The Investment Checklist

by Michael Shearn

  On the other hand, profitability can increase if a state approves new slots or table games for existing casinos, as West Virginia did when it allowed Penn National Gaming to add table games to its casino there. If a state is considering increasing the tax rate or allowing more gambling units, this information is found with the regulatory board. You need to closely monitor the licensing entities in these states for any proposed changes to understand what impact, either positive or negative, the changes will have on profitability.

  Businesses regulated at the federal level have more risk in one respect, which is that a single rule change can affect the entire business. Most locally or state-regulated businesses would only have a percentage of business affected by each change.

  For example, the for-profit education industry is regulated by the federal government through the U.S. Department of Education (ED). The ED sets the standards that need to be followed by this industry. A single rule change could have disastrous effects on the future profitability of the industry. For example, the ED is setting standards that must be met for the students of a for-profit institution to qualify to receive federal student loans, which represents more than 70 percent of the revenues of each institution. In 2009, the ED considered not extending loans to for-profit colleges if they failed to meet these standards. These changes could have disastrous effects for some for-profit colleges.

  Source #5: Switching Costs

  Why would you not buy a cheaper product of the same quality or a better product for the same price? The answer is that there may be an additional cost associated with changing products, or a reduction in the benefit you stand to receive. These are often called switching costs, like those you incur if you change cell phone providers.

  The strength level of switching costs is determined by how embedded the product or service is with the customer or the amount of training needed to use it. Think about how much training you face when learning new software: If you have to retrain yourself or your employees when changing products, you’ve encountered a switching cost.

  For example, Bloomberg, a high-end provider of financial and trading information, has embedded its services with customers through a lot of training, so it does not make sense for those customers to switch and invest the time to learn another product. The savings of switching to a lower-priced competitor would be outweighed by the additional training time. Also, because many of its customers are traders, the benefit of switching to a less costly service to save maybe a few thousand dollars a year is small in comparison to the size of the transactions they are making. Finally, there is also some chance of making an error as customers learn any new system.

  In order to learn if the protection provided by switching costs is deteriorating or improving, you need to closely monitor a company’s customer-retention rates. For example, Blackboard is a leading provider of software applications and services to educational institutions. Its software enhances the learning experience by allowing students to interact with teachers, classmates, and course materials outside of the traditional classroom environment. Blackboard’s products are used daily by students, parents, and administrators, and the software is deeply embedded within a school’s other information systems. For example, a professor may assign digital material on a class website. This embeddedness, or stickiness, is reflected in Blackboard’s high customer retention rates. At greater than 90 percent for most of its products,12 Blackboard’s customer retention is roughly five times larger than the company’s closest competitor. If this retention rate begins to drop, however, this might signal that Blackboard’s competitive advantage is eroding.

  Source #6: Cost Advantages

  Cost advantages include such factors as economies of scale and advantageous locations. The more structural a cost advantage is, the more sustainable it is. For example, lowering costs by moving a call center to India will help a business, but most of its competitors can narrow this advantage by doing the same.

  Economies of scale are a more structural kind of advantage. As a business with fixed costs grows, it is able to take advantage of lower per-unit costs. This way, it is able to charge lower prices for its products or services compared to competitors. This widens the competitive advantage and makes it more sustainable.

  There are various ways for a business to create advantages based on economies of scale, including increasing efficiencies by consolidating a fragmented industry.

  Obtaining a Cost Advantage through Industry Consolidation

  In large, fragmented markets, especially those that have become commoditized, you can often see businesses with low-cost advantages building market share. The higher the market share, the more customer choice is limited, which gives the surviving dominant players an advantage.

  For example, LabCorp and Quest each played large parts in the consolidation of the laboratory testing business. In the early 1990s, there were seven or eight national lab companies that all performed the same type of tests. As lab-test reimbursements increasingly fell to health-maintenance organizations (HMOs), the HMOs demanded lower prices. LabCorp and Quest acquired other businesses to achieve economies of scale, and they contracted with HMOs to offer lower pricing. Although end-customers could choose to use other labs, the scale already achieved by LabCorp and Quest made matching their pricing difficult for competitors. Other labs quickly found that their existing customers didn’t want to pay higher co-pays for non-contract testing, and the competition folded.

  Obtaining a Cost Advantage through a Good Location

  Whenever a business has a geographic location that competitors are unable to easily duplicate, this can give a business a cost advantage. For example, cement plants in certain areas of the United States benefit when housing and public construction increase demand locally for cement. Because it is difficult to build new cement plants (“not in my backyard”) and because it is generally inefficient to ship cement long distances because of its weight, those cement plants are able to undercut the prices of most competitors.

