Liontrust Responsible Capitalism Report 2024 - Flipbook - Page 52
INVESTMENT PROCESS
“Economic advantage” is the collection of distinctive characteristics
of a company that competitors struggle to reproduce, even if
those competitors have understood the benefits arising from
those characteristics. It is the managers’ key belief, backed by
their long-term experience exploiting companies with economic
advantage, that only distinctive and hard to replicate intangible
assets can form the basis of a sustainable competitive advantage.
These characteristics provide a barrier to competition, thereby
protecting profitability. In the team’s experience, the hardest to
replicate of these particular characteristics fall into the following
three categories of intangible assets:
Intellectual
property
Strong
distribution
networks
Significant
recurring
business
Other less powerful, but nonetheless important, intangible
strengths include: franchises and licences; extraction rights; good
customer databases and relationships; effective procedures and
formats; strong brands and company culture.
How the team identifies companies with economic advantage
The managers evaluate companies in the UK stock market for
their possession of durable economic advantage. To pass their
test for economic advantage, a company must demonstrate that
it has either:
• intellectual property
• a strong distribution channel
• repeat business
This initial screen gives the team its universe of potential
investments.
Identifying intellectual property
• Intellectual property assets include patents, copyrights, extraction
rights, trade secrets and know-how.
• Patents are property rights that are granted by the state to an
inventor. The inventor has exclusive rights for a period of time that
prohibits others from imitating the invention.
• Copyrights protect the expression of ideas, not the ideas
themselves.
• Extraction rights are legal permits allowing an individual or
business to extract a resource from a specified area.
52 - Responsible Capitalism Report 2022
• Trade secrets represent pieces of information that are held within
a company and not released to the outside world. They are often
protected by non-disclosure clauses in employee contracts.
• Know-how relates to the particular knowledge that individuals have
in a certain business area. This can range from the knowledge of
how to perform a particular manufacturing process to service skills
such as scientific translation.
• Intellectual property assets, particularly patents, copyrights and
extraction rights, are often protected in law. In the case of patents
and copyrights, this protection helps deliver significant product
pricing power. Frequently, intellectual property assets are created
and enhanced through a high level of expenditure on research
and development (R&D). A company’s accumulated R&D helps to
enforce a barrier against competition.
Identifying strong distribution networks
Distribution channels can be both physical and electronic. A
physical distribution channel can either be formed through a
network of appointed distributors or alternatively via a company’s
own distribution sites. When a company owns its distribution as
opposed to using distributors it is able to benefit directly from
giving its customers strong local service and in return build up
valuable local knowledge. A physical distribution channel takes
time to build and can provide a powerful barrier to competition.
Increasingly, particularly in areas such as media and information
technology (IT), companies are developing electronic distribution
channels. Market research and IT companies, for example, can
send data direct to clients electronically. Once data connections
are set up, and particularly when they become embedded in client
systems, it becomes difficult for competitors to dislodge incumbents
and hence a powerful barrier to competition is created.
Identifying companies with significant recurring business
Recurring business can result from the strength of a company’s
product, from the convenience of its distribution network, or from
strong customer relationships and brand. Certain companies are
guaranteed a level of recurring business through the strength of their
customer contracts and service agreements. A significant volume of
repeat business (which the team defines as at least 70% of annual
turnover) gives a company a high degree of earnings visibility.
This visibility helps companies plan and drive long-term growth.
Furthermore, contracted revenue will tend to have pre-arranged
pricing structures. This limits sudden competitive pricing. Contracted
recurring revenue is a powerful barrier against competition.
Mutual reinforcement of economic advantages
The intangible assets that create an economic advantage are often
mutually reinforcing. Strong intellectual property, for example, can
be best exploited through an established distribution network. A
brand will be strengthened by good customer relationships and
culture. Repeat business will be aided by a strong brand. That is
why companies with a real depth and breadth of intangible assets
tend to have a significant economic advantage.