How to find stocks with the hallmarks of 'sustainable' competitive advantage

There are over 2,400 stocks listed on the ASX, but believe it or not, only a choice few can truly lay claim to having a competitive advantage – which simply put is a company's ability to reinvest capital back into the business to achieve above average returns; and on historical measures this would be around 10 percent. It's not rocket science, for every $1 invested back into the business, companies with a truly competitive advantage can usually achieve a $1.10 or more in return.

But to ensure that above average returns are attributable to defendable points of difference – even when prices go up – and not just due to one-off flukes or abnormal trading conditions, you need to look for 'sustainable' above average return on equity (ROE) over a number of years.

Only 213 stocks listed on the ASX can lay claim to having a historical ROE greater than 15 percent-plus, which is the benchmark by which growth stocks are typically measured. However, once we filter these 213 stocks for a forecast ROE greater than 10 percent, the number virtually halves to just 124 stocks. 

The next step is to take these 124 stocks and apply one more filter, which in this case is an historical change in value greater than 10 percent, and when we do this our list of growth stocks with a sustainable competitive reduces to just 70.

However, even after recent share market corrections, too much of the growth upside is still factored into the price of most of these 70 stocks, which all too often doesn't make for an attractive entry point.

It's no good finding high-quality growth stocks if you have to pay too high a price for them. Indeed, paying a (slight) premium for the best of these growth stocks might be justifiable, but if you're paying $1.60 for a $1 worth of value, your potential downside is probably too high.

As a result, we then filtered these 70 stocks on those trading at premiums to intrinsic value no greater than 30 percent, and this narrowed the pool down to 29 stocks.

With funding providing meaningful clues into how sustainable growth and superior returns might be into the future, we then removed all remaining stocks trading with a funding gap.

Admittedly, there are some great stocks that don't make final cut because they're carrying varying amounts of debt on balance sheet, and we mention some of these below. But the 13 stocks with a funding surplus in our final universe are more likely to avoid excessive borrowing, expand their businesses, pay dividends and withstand economic downturns.

All things considered, the 13 remaining stocks worthy of further homework to discover the full extent of their competitive advantage include:  

Stock

Premium

/discount to intrinsic value

Forecast ROE

Historical change in value

Historical ROE

Market cap

Brambles Ltd (BXB)

-23.4%

24.30%

16.29%

26.57%

$15.03bn

Medibank Private (MPL)

-20.23%

21.35%

73.00%

20.12%

$6.46bn

Flight Centre (FLT)

24.93%

20.37%

17.10%

21.67%

$3.57bn

JB Hi Fi (JBH)

40.70%

38.49%

24.31%

43.03%

$1.87bn

Breville Group (BRG)

-4.64%

21.29%

14.52%

21.00%

$755mn

Monadelphous Group (MND)

52.27%

21.92%

16.42%

28.44%

$600mn

Ozforex Group (OFX)

-7.08%

55.10%

26.01%

58.19%

$600mn

Webjet (WEB)

-15.31%

26.39%

24.53%

24.82%

$341mn

Nick Scali (NCK)

10.94%

39.44%

10.86%

39.93%

$287mn

3P Learning (3PL)

-2.41%

36.03%

76.37%

20.34%

$256mn

Citadel Group (CGL)

-24.36%

18.76%

118.69%

17.99%

$203mn

Godfreys Group (GFY)

-1.72%

12.85%

587.23%

22.93%

$120mn

eBet (EBT)

-18.71%

13.80%

34.15%

26.79%

$60mn

(NB: A negative percentage indicates that the intrinsic value is less than the market price, hence stocks with positive values are trading at a discount)

Source: Skaffold 22 September 2015

Top four picks

The four stocks deemed to have the hallmarks of a sustainable competitive advantage currently trading at varying discounts to their intrinsic value – and no debt – are Flight Centre (ASX: FLT), JB Hi Fi (ASX: JBH), Monadelphous Group (ASX: MND), and Nick Scali (ASX: NCK).

Three key attributes to look out for

Given that the above list will always be a constantly moving beast, it's critical that you understand where exactly a company's sustainable competitive advantage comes from, and how defendable it really is.

Companies enjoying strong competitive advantage typically either have a structural cost advantage, a capital advantage or attributes that foster pricing power, while the best companies, exhibit a combination of all three. The more difficult or costly it is for competitors to recreate a stock's business – aka as barriers to entry – the stronger its competitive advantage is likely to be.

Two key sources of competitive advantage include scale or size, and government protection.  As a case in point, RIO Tinto (ASX: RIO) and BHP's (ASX: BHP) ability to derive a competitive advantage from access to the world's lowest cost iron ore mining production, plus government protection in the form of mining tenements, are key factors that can't be recreated by competitors.

Due to their size and scale, plus myriad forms of government protection – enshrined in the 'four pillars policy' that prevents them from merging the big-four banks collectively enjoy competitive advantage. Due to its scale and customer captivity, having locked up geographical locations, Ramsay Health Care (ASX: RHC) seems to have an unassailable competitive advantage, as does Cochlear (ASX: COH) due to the scale of its global reach and patent technology.

Due to regulatory barriers discouraging other players from entering the market, Challenger Ltd (ASX: CGF) enjoys an 80% share of Australia's annuity market. Given that regulatory hurdles only perpetuate limited competition, Challenger should go on achieving above average returns on invested capital for at least the next 10 years. 

Those who doubt the impact of government protection only need to look to Telstra (ASX: TLS), and more recently Tatts (ASX: TTS) and Tabcorp (ASX: TAH) that have lost varying shades of monopoly to regulatory reform. Echo Entertainment's (ASX: EGP) Star City is also poised to lose its monopoly in Sydney when Crown Resorts (ASX: CWN) opens at Barangaroo from 2019.

Other classic examples of one-time growth stocks losing their competitive edge to disruptive technologies are the listed network TV channels. Nine Entertainment's recent earnings downgrade dragged down the market value of several major media companies, including Seven West Media, amid fears the ad market will continue migrating from free-to-air TV into other forms of media.

A third source of competitive advantage, is what's called customer captivity, and relates to the difficulty with which customers can move to another supplier. There are no better examples of customer captivity, than internet stocks like Seek (ASX: SEK), REA Group (ASX: REA) and CarSales.com Ltd (ASX: CAR) that dominate their respective sectors; plus recently listed midcap iSentia Group (ASX: ISD).

These stocks benefit from the 'network effect' where the greater the number of people joining, the more valuable and bigger it becomes in scale  which only adds to pricing power.