  The Best Kind of Sustainable Competitive Advantage Is Structural

  When customers have limited choices in the products or services they can use for extended periods of time the competitive advantage is likely structural. A structural competitive advantage can be a result of regulation, a prime location, or better distribution networks. For example, think about a prime piece of real estate in your community where there is easy access, visibility, and location. This location typically will be able to charge higher rents to retailers because it is in a good area where more customers are likely to shop.

  The best way to identify a structural competitive advantage is to view it from the perspective of customer choice: Does the customer have limited products or services to choose from, or does the customer have many choices? For example, if you are buying infant formula you are limited to two main products: Enfamil manufactured by Mead Johnson and Similac manufactured by Abbott Nutrition. In contrast, when choosing a restaurant, you have a myriad of choices.

  Structural advantages are typically the most sustainable advantages. For one thing, the more a competitive advantage is based on structural characteristics, the less the business depends on such factors as management execution. For example, bond ratings firms Moody’s and Standard & Poor’s both possess strong structural competitive advantages because the government limits the number of firms that can issue ratings through regulation, so they rely less on having good management. In contrast, a restaurant (and retail in general) depends a great deal on the quality of management, so they have far less of an advantage.

  Why It’s Hard to Find Businesses with Sustainable Competitive Advantages

  For most businesses, a competitive advantage is not sustainable over an extended period of time. Competitive advantages expire. Even when a business appears most formidable and generates the strongest financial metrics, it can be on the verge of failure. If a business doesn’t innovate successfully and defend itself, competitors will always be there to chip away at
the business.

  For example, Sony knows that when it creates a new product, it has between one and two years before other consumer-electronics manufacturers imitate that product. Therefore, when the management team sits down to decide how they are going to price their product, they price it at a level where they will be able to recover their investment in an 18- to 24-month period.

  Most advantages are temporary, such as when a business launches a new product that is superior to the competition’s product, and many advantages decline over time. For example, microchip manufacturer Intel used to make excess profits for long periods after introducing a new chip. The reason for this was that, in the past, there was less competition in chip making. Computer makers were willing to pay a premium to Intel to have the latest microprocessors in order to differentiate themselves. However, as more competitors have entered the industry, Intel now has a smaller window of time in which to earn a higher-than-average profit on a new chip.

  It is increasingly difficult to find businesses with competitive advantages, for several reasons:

  Consumers are less loyal to products or brand names. Witness how private-label products continue to take market share from branded products.

  Increased global competition has lowered the bar for new entrants in most industries, such as manufacturing. For example, global competition has almost shut down manufacturing of shoes in the United States, where production fell from 121 million shoes in 1999 to only 31 million in 2007.13

  Technological advances have shortened the lifecycle of many competitive advantages. Let’s take a closer look at this reason.

  Competitive advantages are less sustainable when they are affected by changes in technology or if they are in rapidly emerging industries. Changes in technology threaten a competitive advantage when they expand customer choice, whether by offering the same product for less or by offering greater benefit for the same price or less. Here are just a few examples:

  Book retailer Barnes & Noble’s historical ability to charge premium prices for books was diminished by online retailer Amazon.com, which is able to sell books at a lower price because it does not have the higher overhead in the form of store leases.

  The Internet has reduced the sustainability of many competitive advantages. For example, newspapers lost most of their classified advertisers and the large percentage of profits they represented to low-cost Internet sites.

  Other businesses are in terminal decline as their products and services are being replaced by new and improved offerings from competitors that exceed what they have to offer. For example, dial-up Internet service America Online (AOL) has been decimated by high-speed providers.

  In all of these examples, customer choice improved due to changes in technology, whether because of lower costs or greater benefits.

  Beware of Businesses that Were Simply at the Right Place at the Right Time

  Too often, investors look at a business’s past success as a result of a competitive advantage, when they should be asking why a business has a competitive advantage and if there are certain conditions that created it. Many businesses may simply have been in the right place at the right time.

  For example, when the price of computers dropped and more consumers could afford personal computers, Dell was able to beat its competitors on price because it had the lowest cost structure of all computer manufacturers. In contrast, other computer manufacturers were locked into distribution agreements that increased the cost of a computer. Over time, however, Dell’s advantage has eroded as competitors now manufacture computers at a lower or equal price. What many investors believed to be an enduring competitive advantage was not.

