How to find fortress shares that will stand the test of time

This top fund manager talks to Cherry Reynard about firms' inbuilt competitive advantages.

Technology has driven a stake through the heart of many traditional businesses that have endured for decades but have suddenly found themselves in decline – following the launch of a new app, for example.

Sectors as diverse as retailing, car production and the music business have suffered, and more sectors are in the firing line.

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In this disrupted world, the extent to which firms can protect their business is increasingly important to their survival. They need to have tangible advantages that can’t be readily replicated by an algorithm or competed away. If a company is to provide a higher return on capital or greater pricing power than the market as a whole, it needs a competitive advantage. Inbuilt competitive advantages are known as barriers to entry.

Blocking tactic

Certain fund managers have long built analysis of barriers to entry into their processes. For Liontrust (LSE:LIO), for example, barriers to entry are key to the 'economic advantage' investment process that powers its Special Situations and UK Smaller Companies funds.

Matt Tonge, who co-manages the process , says:

"A fundamental principle of competitive markets is that profits regress to the mean. We believe the secret to successful investing is to identify the few companies that benefit from a durable barrier to competition, which allows them to defy this principle and sustain higher-than-average profitability for longer than expected."

Tonge argues that the most durable barriers are the intangible ones, because these are harder for competitors to reproduce. He says: "One core intangible barrier we look for is intellectual property. This can take the form of patents, copyrights, extraction rights, trade secrets or simply knowhow. The other intangibles we view as key are significant recurring business and strong distribution networks, either physical or electronic."

Richard Pease, manager of the CRUX European Special Situations and CRUX European fund, also looks at barriers to entry as part of his investment process. However, he points out that where a firm benefits from an obvious barrier, the market will spot this and the company’s share price with be relatively high as a result.

'Soft' barriers – based on service levels, trust or credibility, for example – may be overlooked, though. Pease gives as an example of a firm benefiting from 'soft' barriers an outsourcing firm in his portfolio. Its margins are good, and its customers have grown comfortable using the company: He says: "It will take a lot for another firm to come and take the company on. Those who use it need a good reason to change."

Companies that sell 'trust', such as firms with a contract for inspecting things, for example, in effect also benefit from a barrier. Pease says: "They have a lot of inherent knowledge and infrastructure. This acts as a barrier to entry. Another example might be firms that make flavourings and smells. For companies such as Nestle (XETRA:NESR), barriers may take the form of critical parts of their products that may represent a fraction of the cost of those products, so they are the last areas companies are likely to scrimp on."

Unwelcome attention

That said, Pease argues that investors need to be wary of monopoly businesses. A monopoly position would seem to erect the highest possible barrier to entry. However, firms with monopolies can become a target for competitors or, more frequently, regulators.

Equally, while patents can provide a solid barrier to entry, the protection they offer has to be balanced against the risks that come with them. In the pharmaceutical industry, for example, investors need to be wary of litigation risk. The patent on the most widely used painkiller in the US might have appeared an effective barrier to entry for its maker, Purdue Pharma, but the firm's strength in the painkiller market has exposed it to significant litigation in the wake of the opioid abuse crisis.

Pharmaceutical firms also face patent cliffs when patents on best-selling drugs end. Many larger pharmaceutical firms have struggled to develop drugs to replace those with expiring patents.

Barriers to market entry add to business durability, but they also attract the attention of competitors, so the strongest barriers are often those that are far from obvious.