Cheapest not always best
People often think that the key to success in the stock market lies in buying low and selling high. History has also shown that over time it pays to buy stocks that are low priced relative to equity, earnings and sales.
Mean reversion, which implies that an extreme outcome will most likely be followed normalisation, is a powerful phenomenon in the financial markets. Substantial under or overestimations are frequently followed by more moderate assessments.
However, although companies trading at low multiples deliver more excess return over time, you cannot always optimise your returns by blindly buying the companies that look cheapest on paper. Stocks must be treated like any other product – in order to get value for money, you need to determine both price and quality.
Over time, the share price will to a large extent correlate with developments in the company's earnings. You would therefore think that a positive outlook should mean a correspondingly high price. That is often, but not always, the case.
Analysts and investors have a tendency to use mean reversion as their starting point when trying to predict a company's long-term development. This may seem sensible as profitable companies often attract tough competition, which in turn leads to a drop in returns.
However, since mean reversion does not act as consistently as gravity, individual firms can – with the help of a sustainable competitive advantage – maintain a high return on invested capital over time. This provides the opportunity to invest in structural winners at an acceptable price when the majority of market participants do not believe in the lasting superiority of a company.
This brings us to the crux of the matter, namely, the relatively limited number of sustainable competitive advantages that a company can have.
The most obvious defence against competition is of course to be found in pure monopolies. If authorities award an operating licence to only one TV channel or telephone company, there can be no competition in that particular market. In theory, that one company should therefore be able to deliver high returns. In this case, however, you would need to be on the lookout for price intervention and political changes that could dissolve the monopoly. That is why we as investors are more interested in competitive advantages with a financial basis, which the company itself can maintain over time.
In his book Competition Demystified, Columbia professor Bruce Greenwald divides structural competitive advantages into three main categories: supply-driven advantages (production), demand-driven costs, and economies of scale.
Supply-driven advantages refer to products that others cannot manufacture, or that a company produces at a lower cost. This can be due to a unique resource base – such as DeBeers within diamonds – but is more often due to patent protected technology and production methods, such as in the pharmaceutical industry.
Knowledge and experience can also provide a competitive advantage. When these are developed in step with product volume, the largest companies remain ahead of the competition as they are furthest down the cost curve. One reason why the Danish company, Novo Nordisk, dominates the global market for insulin is because it has built up its knowledge and experience through many years as industry leader.
Demand-driven advantages arise when consumers have a preference for specific products or services either because these have a strong brand name, or due to habit, combined with the fact that it is difficult to substitute or find alternatives to existing solutions.
Cadbury's chocolate, Heinz ketchup and Fairy washing-up liquid are examples of products that consumers stick with out of habit and confidence in the brand name.
In the mobile market, for a long time it was impossible to transfer a telephone number over from one operator to another. Many consumers preferred to pay higher prices than have to go to the trouble of communicating a new telephone number.
The strongest competitive advantages can be found when economies of scale are combined with customer preference. This gives rise to a self-perpetuating cycle whereby large sales volumes push up income which can in turn be used on product development and advertising. The larger the market share of a company relative to its competitors, the greater this advantage becomes.
Let us imagine a market in which the dominant player has a market share of 70%, versus 10% for the second largest player. If the market leader spends 5% of its sales income on marketing to reach the entire customer group, the smaller company would need to spend 35% of its sales to achieve the same result. It is therefore extremely difficult for smaller players to pose any real threat.
Economies of scale can also be found in production, whereby the cost per product becomes lower while the advantage vis-à-vis its competitors grows.
Global companies such as Coca-Cola, Procter & Gamble, Google and Microsoft are examples of the effect that a powerful combination of scale and preference can have.
As value-based investors, we always look for mispriced shares, but this does not mean that we only look for low multiples. Good businesses with a sustainable competitive advantage are worth searching for. If you can buy them at a reasonable price, then you have the foundations in place for a potentially formidable investment.