Certain types of competitive advantages travel better to new places than others...

From Quality Investing: Owning the best companies for the long term:

Companies that rely on unique business structures for competitive advantage at home will face the greatest difficulty expanding geographically. Advantages that derive from a unique distribution system, localized scale advantages, or favorable regulatory treatment may not be replicable abroad. The inability of grocery retailers, hospital operators, and airlines to globalize their businesses successfully testifies to this effect. 

Conversely, certain types of competitive advantages travel better to new places than others. Thanks to the globalization of travel and media, premium brands transition relatively easily into new markets. Louis Vuitton and Nike are well-known in all corners of the world, even where their merchandise is not yet available. Manufacturers operating their own stores enjoy a particular advantage, as their vertical integration makes them less reliant on a country’s infrastructure. 

The uncertainty of geographic expansion leads us to prefer companies with proven track records of successfully exporting competitive advantages into new geographic areas.

Structural end-market growth...

From Quality Investing: Owning the best companies for the long term:

Whereas cyclical growth refers to episodic expansions, structural growth refers to more permanent expansions supported by persistent trends deemed likely to endure. The inherent prognosis, however, warrants skepticism, as the observed pattern is often in fact cyclical and merely temporary. Many emerging market trends previously considered structural seem, in hindsight, to have been more cyclical in nature. 

Despite this, there are a number of long-term trends that are more likely to prove sustainable than others, ranging from disease prevention to urbanization and aging demographics in developed markets. But it is not safe to assume, for instance, that all people on earth want to own a certain number of cars or spend a stated portion of income on beer. 

There are many examples of erroneous assumptions along these lines. A notable one occurred in the US golfing industry. Growth was projected to increase in tandem with a rising population, favorable demographics, and increasing wealth. The projection was wrong. Between 2006 and 2013, the number of golfers in the US fell by 18% despite 6% growth in the US population. A broader example is occurring in China, where once soaring consumer appetites for goods like cognac and pastimes like gambling have abruptly reversed. Only time will tell if this reversal is temporary or permanent.

Margins and competitive advantage

From Quality Investing: Owning the best companies for the long term:

Gross profit margin demonstrates competitive advantage: it is the purest expression of customer valuation of a product, clearly implying the premium buyers assign to a seller for having fashioned raw materials into a finished item and branding it. 

Although gross margin is a partial function of a company’s industry and high gross margins can reflect low asset intensity, sustained high gross profit margins relative to industry peers tends to indicate durable competitive advantage. Zeroing in on gross margins, as opposed to bottom line net income, also helps distinguish competitive advantage from managerial ability: bloated but short-term cost structures can reduce net income and disguise real long-term competitive advantages. High gross margins also confer other advantages: they can expand the scope for operating leverage, provide a buffer against rising raw material prices and provide the flexibility to drive growth through R&D or advertising and promotion. 

The more incremental top-line revenue that ends up as bottom-line profit, the better. Suppose two rivals each grow revenue by a dollar. If it costs one of them ten cents to do so and the other 80 cents, the growth is clearly more valuable for the former. Businesses with high operating margins are typically stronger than those with lower ones. 

Sustained margin expansion also signals strength. Big swings in operating margins can indicate that major cost components are outside of management’s control, suggesting that caution be applied. A company that consistently achieves both high gross and high operating margins indicates a strong competitive advantage sustainable at tolerable cost.

Quality investing...

From Quality Investing: Owning the best companies for the long term:

Quality investing is a way to pinpoint the specific traits, aptitudes and patterns that increase the probability of a particular company prospering over time – as well as those that decrease such chances. 

In our view, three characteristics indicate quality. These are strong, predictable cash generation; sustainably high returns on capital; and attractive growth opportunities. Each of these financial traits is attractive in its own right, but combined, they are particularly powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can be reinvested again. 

A simple example illustrates their power. Say a company generates free cash flow of $100 million annually. Its return on invested capital is 20% and it has ample opportunity to reinvest all cash in expansion at the same rate. Sustained for ten years, this cycle of cash generation and reinvestment would drive a greater than six-fold increase in free cash. Albert Einstein famously referred to compound interest as the eighth wonder of the world. Compound growth in cash flow can be equally miraculous. The profound point is that the critical link between growth and value creation is the return on incremental capital. Since share prices tend to follow earnings over the long term, the more capital that can be deployed at high rates of return to drive greater earnings growth, the more valuable a company becomes. Warren Buffett summarized the point best: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” The best investments, in other words, combine strong growth with high returns on capital. 

It is relatively easy to identify a company that generates high returns on capital or which has delivered strong historical growth – there are plenty of screening tools which make this possible. The more challenging analytical endeavor is assessing the characteristics that combine to enable and sustain these appealing financial outputs. 

Above all, the structure of a company’s industry is critical to its potential as a quality investment: even the best-run company in an over-supplied, price-deflationary industry is unlikely to warrant consideration. On top of this, there are bottom-up, company-specific factors that must be understood. In combination with attractive industry structures, these form the building blocks which can enable a company to deliver sustained operational outperformance and attractive long-term earnings growth.