are these fund managers who take market power into account? On average they are older and more experienced. And I suspect they’ve learned in their careers to focus less on talking about trenches and other vague and ephemeral concepts, and instead on how close the company has come to monopolizing its own niche.
The fewer competitors the better.
For more from Joachim Clement, CFA, don’t miss it Geo-Economics: The interaction between geopolitics, economics, and investmentsAnd 7 mistakes every investor makes (and how to avoid them)And Define risk and toleranceand subscribe to his account Clement on investing comment.
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All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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