  Most Investment Gains Are Made During the Development Phase, Not After

  As you are learning about the source of a competitive advantage, it is important to remember that the greatest gains in a stock are usually made as a business is developing its competitive advantage rather than after it already has developed one. For example, we all know that Wal-Mart has a competitive advantage, but investors earned the biggest stock gains as Wal-Mart grew and developed this advantage.

  Ideally, you want to identify those businesses that are in the early stages of building a competitive advantage. It can take years and sometimes decades for a business to develop its competitive advantage, and it is difficult to see a competitive advantage building, because in most instances, the business is losing money during that time. For example, online retailer Amazon.com lost money for eight years while using its capital to rapidly expand its customer base and develop its markets before committing to more efficient operations and profit. The best way to distinguish whether a business is building a competitive advantage or wasting money is to monitor the number of customers a business serves. The investments Amazon.com made increased the number of customers it served. In contrast, businesses that fail are those that continually spend money but do not increase the number of customers they serve.

  Look for those businesses that continue to push product or service innovation by investing in research and development (R&D) or that are wisely spending marketing dollars to increase awareness of their products with superior value propositions or unique appeal. For example, Apple remained committed to its R&D program even after revenue dropped by 33 percent. Apple increased its R&D spending by 13 percent in 2001, which increased its R&D as a percentage of sales from 5 percent of sales in 2000 to 8 percent of sales in 2001, as stated in their 2001 10-K. During this time, many shareholders questioned why Apple would continue to increase its expenses, even though its revenues were declining. Yet because of these expenditures, when Apple introduced the iTunes music store in 2003 and the iPod in 2004, the stage was set for rapid growth.

  Be cautious of those businesses that only imitate innovation. For example, Wal-Mart has always had cutting-edge information-technology (IT) systems for retail. It was one of the first retailers to invest in barcode scanners to increase efficiency. (It’s hard to imagine, but barcode scanners were considered revolutionary at the time.) A couple of years later, Kmart added barcode scanners, which helped Kmart, but by then, Wal-Mart was already using the next generation of IT tools in the form of a private satellite network. In IT and in other areas, Kmart’s imitation of Wal-Mart wasn’t as effective as Wal-Mart’s innovation, and Kmart was left behind.

  What Is Not a Sustainable Competitive Advantage?

  It is important for you to distinguish a business’s competitive strength from a sustainable competitive advantage. If a business has good customer service, a quality product, and knowledgeable workforces, those are all strengths, but those can often be duplicated. For example, a business that returns its phone calls within an hour is preferable to one that returns calls the next day, but a competitor can easily duplicate this enhanced customer service. Some strengths are more difficult to develop than others, such as having very knowledgeable employees, a strong employee culture, or an efficient production process.

  For example, in the for-profit education industry, there are some advantages that are easy to copy and some that are difficult to copy, as shown in Table 4.1.

  Table 4.1 Comparing Competitive Advantages in Education: Are They Easy or Difficult to Copy?

  Competitive Advantages that Are Easy to Copy Competitive Advantages that Are Difficult to Copy

  Quick approval of student-loan applications Accreditation

  Ability of students to work on their own schedules Quality Faculty

  Study from home Resources

  Easy-to-navigate website Quality of education

  Therefore, sustainable advantages include factors that are difficult to copy, such as accreditation, whereas competitive strengths include such factors as an easy-to-navigate website.

  16. Does the business possess the ability to raise prices without losing customers?

  The best indicator of a competitive advantage is a business’s ability to increase prices without losing customers. For example, the following companies (and others, of cours
e) all have pricing power:

  Blood-testing equipment maker Immucor

  Luxury goods manufacturer Louis Vuitton

  Global financial information providers FactSet Research Systems and Bloomberg

  Salt producer Compass Minerals International

  Häagen-Dazs ice cream (owned by Nestlé S.A.)

  Häagen-Dazs ice cream is able to sell its products at a large premium over its cost of production, therefore demonstrating pricing power. In contrast, commodity-type businesses, such as steel producers, do not have pricing power. In most cases, these types of businesses must decrease their prices to spur demand, and the price is typically set by the production cost rather than the value of the product to the purchaser.

  Common Characteristics of Firms with Pricing Power

  Businesses that have pricing power typically have a few characteristics in common:

  They usually have high customer-retention rates.

  Their customers spend only a small percentage of their budget on the business’s product or service.

  Their customers have profitable business models.

  The quality of the product is more important than price.

  Let’s look at each of these individually.

  High Customer-Retention Rates