Truly great businesses with sustainable competitive advantages are exceptional, and these companies are usually very expensive.
Just as we see degrees of uncertainty, we see degrees of competitive strengths. Some businesses may not have any competitive strength at all, and may be valued at book value or less, and other businesses may have some competitive strength and may deserve to be valued accordingly.
Our valuation models try to reflect the competitive strength, (also potential growth and risks) and therefore considers the situations when a company may generate above or below average returns on invested capital.
As for compounders, and for any valuation, among other things, we look for relatively undervalued companies: companies selling at prices relatively cheap compared to other companies of the same general quality, growth potential and risks.
Compounders Rare birds
This investment approach aims to look for companies with “moats”. A moat refers to competitive advantages as defined by Michael Porter.
Why is this important ?
In the normal course of events, when a company does not benefit from moats, competition brings profits down to a minimum. Once a company benefits from moats it may be able to generate higher returns on capital and therefore it may be paid for at a higher price multiple.
Also, if sustainable, moats may favor the generation of future resilient cash flows (or earnings power).
Truly great businesses, or compounders are rare birds
Even with best businesses we may have disappointments. Business models evolve, risks evolve too, and what may have been a competitive advantage may become obsolete. Sometimes, you can be surprised to find that what you expected to be a resilient competitive advantage was in reality a transient competitive advantage.
There are different kinds of risks to competitive advantage, for example, we can point risks related to technological changes (which may lower barriers to entry) and/or changing trends such as changes in the behavior of customers, changes in business models (such as changes in distribution channels) etc.