When we look for shares to buy or businesses to invest in, we look for profitable businesses with a good return on equity (that is increasing the value of your share in the business, as well as increasing shareholder’s equity).
If a business is making great profits, what we need to assess is if it can it continue to make and grow those profits, and for how long.
Determining Intrinsic Value
Traditional value investors dislike paying for growth, as it is unknown and is the least reliable part of any intrinsic valuation calculation.
To increase the reliability of the intrinsic value calculation, we consider ‘barriers to entry’ or ‘competitive advantage’. Some indicators of competitive advantage may be:
- Market domination
- Propriety knowledge or technology
- Know how
- Government Licenses
- Customer captivity through; high switching costs, habit, search costs
- Running an efficient operation
A good brand can also be an advantage; however, brands require continual investment. While some brands enable a company to command a premium price (for example luxury brands such as Louis Vuitton), others fail in transferring brand recognition into a higher return on equity.
The Changing Market
Competitive advantage needs to be viewed as a long-term attribute, taking into consideration the changing market and likely number of competitors exiting and entering the economy. For example, a business that is highly profitable but with no current competition would likely see their profits decline as competitors begin to enter the market.
As value investors, we understand that competitive advantage will not last forever, no matter the business or brand. What we are trying to assess is the strength and longevity of the advantage, often referred to as ‘the moat’ in its role of protecting the business. We can arrive at our intrinsic valuation of the business by estimating its future growth and durability and comparing this to the current price.
arcinvest uses a value investment philosophy to assess and manage investments. Contact us for a complimentary discussion about your current investments.