“The key to investing is not to judge how much an industry will impact society or how much it will grow, but rather to determine the competitive advantage of a particular company and, more importantly, the durability of that advantage. The products or services that are surrounded by wide, sustainable moats are the ones that will generate profits for investors.” — Warren Buffet
In the investment world, we hear loads about investing in corporations which have a moat or some form of long-term competitive advantage that’s difficult for competitors to meet up with.
Why will we hear a lot about this idea? One vital reason is that Warren Buffett likes to speak about itso many individuals have tried to work out what exactly he means by a moat. After all, there is no such thing as a approach to measure this concept: it’s a qualitative metric that’s not possible to measure usually.
A moat could be a strong brand – for instance, Coca-Cola or Disney – or mental property, corresponding to the patented drugs of a pharmaceutical or biotechnology company.
But perhaps we’ve been specializing in the flawed metric from the beginning.
Instead of on the lookout for moats, we must always have been on the lookout for market power. In “Mutual Fund Bets on Market Power” Stefan Jaspersen recently looked into whether corporations whose products face less competition have a bonus. Using a database of product competition between US corporations, he was in a position to show that corporations with less product competition are likely to be older, have higher valuations and fewer liquidity, and are covered by fewer analysts.
In short, these are frequently small to medium-sized corporations operating in small market niches where a couple of highly specialized corporations compete. Because these area of interest markets aren’t particularly followed by investors, there are few analysts covering their corporations. As a result, news about developments in these markets tends to spread slowly.
All of those aspects should result in higher long-term stock price returns for corporations with fewer competitors. However, the study also found that corporations with low market power generated virtually the identical returns as their high-market-power competitors from 1999 to 2017. However, fund managers who invested in corporations with more market power generated 1.56% higher returns per 12 months than the common actively managed equity fund.
How is that this possible? The trick is that market power is just not stable. The variety of competing products is continuously changing. Fund managers who know the market power of an organization, for instance by observing competition and the efficiency with which an organization converts investments in research and development into actual sales, tend to take a position in an organization when its market power is high or increasing, and sell it when its market power is low or decreasing.
In fact, fund managers put money into corporations that operate in less efficient markets with fewer competitors and due to this fact have the chance to realize a bigger market share and increase their profit margins. And this offers the fund manager a bonus, whatever the fund style.
And who’re these fund managers who consider market power? On average, they’re older and more experienced. And I think they’ve learned over their careers to focus less on talk of moats and other murky and ephemeral concepts and as a substitute on how close an organization is to holding a monopoly in its particular area of interest.
The fewer competitors, the higher.
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