Archive for the ‘ROIC and Competitive Advantage’ Category

I think the main reasons for why a business can have a high return on invested capital (ROIC) [1] [2] are:

  1. The business has had good luck;
  2. The business has been more operationally efficient than its competitors[3];
  3. The business has a sustainable competitive advantage;
  4. The business has a temporary competitive advantage; 
  5. The business’s earnings are high because the industry or the economy is at a cyclical peak; or,
  6. The business is in a new industry and competitors have only started to enter the industry.

The problem is that most of these reasons are likely to be unsustainable. This is because:

  1. The business’s good luck can easily run out;
  2. Competitors can become more operationally efficient, or the business becomes less efficient[4];
  3. The business’s temporary competitive advantage disappears;
  4. The business’s earnings falls because the industry, or economic, cycle turns; or,
  5. Competitors enter the new industry.

This is why I want a business, which has a high ROIC, to have a sustainable competitive advantage.[5] I think is far more likely that a business will be able to sustain a high ROIC if the high ROIC is due to a sustainable competitive advantage and not because of one of these other reasons. If is far more likely because it will be unprofitable for other businesses to compete against them.[6]

I will discuss what I think is a sustainable competitive advantage in my next post.

[1] A business’s ROIC is its Return on Invested Capital. It tells you how profitable a business has been. It does this by telling you the amount of capital the business needed to produce its profit. 

[2] A high ROIC is defined as a ROIC significantly above my discount rate.

[3] See, ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[4] I believe that most businesses with good operational efficiency only have a temporary competitive advantage (there are exceptions). I think it is usually only temporary because this operational efficiency can naturally decline, or a competitor can reproduce it.

 A business’s good operational efficiency can naturally decline because:

  1. Management dies, or retires, or is poached by other businesses; or,
  2. Management becomes sidetracked by some major internal or external issue (for example they make a takeover offer, or are involved in a major lawsuit); or,
  3. Management simply loses its drive.

 A competitor can reproduce another business’s good operational efficiency by copying the successful business’s operational practices, or by recruiting better management.

[5] However, the closer my valuation assumes a business’s ROIC is to my discount rate the less sustainable the business’s competitive advantage will need to be.

[6] However, as Greenwald and Kahn point out, if competitors are not rational and do enter, or expand within the industry, I must never assume that they will then realise their error and just as quickly exit the industry, or reduce capacity. These two processes are not symmetrical. Competitors with patient capital and an emotional commitment to the business may not exit the industry for a long time. Greenwald uses the analogy that it is much easier to buy kittens and puppies then to drown them later. This will impair the profitability of those businesses in the industry that have a sustainable competitive advantage for years. See P25, ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

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