“We have to have a business with some intrinsic characteristics that give it a durable competitive advantage… It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” –Charlie Munger (Warren Buffett’s partner at Berkshire Hathaway)
In our post describing the intrinsic investing approach we discussed a “special class of companies that offer far more predictable futures.” The fact is, capitalism is brutal. Any time a company successfully develops a profitable business opportunity, other companies will flood the opportunity with competition. This is why even the fastest growing companies find that growth doesn’t last nearly as long as expected and why most business opportunities offering high returns on capital see those returns ground down towards market rates of returns.
The free flow of capital and the freedom for companies to enter new markets and geographies makes it almost impossible for most companies to protect highly profitable business opportunities. This is a good thing for consumers. This competition means that companies have to constantly keep prices low and bring new innovations to market if they want to survive. But it isn’t good for investors.
However, some companies exhibit “intrinsic characteristics that give it a durable competitive advantage” in the words of Charlie Munger. These companies and the business opportunities they pursue have some aspect that limits the ability of other companies to compete. These companies are therefore able to generate above average returns on capital for very long periods of time. These high returns drive strong cash generation, which frees the company to make smart long-term decisions that enable them to take advantage of the ups and downs of the economic and competitive cycle rather than be taken advantage of. They don’t always engage in the most exciting businesses, but they offer investors the exciting opportunity to participate in unusually profitable business models.
It is in these “wonderful companies” that we seek to invest.
Some quick examples:
TransDigm Group (TDG): This company sells various parts for airplanes. Once they win a “slot” in a plane design, they essentially lock in an annuity stream of revenue from selling replacement parts for decades to come. Due to FAA regulations, it is very difficult for competitors to offer similar parts. They are the only provider of their products for 75% of their revenue and the airlines must replace these parts on a schedule mandated by the FAA.
MasterCard (MA): Along with Visa, the two companies offer the “rails” over which the large majority of global credit and debit payments flow. Their competitive advantage rests on a network effect under which consumers are unlikely to start using a competing payment network unless many merchants accept that network. However, merchants are unlikely to start accepting a new network unless many consumers are already using it. This dynamic is why in the midst of so much disruption from mobile payments, even Apple with all its resources and massive installed base of customers decided to build Apple Pay on top of the payment “rails” offered by Visa and MasterCard rather than attempting to develop a competing payment network.
Broadridge Financial (BR): Broadridge operates behind the scenes to process an amazing volume of securities transactions (stock and bond trades) and investor communications (trade confirms, monthly statements, etc). After a bank or brokerage firm builds Broadridge into their business processes, the switching costs (especially the time and disruption to their business) are very high. Of particular note, Broadridge has an effective monopoly on running the US proxy voting process (shareholder votes on board members and corporate actions) with over 98% of the market.
These sorts of companies have been able to develop business models with competitive advantages that reduce the ability for other companies to compete away their profits.
Ensemble Capital’s clients own shares of TransDigm Group (TDG), MasterCard (MA), Apple (AAPL) and Broadridge Financial (BR).
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