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The Aura Of A Sustainable Competitive Advantage

moat and castleThe widely-recognized value investor, Warren Buffett, loves putting his money in companies that have something called a “sustainable competitive advantage”.

In a December 1999 issue of Fortune Magazine, he mentioned the following (emphasis added): “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

How apt that our reader, Ivan Looi, asked in our Facebook page how to know if a competitive advantage is sustainable and how to identify a widening moat around a particular company.

Different Types of Moats

Pat Dorsey, the author of The Five Rules for Successful Stock Investing, mentioned in his book that a moat or competitive advantage can come about due to:

  1. Real product differentiation through superior technology or features
  2. Perceived production differentiation through a trusted brand or reputation
  3. Being a low-cost producer
  4. Locking in customers by creating high switching costs
  5. Locking out competitors by creating high barriers to entry or success

In Singapore, companies such as Raffles Medical Group Limited (SGX: R01), Keppel Corporation Limited (SGX: BN4) and Silverlake Axis Limited (SGX: 5CP) exhibit one or more of the competitive-advantage pointers.

Raffles Medical has a trusted brand with a huge network of clinics, hospitals, surgical centres, specialty units and medical laboratories around the island. It takes time to build a reliable reputation.  

Keppel Corporation locks out competitors in the industry by creating high barriers to entry. It can take a a load of cash and a lot of sweat to compete with the conglomerate.

Silverlake, on the other hand, locks in customers by creating high switching costs. Banks using Silverlake’s proprietary software packages may be unlikely to switch as the training costs and new software and installation costs to implement new software may be unattractive.

Sleuthing the Company

To know if a competitive advantage is sustainable, investors have to firstly identify what the moat is and then look at what the company is doing to widen its moat.

Is the company just resting on its laurels or is it constantly trying to find ways to grow itself? A company’s annual reports, regulatory announcements and general news could provide invaluable clues.

If the company is widening its moat, it should show up in the financial ratios. For instance, the net profit margin and the return on equity (ROE) – provided the company has low debt – should rise over time. The company should also be generating lots of free cash flow year after year.

Here is a snapshot of the three companies’ net margins and Return on Equity.

2008 2012
Company Net Profit Margin ROE Net Profit Margin ROE
Raffles Medical 15.7% 14.2% 18.2% 14.6%
Keppel Corp 9.3% 23.9% 16.0% 24.2%
Silverlake 34.8% 11.3% 49.2% 33.3%

It would seem that their moats have widened given the expanding margins and growing Return on Equity. Silverlake stands out with its very wide margins and ROE.

Foolish Takeaway

Let me sign off with another of the Sage of Omaha’s wise words, as articulated during the 1995 Annual General Meeting of Berkshire Hathaway (emphasis added) –

“Wonderful castles, surrounded by deep, dangerous moats … [where] the moat is permanent and acts as a powerful deterrent to those considering an attack; and inside, the leader makes gold but doesn’t keep it all for himself. Roughly translated, we like great companies with dominant positions, whose franchises are hard to duplicate and has tremendous staying power or some permanence to it”.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.  Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.