“The key to investing is not to assess how an industry will affect society or how far it will grow, but rather to determine the competitive advantage of a given company and, above all, the sustainability of this advantage.The products or services that are surrounded by wide and enduring moats are those that offer rewards to investors. warren buffet
In the investment world, we hear a lot about investing in companies with a gap or some form of sustainable competitive advantage that is difficult for competitors to overcome.
Why do we hear so much about this concept? A big reason is that Warren Buffett likes to talk about it, so many people have tried to figure out what exactly he means by a gap. After all, there’s really no way to measure the idea: it’s a qualitative metric that’s impossible to assess in most cases.
A moat can be a strong brand – Coca-Cola or Disney, for example – or it can be intellectual property, for example, patented drugs from a pharmaceutical or biotech company.
But maybe we’ve been focusing on the wrong metric all along.
Instead of looking for moats, we should have been looking for market power. In “Mutual funds bet on market power”, Stefan Jaspersen recently explored whether firms 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, more liquidity weak and to be followed by fewer analysts.
In short, they are mainly small and medium-sized companies that operate in small market niches where a few highly specialized companies compete with each other. Since these niche markets are not widely followed by investors, few analysts follow their companies. Therefore, information about what is happening in these markets tends to travel slowly.
All of these factors should allow companies with fewer competitors to achieve higher long-term stock market returns. Yet the study also found that from 1999 to 2017, companies with little market power had virtually identical returns to their peers with high market power. But fund managers who have invested in more powerful companies in the market have outperformed the average actively managed equity fund by 1.56% per year.
How is it possible? The thing is, market power 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 how effectively a company converts its research and development investments into actual sales, for example, tend to invest in a company if its market power is high or rising and to sell if its market power is low or declining.
This is because fund managers invest in companies that operate in less efficient markets with fewer competitors and thus have the ability to gain greater market share and increase their profit margins. And that creates an advantage for the fund manager regardless of fund 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 over the course of their careers to focus less on talk about moats and other arcane, fleeting concepts and instead focus on how close a company is to having a monopoly in its particular niche.
The fewer competitors, the better.
To learn more about Joachim Klement, CFA, do not miss Geo-economics: the interplay between geopolitics, economics and investments, 7 mistakes every investor makes (and how to avoid them)And Risk profiling and toleranceand sign up for her Klement on investment comment.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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