Use Business Models To Attain Higher Returns On The Stock Market
Warren Buffett once famously said that 'when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.'
Notwithstanding this, management can still have a big influence on the shape of an industry by being innovative particularly through the application of new technology. In a number of cases companies have even transformed the underlying economies of a sector.
Sustainable competitive advantage should always be of interest to the investor because it helps to underpin a company's future earnings and increase the reliability of brokers' earnings forecasts. If as a direct result the company meets or exceeds market expectations then, all other things being equal, this drives its share price higher.
So, when determining whether to invest in a share, a sound understanding of the future economies of both the company and its industry is crucially important for share selection.
Investors should consider the structure of the industry, the intensity of competition, barriers to entry, the substitutability of products, the degree of pricing power and whether it is sustainable.
If competitors are not locked out through effective barriers to entry (eg patents, high infrastructure costs etc …) historically high margins will be whittled away as high prices attract additional capacity and competition over time.
As the supply and demand imbalance is correct, this in turn will reduce a company's pricing power, unless it can stay ahead of the competition with, for example, the periodic release of next generation products and services.
Investors, therefore, should be wary of companies with unattractive economics where products have become commoditized, where companies have one-off transactional customers but lack strong and recognized brands or where there is international margin pressure from cheaper substitute products.
Conversely, things like top-class brand names, newly patented products and copyright help to add a competitive edge enabling a company to sustain its higher margins and fight off the competition.
Different sectors will always employ varying amounts of capital and labor and therefore have different economics. Generally speaking, however, a return on capital employed of over 20% implies some sort of competitive advantage.
Moreover, by being innovative the management of a successful company can sometimes transform the underlying economies of their industry.
One example, where this has happened over the last 5 or 6 years is commercial printing in the UK. It is a fiercely competitive, highly fragmented market where margins traditionally have been low. There are around 2,500 print shops nationwide, mostly small chains and independents with only a couple of sizable High Street brands.
One leading player, relatively new to the market, however, has really made its mark and managed to create significant competitive advantage by introducing a centralized production model.
Unlike its competitors no printing is done locally in the High Street. Instead, all its customers' print orders are transmitted electronically via the internet to its centralized printing hub, a process controlled by unique proprietary software.
Centralized production allows the aggregation of orders and deliveries economies of scale enabling the company to undercut local competition on price by up to 77% (source: Nationwide Survey and Store Checker price comparison). Meanwhile, overnight printing and delivery still ensures a 24-hour turnaround capturing the bulk of the market.
A few years ago the 'Print Week' survey of the UK's 500 largest commercial printers found that the average pre-tax profit as a percentage of turnover amongst UK printers was a mere 2.6%.
By contrast, our leading player with its unique centralized production model and economies of scale enjoyed an equivalent pre-tax profit margin of 14%!
What this shows is that investors can profit from analyzing companies' business models and identify innovative companies that generate higher returns, which in turn can drive share prices higher and make you wealthier.