Competitive Advantage Period is a key investment concept that is often overlooked by investors. In this article, our analyst Daniel Wu outlines how this concept can help investors better determine what they’re paying for when they buy a stock.

Under the expectations investing framework which the Montaka team utilizes extensively, one key component that attract less consideration is the Competitive Advantage Period (CAP). The CAP can be defined simply as the time during which a company is expected to generate returns on incremental capital in excess of its cost of capital. A company’s CAP depends on many internal and external factors, and a company with a long and preferably constant CAP can be said to have an enduring moat.

By definition, a company will only create value if it can generate returns (earnings and cash flows in this instance) on the incremental capital invested that are in excess of the cost of providing that capital. The cost of capital, better understood as the weighted average cost of capital (WACC) or discount rate, represents the time value of money, risk and opportunity cost of providing capital for one endeavour versus another. The higher the cost of capital, the higher the return that capital providers demand. For example, a company that generates $8 of cash earnings off an incremental $100 investment (an 8% incremental return) when its cost of capital is 10% is destroying value, and the longer it operates in this manner, the more shareholder value it will destroy. Conversely, the same company that can generate $15 of cash earnings (15% return) will be creating $5 of incremental value, and the longer it can maintain an above-10% return, the more value it will create.

Of the three main components of valuation analysis – cash flows, risk (the discount rate), and the forecast horizon – only the first two tend to receive any serious consideration from investment analysts. Indeed, most sell-side analysts and likely many buy-side analysts simply assume a shortened 5 to 10-year forecast horizon and tack on a terminal growth rate at the end to account for terminal value. But as demonstrated in the example above, this can significantly misstate the value of a company. The terminal growth rate implies that the company earns above its cost of capital into perpetuity, which will overstate the value of structurally weak or declining companies (e.g. retailers). Conversely, the shortened forecast horizon may understate the value of high-quality companies with wide, defensible moats that are likely to be earning above their cost of capital well beyond the 10-year horizon.

Giving more explicit consideration to the CAP can help investors avoid some of the above pitfalls. Again, by definition, once a company reaches the end of its CAP and stops generating excess returns, it will no longer create additional value and therefore the likelihood that it is or remains undervalued diminishes significantly. It is also an effective way of capturing long-term future optionality within a business that may be difficult to express through cash flow forecasts. Therefore, investors will want to buy and own companies that they assess to have long, and ideally constant, CAPs. Of course, investors cannot know for certain what a company’s true CAP is, and CAPs can change over time as a company evolves, but there are qualities to look out for that can help investors gauge the relative length and durability of a company’s CAP.

Internal factors that influence a company’s CAP include things such as its business model, competitive positioning, the uniqueness of its products and/or services, brand strength, and the quality of management (especially as it pertains to resource and capital allocation). External factors influencing the CAP include technological advancement and disruption, industry headwinds or tailwinds, and economic, political or regulatory changes. As the mix of internal and external factors affecting the durability of a company’s excess returns is constantly shifting, investors need to be on top of these changes lest they get wrong-footed.

The foregoing discussion on CAP can be further adapted into a Market-Implied CAP (MICAP) within the expectations investing framework. The core tenet of expectations investing is understanding what market expectations are built into the stock price for any given company. A large part of that will be figuring out what earnings and cash flow expectations are implied by the current stock price (sell-side consensus is as good a place as any to start), but a less obvious part is understanding what the market thinks about the CAP. If an investor mechanically applies a 10-year CAP and concludes that the market implied earnings and cash flow expectations are overly optimistic, it would be the wrong conclusion if the MICAP is actually closer to 30 years.

All of this is not to say that a company with a long and constant CAP can’t be overvalued. There are many instances, especially in today’s market, of companies with wide moats and enduring CAPs that appear to be very expensive. The CAP is simply one consideration (albeit often overlooked) when it comes to securities analysis. The more important consideration for investors remains the trajectory of future earnings and cash flows.

Daniel Wu is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.