You often hear that value investors seek out wonderful businesses run by capable, competent management with a durable competitive or economic advantage. But when you say a company has a competitive advantage, what does that really mean?
A true competitive advantage exists in only a few forms. The simplest type occurs when a government grants licenses to a few companies and excludes everyone else. Cable companies, electric utilities, and telephone companies are the most common. But these companies don't enjoy the same incumbent competitive advantages they did 50 years ago.
Other competitive advantages exist when a company is the low-cost producer, such as USG (NYSE: USG) in wallboard, holds a patent (which is good for a finite period of time), or possesses another attribute that turns potential competitors away.
Commodity-type businesses rarely have sustainable competitive advantages. Ultimately, they're resolved to share the market space with many competitors until the economic profit is zero or, in other words, the cost of capital is equal to the required rate of return that investors demand on their money.
To illustrate my point: A hypothetical company, Bright Lamp Inc., makes lamps. Bright Lamp has been quite successful and has earned $10 million each year for the past three years. Its investors are willing to accept a 10% return on their investment. This gives Bright Lamp an earnings value of $100 million (earnings value = 1/cost of capital).
Bright Lamp has $50 million in assets, which includes both tangible and intangible assets. A potential competitor will look at this company and realize that for an investment of $50 million, it, too, can command an earning value of $100. And if the market assigns Bright Lamp a value of $130 million, the gap is wider, which is even more of an inducement for competitors.
So what happens next? A new company starts making similar lamps, and Bright Lamp earns only $7 million. It now has an earnings value of $70 million. A second competitor will still be induced by the opportunity to invest $50 million in a company that has an earnings value of $70 million. The process continues until earnings for Bright Lamp reach $5 million, at which point there is no excess profit to be made. Bright Lamp, a good company, resolves to earn only its cost of capital and no more. Sure, commodity companies could tinker with their products to differentiate them, but so will everyone else in the long run. In the end, you're back where you started.
The franchise value
Warren Buffett recognized the value of franchises before most investors, and the results speak for themselves. Simply, a franchise exists where a company benefits from barriers to entry that keep potential competitors away. It virtually insures that if competitors enter, they will operate at a severe disadvantage. In 1987, Warren Buffett and Charlie Munger invested $1 billion from Berkshire Hathaway's (NYSE: BRK-A) cash pile into Coca-Cola Company (NYSE: KO). At the time, this investment represented more than 20% of Berkshire's book value! Other Buffett franchise-type investments included Wrigley's (NYSE: WWY) and Gillette, now owned by Procter & Gamble (NYSE: PG).
One need look no further than these companies to see the awesome value of a franchise. Coca-Cola benefits from the advantage of having high switching costs. As you drink more Cokes, you begin to develop a habit that's hard to break. I can't think of anyone who will give up Coke for another brand to save a dime per can. If you're traveling in a foreign country, I'd be willing to bet that you grab a Coke and not the local brand. Coke has an amazing moat that will likely stay strong for a really long time.
Same goes for Gillette razors. Buffett loved the idea that each morning millions of men woke up to use a product they would have to replace on a regular basis. How many people would sacrifice the safety of their face or legs to go with a cheaper, inferior razor?
My favorite holding period is forever
When you can find a company with a truly remarkable, durable competitive advantage at an attractive price, you can follow Buffett's mantra about holding stocks forever. They consistently earn rates of return way above their cost of capital, and they do so without serious threat from outsiders.
I seriously doubt Coca-Cola has any reason to worry that some bright, young entrepreneur will appear anytime soon with a brilliant business plan for a cola company.