RORY SPANGENBERG: Competitive advantage drives value and long-term returns
While competition strategy and competitive advantage have long been popular areas of study for noted academics such as Michael Porter, investors have generally overlooked the importance of a thorough assessment of competitive advantage in fundamental analysis, and have largely neglected to integrate these into robust valuation frameworks.
In their seminal 1961 paper “Dividend Policy, Growth & the Valuation of Shares”, Franco Modigliani and Merton Miller introduced the concept of a competitive advantage period (Cap) — the number of years a company is expected to generate returns on incremental investments that exceed its cost of capital, with economic theory suggesting excess returns would result in competition to drive returns down to the cost of capital over time.
The market does a poor job of pricing Cap, the key driver of long-term value, creating opportunities for investors with an informed and differentiated analysis of the probable Cap as well as the ability to value this appropriately.
Any analysis of competitive advantage should consider industry structure and the competitive landscape a company finds itself in. Industry concentration, relative market share and barriers to entry can contribute meaningfully to competitive advantage as well as its duration.
Other company-specific forms of competitive advantage may come in the form of sustainability practices, a licence, a patent, an established brand, distribution network or scale advantage often built up over decades.
Taking a view on the source, strength, durability and trend in a company’s competitive advantage, as well as the likely rate of change, directly informs the Cap and “fade” rate of returns relative to cost of capital, which can then be integrated into a financial model to inform valuation.
A more explicit approach to the intermediate period of a typical three-stage model, with fade and duration directly informed by competitive advantage, results in a greater sense of tangible value and sensitivity than would otherwise be the case. In this way, the residual value that often resides beyond the initial assessment of the Cap is not lost in a less-nuanced assessment of terminal value.
The implied Cap can also be “backed out” from the current market valuation and be considered in a conceptual framework, relative to a subjective assessment of the likely Cap or to the market and industry peers.
The first, and by some distance the most attractive, of the investment opportunities presented by a fundamentally derived assessment of the Cap, is in high-return businesses whose returns are deemed to be more sustainable than the market expects. A company’s ability to sustain or extend its Cap beyond the market’s expectation results in a higher level of value creation than that implicit in the price, resulting in a higher return to long-term investors with this differentiated view. Good companies not becoming average companies has the added benefit to investors of compounding returns and greatly reduced frictional costs arising from lower transaction activity and potential tax liabilities.
A second type of investment opportunity may arise from a fundamental assessment of the potential Cap for a company, which may be considered a perpetual value destroyer, but through either strategic, cyclical or changing competitive dynamics is able to improve returns and establish a competitive advantage not previously discounted by the market. While the risk proposition here is generally greater, investors can be meaningfully rewarded by changing perceptions and the subsequent rerating of these companies, in addition to the improvement in financial performance.
Often, simply because of the substantial duration mismatch between a company’s Cap and investor’s shorter analysis time frames, much value creation occurs beyond a period over which most investors are able or willing to consider Cap discreetly. By lengthening analysis and investment time frames, more of the value “lost” in the residual can be brought to the fore to be explicitly considered.
The nature of competitive advantage is such that it requires time and an informed but subjective view. Investors thus need to be comfortable with the fact that any quest for accuracy over an extended analysis time frame is futile, and that a probability-weighted, scenario-based investment thesis and valuation is far more realistic and valuable than a point estimate approach, accounting more fully for the potential delta in competitive advantage over time.
Investment outcomes are likely to be greatly enhanced by a more nuanced approach to analysis and valuation, focused on the inherent risk and sensitivity to changes in the strength and duration of competitive advantage and directed at developing a deeper understanding of intrinsic value.
• Spangenberg is chief investment officer and director of global equities at Northstar Asset Management.
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