My style of investing involves choosing companies with strong competitive advantages. These are companies that are very difficult to compete with for one reason or another. Firms with strong competitive advantages are able to protect their profits, maintain a large share of the market and charge higher prices for their products. Here are two companies in the FTSE 100 index that meet this criteria.
FTSE 100 company #1: Diageo
Diageo (LSE: DGE) enjoys a strong competitive advantage through its portfolio of recognizable and popular alcoholic brands. These include Smirnov, Guinness and Johnnie Walker. Customers are loyal to these brands, allowing the company to charge higher prices. Thanks to this, Diageo has maintained an impressive average gross margin of 61% over the last five years.
Although the pandemic had a severe negative impact on the company, Diageo’s results for fiscal year 2021 released last week suggest that the company is recovering strongly. Last year, organic sales grew 16% year-on-year and adjusted earnings per share grew 7.4%. Management also expect this momentum to continue giving reason for investors to be optimistic about the future.
FTSE 100 company #2: Rightmove
Rightmove’s (LSE: RMV) competitive advantage comes from a phenomenon called the network effect. This is where the more people use a product the more valuable it becomes. In Rightmove’s case, the more people searching for properties, the more valuable the Rightmove platform is to estate agents. Equally, the more estate agents on the Rightmove platform, the more valuable it is to prospective customers. With nearly 20,000 advertisers and 1.7bn minutes of consumer traffic per month, Rightmove enjoys a very strong network effect. This makes it easier for the company to maintain its high market share of over 90%. It also allows the company to maintain very high margins. Over the last five years, the company has averaged an operating margin of 72%.
Similarly to Diageo, the pandemic impacted Rightmove significantly. Revenue declined 29% in 2020 largely thanks to a discount the company offered to advertisers. However, interim results released last week showed that Rightmove generated £149.9m in revenue during the first half of this year. This is 4% higher than the figure achieved in the first half of 2019 indicating that the company has fully recovered from the effects of the pandemic.
Am I buying these shares?
While both companies are very attractive due to their competitive advantages, I will not be adding them to my portfolio. This is because they are both too expensive for me.
At the time of writing, Diageo is trading at a trailing adjusted price-to-earnings (P/E) ratio of 30. For me, this is slightly too high for a company that analysts expect to grow earnings by 11% next year.
At the time of writing, Rightmove is trading at a trailing P/E ratio of 42. Again, for me, this is too high for a company forecasted to grow earnings 10% in 2022.
Both firms also seem expensive compared to the FTSE 100 index which is currently trading at a forward P/E ratio of 13.5.
Despite their lofty valuations, the fact that they both have very strong competitive advantages means that I am keeping a close eye on them for the future.