Competitive Advantage Thinking S Every manager wants to improve the company's stock price. The question becomes, How? Lots of evidence points to the reality of having a . What is it, and how many companies have one, or more? The experts we contacted say that competitive advantage is strongly indicated when a company is earning returns on investment that exceed its cost of capital.oleae. 2} WNC Tecan eros ter, so why is the stock price stagnant? Here are a couple of clues. Is your company earning Peer MELA een Tere Ceo Be ie a your company have a competitive advantage? BUR reece ee aC OMe oe Ree Perec Cheer Nao Cha eco Sera CS Cee ree aay acco Seon en too of capital. Thus, they believe a company can’t grow its value without 4 competitive advantage. Pa neced tere eR Re eee Reo acne Peter can rte aes Crea reece MONIES Pretec CCM (ree oR Ver nes NT Bete) PN ete cers Sa Soe aE Peer ecerre ae OM rer Coen UC I ccar eee es Rec ee CR To LC teh TUE eto a Seton enh com UN ae Cee a Pg eee en ae Rest een ee UT tc MeL Pa cece ase a eos COOL CS Dee Us Renae ee eee ect oer con ment that exceeds its cost of capital,” and the company pe tee ee eee ee eect eee eee eka ceed ceed ecteny rising stock price, during the time they have a competitive advantage. Our participants readily agree that companies eek ec eet me eee cn ear ct eee cra ecm kee “At any time, 50% to 60% of companies probably are close to neutral, a little above and a little below, and Teens ec nets ao nemo nar rs Robertson Stephens and co-author of the popular book The Gorilla Game a few years back Sete CR cours RoR ones Ue: et Men Come nice) Resa a UC are in positive territory, one-third are neutral, and one-third Pee et ee eee eee eet eee RU keene cere ae Ck Advantage Length Peer ee eC Reon eth eeu ee atte first step in evaluating a company for investment. Even Se ee ee ee ae VATS PLPsitenoer var Summase uprinkgs Competitive company can sustain and, better yet, grow that advan- ‘tage. Mauboussin and Johnson call it the Competitive Advantage Period (CAP). Value Growth Duration (VGD) is the term used by “Mallette, partner at L.E.K. Consulting LLC, borrowing a phrase first cited by Alfred Rappaport, a long-time advi- sor to LEK. and author of the seminal book Creating Shareholder Value in 1986. Still another popular term is the Fade rate, used by HOLT Value Associates in its work with portfolio managers and corporate executives. Behind the analysis is the notion that competitive advantage lessens and eventually ends becouse competitors ‘move in producing similar or better products or services, or because market usege peaks and flattens or falls Investors believe that reversion to the mean ultimately occurs for vie- ‘ually all companies, recognizing that some are able to PU tee CE Jan/Feb 2002 ‘extend their advantages over longer time periods, Inherent in CAP is the market's expectations of how Jong it will last. Mauboussin says that the investment market determines a company’s competitive advantage period on the basis ofits expectations. CAP essentially is “how long the market expects the company to generate ‘excess returns on new investments” he says. Explains Mallette: "VGD is the way in which investors opine on their expectations for the economic success of a compa- ny’s strategy through the stock price.” Last fall, Rappaport and Mauboussin joined their years of analysis of market behavior in a new book, Expectations Testing (a lengthy article on the book and an interview with the authors ran in the November/December 2001 issue of Shareholder Value). A sustainable competitive advantage doesn’t automatically produce higher stock price, Mauboussin points out. The reason: The market price may already “completely reflect a company’s com petitive strengths." Thus, ‘the Key to successful investing is ‘ anticipate revisions in expectations” he says. Mauboussin quotes Warren Buffett, who has said that hr likes to invest in businesses that heve "economic moats around them — moats that are wide, and deep, and that have lots of alligators in them to fend off the competi- tion.” Buffet, adds Mauboussin, secks to find companies that “will expand the moat over time.” Calculating Compe! je Advantage Our experts on competitive advantege fundamentally ‘agree that economic frameworks offer the best way to define, measure, and forecast a company's competitive advantage. Mauboussin puts all the pieces together by «estimating the market-implied CAP. Cash flow expecta~ tions resulting from capital investments measured as excess returns form the basis, “Birst principles,” he says, “suggest that the value of any. financial asset, including stocks, boils down to a cesh flow stream, an appropriate discount rate, and a forecast peri- od.” With the stock price known, investors "must read ‘expectations for cash flows and the cost of capital.” Given all three, ‘the investor is ready to estimate the market- implied CAP mechanically simply stretching the forecast horizon out as far as possible to solve for the current stock price.” That period is the market-implied CAP. Detailing the analysis, LE.K’'s Mallette examines how companies earn returns above the cost of capital. That ‘Shareholder Valueanalysis, he says, starts with the "value drivers that deter- rine the value of a company’s cash flows” He cites six vital value drivers — sales growth rate, operating profit agin, cash tax rate, incremental fixed capital, incremen~ tal working capital investment rate, and cost of capital. His formula for setting the VGD of a company centers ‘on analyzing the markets expectations for each of the six value drivers, and then calculating “the length of time @ ‘company would have to sustain those expectations for cach flows to be worth the current price.” Mallette sug- gests that