Liontrust Responsible Capitalism Report 2024 - Flipbook - Page 76
ECONOMIC ADVANTAGE TEAM’S 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 longterm 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. The team prioritises three categories of intangible
assets as the first gateway into the investment process:
Intellectual
property
Strong
distribution
networks
Significant
recurring
business
Other important, intangible strengths the team look for include:
franchises and licences; extraction rights; good customer databases
and relationships; effective procedures and formats; strong brands
and company culture. However, possession of these alone are not
enough for consideration under the process.
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. 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 physical or digital. A physical
distribution channel can either be formed through a network of
appointed distributors or via a company’s own distribution sites.
When a company owns its distribution, as opposed to using
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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 digital 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.
Companies with economic advantage – the investment universe
Identifying companies with these assets gives the team a list of
companies which can withstand competitive pressures. The team
believes that these companies have the ability to deliver sustained
earnings growth ahead of the market’s expectations which in turn
will lead to long-term share price outperformance.
Financial advantage
Having identified whether a company possesses an economic
advantage, it is next assessed for evidence of this theoretical
advantage showing up as superior financial returns. The team
assesses this using the Quest database (owned by Canaccord
Genuity) which examines the cash flow return on capital (CFROC)
to measure the economic return on gross invested capital. CFROC
is real, post-tax and takes asset life and asset mix into account. For
a company (or indeed any project) to be economically successful,
it must make a higher return than the cost of the capital invested
in it. Quest uses a long-run weighted average costs of capital
(WACC) based on the capital asset pricing model (CAPM) as
the benchmark against which CFROC is measured. A company
which can earn a CFROC higher than its long-run cost of capital,
and then reinvest this return back into the business, will benefit
from compounding, which in the long run should lead to equity
value creation and strong share price performance. The process
will only invest in profitable companies.