Three global stocks with the competitive advantage to beat their rivals - and one trap card
In this special fourth edition of Expert Insights, we ask Matthew Landy of Lazard Asset Management just one question that required a lot of depth and time to discuss.
In a previous episode, Landy talked about the traits that outstanding companies have - a wide moat and a strong competitive advantage. In this episode, we will take a much more in-depth look at the latter of these two traits. In particular, we'll discuss the rigorous criteria that Lazard uses to filter down the investable universe from thousands to just over 200, then eventually down to the final 25 which make it into the global equities portfolio.
Finally, we'll discuss two companies that make the grade and a company that, at first glance, did make the grade but turned out to be a classic value trap.
For his full thesis and the companies he mentions, watch the video or read our edited transcript.
LW: How do you evaluate companies for their competitive advantage?
Matthew Landy: We see five sources of an economic franchise. And sometimes companies can have multiple, and sometimes it's only one.
So one is a natural monopoly. Infrastructure companies tend to fit that category. So once you build an electricity transmission grid, for example, there's no point replicating that. The costs involved are so enormous that it makes sense for only there to be one provider of the electricity transmission grid.
Brands clearly can be very powerful. In particular, the consumer sector obviously. It creates loyalty, and it often enables you to earn very high-profit margins on your product.
Intellectual property gives you a period of exclusivity over a product or service. We see that a lot in the healthcare space, particularly in medical devices.
Network effects - I mentioned Visa, MasterCard, and Google arguably have that as well, where effectively, the more people that use the product, the more valuable it becomes to consumers over time. It's a very rare competitive advantage, but when it happens, it's incredibly powerful.
Switching costs is another, and you see this a lot in the software industry. It's where a product, the nature of a product or service means that it's hard for customers to switch to a competitor.
An example of that would be Oracle, which is the largest provider of database systems in the world. Taking out a database system has been likened to ripping out the plumbing and wiring in a building. So once you install Oracle databases in your corporate IT stack, you're very reluctant to change. That underpins very high recurring revenues for Oracle and a very stable market share.
Obviously, if you have more market share and more volumes, your average unit costs are lower than competitors, and it gives you an enormous competitive advantage.
Stericycle in the U.S. would be an example of that. So it's the largest medical waste disposal business. It's about route density, picking up waste from hospitals. They have five times the market share of their nearest competitor.
In terms of how we determine whether a business is losing its competitive advantage. I mean, the obvious one is earnings and margins - but that typically comes too late. Once that starts happening, it's often too late and the share price will almost certainly fall. So you're trying to get ahead of that. What we look for is particularly in terms of technology; the question is, is it a substitute or is it a compliment?
One of the businesses that we own at the moment is Nielsen. It owns the monopoly on the TV rating system in the U.S. and its share price has been under a lot of pressure because people are concerned that as viewers are moving to streaming and internet-based TV, IPTV versus linear TV, their rating system is no longer as valid or as lucrative.
And look, we've been a shareholder in that business so we obviously disagree with that view. In terms of trying to work out the disruptive effect of streaming, it's always a case-by-case sort of analysis.
But in this case, we think the barrier for them is that they have a rating panel. It's a panel of actual people who sit down and watch TV and on a little computer pad record what they see.
It's very old-fashioned, but that's a huge barrier because actually building a panel of people, a representative sample, is very expensive, and maintaining it is very expensive as well. And you need that actual real-world interaction with real live human beings to tell what they've actually watched in order to get a valid ratings assessment. And so we think they will be able to roll that out to a streaming environment as well.
Another example would be Tesco in the U.K. So it's this U.K. supermarket chain. This is many years ago and the price had fallen a lot and looked very cheap to us. It's the number one supermarket chain in the U.K. But we decided not only not to invest, but we actually deleted it from the universe.
The reason for that is twofold:
- There was new competition coming to the market. So the discounters, so Lidl and Aldi, were coming in with a very narrow product range at very low prices and starting to carve out some of the margin, the profit pool from Tesco.
- The rise of e-commerce was also taking market share from them as well. And we felt that with their big physical real estate footprint, they were going to struggle. And that was the right call.
Fortunately, it did look cheap, but it was cheap for a reason. It really was a value trap. So we, fortunately, avoided that one.Access companies with an 'economic franchise'
The Lazard Global Equity Franchise Fund seeks long-term, defensive returns by investing in listed companies which possess a combination of high degree of earnings forecastability and large competitive advantages. Find out more here.
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Hans is a content editor at Livewire. He is the lead writer of Charts and Caffeine and created Signal or Noise. He graduated with an economics and journalism double degree from Macquarie University.