Attributes of defensible quality

When I’ve found a company whose accounts suggest it could be a quality compounder, my next task is to find out how the business works. More specifically, I want to try and understand whether it has the durable competitive advantages needed to support many more years of quality compounding.

It’s worth pointing out that competitive advantage generally comes from within a business. It isn’t about sector growth or macro trends, Warren Buffett emphasises:

“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 following checklist can help you identify companies with genuine competitive advantage. For those who want to dive deeper, there’s more to explore in this article. 

Intangible assets

Intangible assets are things you can’t see but which have value and are hard to replicate. Think about brands and cornered resources (patents and regulatory approvals), for example. These can provide pricing power and stable long-term demand.

However not all intangible assets are equally durable – some brands lose their appeal after a while. Similarly, patents expire and regulatory approval may also carry responsibilities and restrictions.

Switching costs

I look for businesses with sticky customers. Software companies can be good for this, especially if they serve business customers. Accountancy software such as Sage is a classic example – it’s a real headache for companies to change to a different provider. 

Network effect

Companies which capture the vast majority of web traffic in their niches can be said to have an excellent network effect. Examples include online real estate group Rightmove and car sales website Autotrader. These two companies have the most listings in their field. More traffic brings more listings. And so on. This is a network effect. 

Buyers and sellers both benefit from using the same service as everyone else.

Microsoft is also a good example. Businesses benefit from using its systems simply because everyone else uses them too.

Cost advantages

Does the company have any cost advantages over existing rivals or would-be competitors?

These often fall into one of three categories:

• Cheaper/better process

• Location advantages – especially in natural resources and heavy industry

• Unique assets – perhaps natural resources, but also data. Consider the way in which the London Stock Exchange has grown, in part because of its access to and control over valuable data.

Greater scale

Businesses with high fixed cost bases can often gain a competitive advantage simply from being larger. By spreading fixed costs across a larger number of customers/transactions, operating profit margin can be increased.

Scalability applies to businesses such as large retailers and manufacturers. But it can also apply to technology firms where the initial cost of developing a product is high, but the incremental cost of an extra user is minimal.

History

One final factor I like to consider is the age and track record of the business. A company that has been generating reliable returns for its shareholders for decades already probably has some advantages of some kind.

I also like to see some consistency in a company’s business model. Evolution is good and necessary, but I prefer to avoid companies that regularly attempt to reinvent themselves.