In the sixth of a series on equity investing, Hugh Young explains why long-term competitive advantage is so important when looking for companies in which to invest. Coca-Cola is one of the most famous brands in the world.
It is not just the iconic italicised logo or the clever marketing that promotes the idea of a unique taste that is impossible to recreate, it is the way the brand has become synonymous with everything that is aspirational about the American way of life.
Warren Buffett is such a fan that his Berkshire Hathaway is the Coca-Cola Company’s biggest shareholder, owning almost one out of every 10 shares.
Buffett mythology also has it that the Oracle of Omaha’s favourite tipple is the cherry flavoured version of the fizzy beverage.
Coca-Cola is a classic example of a company that enjoys what Buffett calls an economic ‘moat’.
In the days before the invention of gunpowder, strategic fortifications were often surrounded by a deep ditch filled with water as a defence against attack. These were called moats.
An economic moat is a sustainable competitive advantage that protects a business. This could be in the form of patents and copyrights, a dominant market share, the unique ability to make a product or provide a service at the lowest cost, or high costs for a customer to switch to a rival’s offering.
In the case of Coca-Cola, it is a brand that has been around for so long, is so ubiquitous and is so entrenched in popular culture that a similar product elsewhere will always be regarded as inferior.
Businesses that possess this sort of sustainable competitive advantage are rare because the operative word is ‘sustainable’.
Companies may enjoy a temporary advantage based on, say, a new low-cost manufacturing base but that edge can disappear because it can be easily copied.
More common are entire industries that, for one reason or another, are very difficult for newcomers to break into.
This makes it easier for the incumbents to protect long-term profits and market share.
For example, some industries are highly regulated. Take banking. There are all sorts of obstacles to starting a bank.
Not only do you need licences from one or more regulator, but you also need to build up trust with depositors as well as a network of companies to lend to.
As such, banks tend to produce excess returns on capital, which can often be sustained over the long-term.
That is, assuming they stick to the simple business of lending and deposit-taking.
Some industries enjoy the protection of more than one economic moat.
Aircraft engine-maker Rolls-Royce’s multi-billion dollar research and development programme created a proprietary fan blade design that offers a significant improvement in weight and resistance to damage.
Investors still need to be wary because what may appear to be a long-term competitive advantage can often turn out to be nothing but a mirage.
Yet, in many ways, the financial clout and intellectual capability to create cutting edge technology does not represent the company’s biggest economic moat.
When choosing something as ‘mission critical’ as an aircraft engine, it is hard to argue against a record of reliability that was first established a century ago during the First World War.
This level of trust in a product is hard to erode and makes it almost impossible for a new competitor to challenge.
There are other industries in which market dominance is the primary economic moat. For example, big supermarket chains rely on economies of scale to build large distribution networks and negotiate better prices from suppliers that allow them to offer consistently lower prices.
Other industries make products that are hard to replace. Surgeons taught to work with a specific brand of artificial joint will be reluctant to undergo the retraining needed to embrace an alternative device by a rival manufacturer.
Some analysts now provide an economic moat rating for companies as part of their stock recommendation.
However, investors still need to be wary because what may appear to be a long-term competitive advantage can often turn out to be nothing but a mirage.
Remember how a Finnish company called Nokia once dominated the market for mobile phone handsets before a small Canadian outfit called Research in Motion came out of nowhere and introduced the world to the BlackBerry?
And yet how many of us own either one today?
Like a certain popular brand of cola, make sure you choose ‘the real thing’.
Hugh Young is the managing director of Aberdeen Asset Management.
