It's common for investors to seek out companies operating in industries that are experiencing strong tailwinds. This approach can boost returns in the medium term provided such businesses are purchased cheaply and have decent management.
The only problem with investing this way is that favourable industries tend to attract competition because of the attractive returns on investment that are available. The impact of this over time is that margins become eroded as companies undercut each other to gain market share.
However, this process usually takes years and in the meantime investors can still make money by backing those businesses with a first mover advantage. This is particularly true in industries with high barriers to entry, where companies are protected from outside competition.
Examples include highly regulated industries such as banking, pharmaceuticals and childcare.
In a small number a cases, a company is able to continue growing its profits even as competition intensifies. These companies are said to have a sustainable competitive advantage because they have qualities desired by their customers that others cannot replicate.
Good management should be able to exploit this situation and deliver excellent returns to shareholders over a long period of time.
Here are three examples of ASX companies with a sustainable competitive advantage.
CSL Limited (ASX: CSL)
Sustainable Competitive Advantage: Low cost, intellectual property
CSL is a world leader in the provision of blood plasma therapies and has a smaller vaccines business. Its sheer scale and substantial manufacturing know-how enables it to provide a reliable supply of diverse products at low cost. Choice and reliability are critical factors for its customers given the consequences of running out of supply.
CSL reinvests its profits in the development of new therapies and increases its production capacity, which in turn enhances its sustainable competitive advantage. The benefits of this are shown by the company's growth in return on equity between 2010 and 2014, from an impressive 22% to an exceptional 42%.
Sydney Airport Holdings Ltd (ASX: SYD)
Sustainable Competitive Advantage: Natural monopoly
Anyone who wants to travel to or from Sydney by air must use Sydney Airport. This is unlikely to change even if a second airport is built in Western Sydney, since Sydney Airport has first option to develop and operate it. Airlines, retailers, taxis and passengers have no choice but to pay whatever prices the company chooses to charge them for access to the airport and its amenities.
Since 2002, revenue per passenger has increased from $19 to over $30 today, giving an indication of the kind of pricing power at Sydney Airport's disposal. Meanwhile, passenger numbers have grown from 23.9 million to 38.5 million and this trend doesn't look like stopping any time soon.
SEEK Limited (ASX: SEK)
Sustainable Competitive Advantage: Network effect
As owner of the premier online jobs portal in Australia, SEEK benefits from a strong network effect. As more people use the service, the more attractive it becomes to both recruiters and those looking for work.
SEEK is now expanding abroad and already 38% of its revenues come from overseas on a "look through" basis. The potential is huge since the company's addressable market now includes billions of people in the developing world.
Foolish takeaway
Whilst all these companies enjoy huge advantages, should anything happen to the industries in which they operate, they could still turn out to be bad investments. This is why it is essential to only buy stocks that trade at a significant discount to intrinsic value.
Furthermore, buying high quality companies at cheap prices delivers double returns, firstly as the stock is re-priced by the market to fair value and secondly as the company grows in value over time.
