8 traits of a great business - part one
Edward Crossin
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What are the ingredients that are consistent in building and sustaining a quality business? In this two part series, we lift the hood to examine the individual components and the competitive advantage these components serve.
This article summarises the first of a two part podcast series published in April 2022 by the team behind Motley Fool Money. Hosts for the podcast are Andrew Page, founder and Managing Director of Strawman and Scott Phillips, Chief Investment Officer at Motley Fool in Australia.
Full acknowledgement and appreciation of the content of this article is given to this informative podcast series.
#1 Sustainable competitive advantage
Beginning with sustainable competitive advantage at the top of the tree, the essence of this principle will flow through seven of the other traits of a successful business.
This sustainable competitive advantage principle has been popularised by Warren Buffett as an economic moat. It describes a business' ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms. Just like a medieval castle, the moat serves to protect those inside the fortress and their riches from outsiders.
The important element within this principle is that it must be sustainable. It must be an edge that can be sustained over the long term, and not an advantage that can be duplicated or eroded over time by outside forces like competitors.
Examples of this advantage include patents, special contracts with customers or suppliers, cost advantages and brand.
ASX companies that demonstrate strong sustainable competitive advantages through the strength of its brand include Coca-Cola Amatil. Through the strength of commanding higher pricing, Qantas and Telstra are two Australian company examples who create a competitive moat with the premium they charge.
Banks like Commonwealth Bank sustain a competitive advantage because they are structurally important for the Australian economy, have deposit guarantees and command dominant brand equity. The power of the Commonwealth Bank's brand helped launch its trading platform Commsec, despite its higher brokerage costs. Today, Commsec is the most used trading platform in Australia.
#2 Network effects
Network effects occurs where the more people that are plugged into your product or service, the more valuable that it becomes. Network effects are typically positive, resulting in a given user deriving more value from a product as more users join the same network.
If you wanted to buy or sell a car or house, you would probably choose carsales.com.au or realestate.com.au. Why? Because that's where most buyers and sellers are. It becomes a self-sustaining and increasing loop: more buyers, more sellers in a roundabout of increasing network effect.
Seek.com.au is another example of an Australian business demonstrating powerful network effects.
The distance between first and second for market share leaders like Seek, carsales.com.au or realestate.com.au is substantial and is challenging for newcomers and market followers to gain market share.
The value of a communications network increases disproportionately as it expands, bringing in more other people for each user to connect with – a ‘direct’ network effect - Patrick Barwise, LSE Business Review
Google plus is a case study of first mover advantage and network effects. There were two principles reasons behind the failure of Google plus. First, Facebook was first. And second, because most users were already using Facebook, the social media giant had commanded a competitive moat of established network effects.
Picture credit - corporatefinanceinstitute.com
#3 Predictable cashflow
A cashflow that is predictable and recurring is a trait of a great business. It shows monotonous regularity, and a solid financial foundation.
The predictability of a business that demonstrates these hallmarks is Woolworths. Another example of a dependable and predictable cashflow is Xero, which runs a?cloud-based accounting software platform, with a subscription business model. The technology company has low customer churn, and also carries the advantage of network effects and high switching costs.
#4 High switching costs
Described by Andrew Page as a trapdoor moat (customers fall down and you're trapped), if a business has high switching costs for its customers, the resulting retention of customers is a competitive advantage.
An example of a consumer pain point are the switching effort costs that are perceived with shopping around for a better home loan. While the actual shopping around process is not difficult to execute, the perception is real, and the retention becomes an advantage for a bank who own the home loan and customer relationship.
Tech companies also deploy a range of strategies to lock users in by making it difficult or costly to switch to a rival - Patrick Barwise, London Business School
In this article Why tech markets are winner-take-all, Partrick Darwise says incompatibility between providers (‘walled gardens’ – for example, where iOS apps do not work on Android), non-portable data, time invested in learning a particular system, service customisation, and accruing content such as playlists that cannot be migrated, all discourage switching.
Enterprise software is an example of a trapdoor moat because for customers, the significant costs to install, train staff, integrate business processes delivers a combination of elements that make it difficult for a customer to switch.
Once a company like Cochlear acquires a customer, chances are they have them for life. Because the installation of a Cochlear hearing implant requires surgery, the likelihood of that customer switching to a different product are remote.
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Cochlear's hearing implant and its inherent high switching cost are a business advantage. Picture credit - Wikipedia
#5 Gross margin
Demonstrated as a percentage, gross margin is the difference between revenue and cost of goods sold, divided by revenue.?
A sustainable high gross margin augers well for long term business profit and net margin.
A business with a low gross margin can also create a competitive advantage, if it can maintain lows costs and simultaneously generate sales momentum and reach an inflection point at scale.
Xero is an example of a company that operates at a strong gross margin: it has a low cost of goods that with a subscription model creates high margins.
Australian data centre operator, NextDC. Picture credit: zdnet.com
#6 Marginal profitability
Important through the lens of growing economies of scale, marginal profit refers to the profit earned by a business when an additional unit is produced and sold.? It is affected by your marginal cost and marginal revenue structures.
Successful software businesses are clear winners in marginal profitability. Megaport, NextDC and Pointerra are examples of businesses with quality marginal profitability.
#7 Customer concentration
Customer concentration reveals the distribution of your total revenue among your customer base.?
Losing a customer can be detrimental for a business. If a business has a highly concentrated group of customers, a small number of eggs in one basket become vital and risky.
On the flipside, if the likes of Transurban (toll roads) or Coles (groceries) have millions of customers, and they lose some customers, the risk is low and the impact is reduced.
Picture credit: Inside Retail
#8 Partner dependency
When the geopolitics between Australia and China changed in 2020, a business with a high partner dependency such as Treasury Wines was negatively impacted.
A business that has the power to call its own shots has low partner dependency. Wesfarmers has low partner dependency because of its high number of partners and the breadth of its diversity: it operates in different industries, with many different customer groups. A business that ranges from Officeworks to energy to safety, Wesfarmers is able to withstand changes in market conditions, regulatory changes and other external forces.
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