Durable Competitive Advantage

A few days back I mentioned that buying the right company is critical over time if one wants to maximize compounding. So how does one determine which companies are actually the best? Well, the following are what I deem as important aspects of a great business:

1. Generates high return on capital

• Simply stated, return on capital is really the return that the company generates from the amount of capital employed within the business.
• The median 5 year return on capital for members of the S&P 500 is 10.38%. Any company that can significantly exceed this number warrants a very close look.
• Also important is that the company CONSISTENTLY generate high returns on capital. This will tend to weed out those companies in cyclical industries which could have very volatile earnings streams as a result of the type of business they're in.

2. Competitive Advantage?

• One of the keys for a company to generate long-term, market-beating returns is for it to have some sort of DURABLE competitive advantage.
• Warren Buffett, arguably the world's greatest investor, calls the competitive advantage the preverbial "moat" around the business.
• Those companies having some sort of competitive advantage tend to be the ones having the highest returns on capital.
• However, a company having a high return on capital does not necessarily mean that the company has a competitive advantage that is DURABLE.
• The difference between a company having a competitive advantage and a DURABLE competitive advantage is like night and day and is CRITICAL to the success of a company over a long time period.
• For example in the mid-90's INTEL generated consistently strong returns on capital in the 25% to 30% range. However, today those numbers are down to 13%. This an example of a company having its "moat" eroding over time. They had a competitive advantage by being the best and largest manufacturer of microprocessors for personal computers by taking advantage of economies of scale and solid research and development. That competitive advantage, however was not durable....they were susceptible to competitors in their industry and to the qualities of the industry itself.

3. What will the company look like in 10 years?

• To me this is one of the keys to investing success. If the company has a high probability of change due to the type of business, how can one readily gurantee that the high returns on capital generated today will remain in the next 10 years?

4. Once one identifies the high return on capital companies, the work is just beginning. Other considerations:

• High turnover product?
• Free cash flow generator?
• Brand "mindshare"?
• Quality management in place?
• Solid balance sheet?
• Shareholder-friendly?
• High insider ownership?
• Solid market growth prospects?
• Minimal amount of debt employed?
• Free cash flow near to or greater than net income?

And, of course:

• Is the price reasonable?