the estimates be drawn from information goined through company reports, analyst research, and interviews with management and other contacts. ‘A company's competitive advantage is captured in three broad factors, continues Mallete: industry dynam ics the value ofthe strategy, and how well that strategy is executed. Industry dynamics can have a big impact, espe- cially in determining the duration of the advantage. How Jong a company can sustain a competitive advantage hits at the heart of the research being done by such spectal- ists as Mauboussin, Johnson, and Mallett. Estimating the Duration Studies have showa that CAPs or VGDs vary by industry LEX. studies indicate that VGDs run between one and five years for banks, three to 15 years for fastfood restau- rants, and three to 10 years for airlines. Commodity prod- 1ucts and low barriers to entry tend to limit the VGD, he explains. Stl, companies can extend their advantage. He cites Southwest Airlines, for applying “a very focused strategy of low-cost point-to-point domestic travel Investors currently estimate Wal-Mart's VGD at 14 years, according to Mallett, built on being able to "lever- age its strategy of pushing costs ower than competitors. AAs new information becomes available on Wal-Mart and its competitors, that view may change, and the stock price would move in harmony For 3M, the strategy focuses on innovation and new products “Innovative products are priced ata premium until the markets saturated or competitors develop similar prod- tits, The expectation of 3M tobe abe to exploit that advan- tage gives it « VGD of approximately 18 years" he sas. CAPs often last a'decade and sometimes surpass 20 years, according to Mauboussin. History shows that com- petitive advantages tend to last longer for. companies wnith moderate economic returns, compared with fast- ‘Shareholder Value Managements sometimes try to extend their competitive growing, highly innovative companies that achieve high: cer excess returns but for shorter time periods. chief rea~ son is the accelerating pace of innovation. Certain hig tech companies need to reinvent themselves every few years to sustain or extend their competitive advantage. Mauboussin compares Coca-Cola and Microsoft to illustrate these differences, At the time, each had price/eamnings multiples of 28, but Microsoft had a much higher return on capital, greater growth rate prospects, and stronger positions in core markets. “However, for Microsoft to be successful over the next 20 years, it like- ly will be with products and services that are very differ cent from today's offerings” he suggests. “Microsoft will have to innovate heavily to sustain its position." In con- trast, Mauboussin believes that Coca-Cola's basic busi- ness model will still "be recognizable.” In this comparison, Mauboussin is quick to point out the Jan/Feb 2002 45weakness of P/E ratios in measuring value and forecasting the future. P/E's don’t separate industry dynamics very well. “Investors must go beyond the multiple to understand the composition of value creation. Thoughtful investors rriably run into the concept of CAP! He also notes the value of understanding whet options are impacting the CAP. Real options are opporti- nies to create value through innovation, R&D, new tech- nology — the chi is to figure out their future valie ‘Their uncertainty “is potentially very valuable for compa- nies that can capture them in the form of option value Innovative companies often are he says In who do so in alley jons-lacen, doing the analysis, CAP from the base business must be separated from the potential real options value, he explains Mallette of L.E.K. says that companies can test to see if they have a competitive advantage and help gauge how long itis likely to last.The test follows a formula: Divide NOPAT {ct operating profit afer tax) by the cost of capital. Add th market value of marketable securities and subtrac ket value of debt. Divide the result by the number of shares utstanding, and then see if it approximates the current share price. If it does, that means shareholders essentially believe that the company will yield the same NOPAT into perpetuity, and all Future investments will return no better an the cost of capital — thus creating no Mallette offers the example shown i In this case, the market isn’t bullish about ma value into even the near future he mar: xercise 1 ment's ability to er Mallette says How to Achieve a Competitive Advantage While Michael Mauboussin analyzes companies side perspective and Francois Mallette advises companies oon building a competitive advantage, Paul Johnson invests millions of dollars based! on his assessments of the market's perception of the sustainability of « com tive advantage. Whether a company has a competitive advantage comes down to two things, Johnson says: control over the edge prices it charges companies, or a significant cost Control over pricing is a"powerful’ advantage, accord back to barriers to entry," he results either from locking a unique product. ing to Johnson. “It re fe advantage typical ustomer in or by havin to switch to another supplier is too high, or no one else has the product. The customer is locked in says. T Service companies can have a unique offering as well 6 Exercise 4. net Eres) er a Sete ti frei $1,413M divided by 22m he explains. Johnson extends gas stations to brain sur ate a gas provider bi In reviewing the ra closer you get to brain surgery, the more you gain a com: pet 1 service spectrum from s little to different in surgeon, you try to get the best one in the werd. 1 of service businesses, he says "the advan’ from Significant cost s usually result economies of scale and often occur in big manufacturing. based businesses, according to Johnson — but they also an be grown through cost efficiencies in any major aspect of a company’s operations. The key is to creat fixed cost involving a lar Thy more units over that same fixed cost. -ge component of running the business, “The advantage comes from being able to make Many companies apply technology ta gain a competi tive advantage through scale efficiencies, Johnson says. Their efforts focus on ws ing technology to turn a major variable cost into a fixed cost. "Most CEOs shud thought,” he adds, believing that they prefer the flexibili- ty of variable costs. “But if you can shift some I of costs from variable to fixed, and then exploit the oi the unit volumes, you can potentially crush competitors, or at leat gain a comp. in driving pricing He adds: in companies constantly push the production envelope in terms of bringing costs down. It's game of efficiency, a game of scale and scope Shareholder ValueThe Problems with Acquisitions ‘Acquisitions may help create scale, but Johnson joins the ranks of most portfolio managers in voicing pessimism about companies’ ability to make them successfully:"The ‘evidence shows that most acquisitions don't work.” The goal, he says, is to have additional units over the fixed cost reduce average cost, producing an advantage. “But precision of the definition is important,” he explains “The large cost component is usually fixed over ‘range. It isn’t like the company has one fixed cost. It doesn't matter how many units are being made. If the ‘company already is operating in that range of efficiency, more units won't help, more units may be unnecessary or may hurt the company. So, to make acquisitions to get scale doesn't necessarily meet the definition of a compet- itive advantage Managements sometimes try to extend their compet- itive advantage into a new business, but not always with ‘good results Perhaps they don't really understand their advantage, or are falsely confident that it can be applied more broadly, suggests Johnson, He cites Cisco Systems. “The company had a demonstrable competitive advantage in the enterprise segment. It had terrific prod- tacts, huge returns on capital — a great example ofa sus- tained competitive advantage, Management decided that it would take that magical technology and the great Cisco brand and go into the earsier market, even though there ‘as no evidence that it would translate and, more impor- tant, no indication that anyone else had a sustainable advantage in that market. Yet, because of Cisco's arro- gance, the company went after that market and it bit them hard. think they misread their competitive advan- tage from the enterprise and tried to apply it to a new market — a very common situation.” ‘An outstanding brand, Johnson adds, can strengthen ‘and extend a competitive advantage, but he doesn't believe that it functions as an advantage per se."Branding only offers a competitive advantage opportunity when it gets layered onto an advantage” Johnson fears that acquisitions may weaken or destroy a competitive advantage. Acquisitions fail, he believes, either because of a lack oF execution or from a lack of good strategic thinking in the first place: "Both come hhome to rest on management's shoulders.” A weak strate gic analysis often is to blame, One misguided rationale involves “applying the company's brand to a new cus- tomer base,” he explains. “Why isn’t that customer base ‘Shareholder Value taking advantage of your brand now? Why will the acqui- sition suddenly make that available? ‘Then there are acquisitions that should succeed based on strategic analysis but fail because the execution “is very hard” to accomplish, “They are paying a premium and hope to run it better than the people they bought it from. It's strange premise” Johnson also looks askance at acquisitions motivated by a “blind effort to grow,” frequently caused by “the constant beating of Wall Street to grow; grow, a5 fast as you can.” It can lead to a misallocation of capita, he says, “going after markets where you don't have a competitive advantage: “There have been many examples ofthis through time, he adds. “They stop defending their established competi- tive advantage to go after new markets in pursuing ‘growth, only to find that the new effort fails and the old advantage is eroding because they haven't given it enough focus and attention. Constant Vigilance Indeed, it takes ‘constant vigilance’ to protect and expand an advantage, according to Johnson. “There are no free lunches,” he says. "You have to keep renewing it” In that effort, management plays the deciding role, Johnson believes, possibly becoming a competitive advantage “Execution isa function of the quality of the people, and, it’s clear that execution is past of constant vigilance: Effective managements have three vital traits, he says: (1) vision, shown in their "good sense of where their ‘company fits in the world and whore they are taking it’; {2) being able to execute the game plan; and {G) alignment with shareholders, ("They care about the shareholders) Even better than one competitive advantage is having ‘two or more. Johnson cites several examples. Coca-Cola has a unique product, strong brand, and ‘economies of scale. “Microsofts the great consumer lock-in ‘example; there are huge disincentives to change operating systems" I, t00, has “great economies of scale” General Electric has a“bunch of businesses, each alittle different, and a goal to be number one or two in each. AS cone or two, you likely have scale economies, a recognized brand, some uniqueness to your product. GE has shown that it tries to renew all these on a constant bass Its con- stantly taking costs out to be more efficient, ts manage- ment exemplifies constant vigilance," Johnson says. Jan/Feb 2002 a