A fundamental principle of competitive markets is that profits regress to the mean. We believe that the secret to successful investing is to identify those few companies that have a durable Economic Advantage that allows them to defy this principle and sustain a higher than average level of profitability for longer than expected. This surprises the market, and leads to strong share price appreciation.
Economic Advantage is the collection of distinctive characteristics of a company that competitors struggle to reproduce, even if those competitors have understood the benefits arising from those characteristics.
In our experience the hardest to replicate of these particular characteristics fall into the following three categories of intangible assets:
Strong distribution channels
Significant recurring business
Other less powerful but nonetheless important intangible strengths include: franchises and licences; extraction rights; good customer databases and relationships; effective procedures and formats; strong brands and company culture.
It is our key belief, backed by our experience of exploiting Economic Advantage, that only distinctive and hard to replicate intangible assets can form the basis of a sustainable competitive advantage. These assets deliver pricing power, protect margins, and thus drive sustained profitability. The market rewards excess profitability, particularly when it is higher than consensus expectations.
How do we identify companies with Economic Advantage?
We evaluate companies in the UK stock market for their possession of durable Economic Advantages. We screen and score companies. To pass our test for Economic Advantage, a company must demonstrate that it has either intellectual property, a distribution channel or repeat business. In calculating a company’s score a higher score is given for these assets than other intangible assets. This initial screen gives us our universe of potential investments.