October 5, 2015
by Baijnath Ramraika, CFA and Prashant Trivedi, CFA
What can past market crashes teach us about the current one?
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“If I have seen further it is by standing on the shoulder of Giants.” – Isaac Newton
“In business, I look for economic castles protected by unbreachable moats.” – Warren Buffett
In our earlier research papers on the topic of high quality, Investment Returns to Quality in Developed Markets and High Quality Stocks in Emerging Markets, we showed that high-quality stocks generate superior investment returns with lower risk compared to their benchmark indexes. While both papers laid out a quantitative framework for identifying high-quality businesses, the optimal investment selection process includes a significant non-quantitative component: the existence of sustainable competitive advantages.
A strong competitive advantage and its sustainability are the most important attributes of a high-quality business. Much of the investment returns that accrue to investors from the quality factor depends on the ability of the business to persist with its supernormal returns on capital. However, the excess returns can persist only if the business is able to keep competition at bay, which is a factor of the sustainability of the competitive advantage of the business.
While it is possible to develop quantitative models that can differentiate businesses that possess sustainable competitive advantages from those that don’t, this is best done within a well-structured human-decision-making process while recognizing its cognitive limitations. Our research paper on the limited rationality of the human mind further investigates the design of such a process such that errors of cognition are minimized.
This article is the first in a series discussing an assessment process for existence or absence of sustainable competitive advantages. In this article, we discuss the basic building blocks of an investment process designed to identify high-quality businesses: the entry and exit barriers.
There is nothing new about much of what is discussed here. The concept of sustainable competitive advantages and the building blocks to the assessment of sustainable competitive advantages have been discussed and elaborated by several market luminaries including Warren Buffett and Charlie Munger. Through this series of articles, we will present a structured investment process that lends itself to modification and adoption by the reader.
Barriers to entry
Buffett says that he looks for businesses with “unbreachable” moats. What does he mean by moats? Moats are deep, broad ditches that were filled with water and surrounded a castle. Historically, moats served as the preliminary line of defense by restricting access to enemy forces and serving as entry barriers. If the playground of a business wherein it operates can be referred to as a castle, the entry barriers that protect that playground can be referred to as moats.
So why are moats important? Let’s say that an industry or business is enjoying supernormal returns on capital. Those returns mean that every dollar of capital invested in the business will be valued at more than a dollar. The possibility of creating a superior asset by replicating such a business will attract other entrepreneurs to commit capital and resources.
This is where entry barriers come into play. If entry barriers are low or non-existent, other entrepreneurs will successfully enter the business, driving supply upwards and returns downwards. This process will continue until all the excess returns are competed away. However, if entry barriers are insurmountable, efforts of competitors will fail and they will be unable to make inroads into the business, allowing the supernormal returns of the business to persist.