How do the competitive moats of CSL Limited, Cochlear Limited and Nanosonics Ltd stack up?

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When you’re looking for your next investment, I believe you should buy shares in companies that exhibit a genuine strength, or competitive advantages in relation to their competitors.

Additionally, these companies should be focused on sustaining these advantages as best they can to allow the business to be profitable over the very long term.

The concept of competitive advantage was first articulated by Michael Porter of the Harvard Business School in the US when he published his books Competitive Strategy (1980) and Competitive Advantage (1985). These are considered today as two of the preeminent texts on the practical application and teaching of business strategy throughout the world.

One of the strategies that allows a company to sustain its advantage is to differentiate its products or services so that there’s a clear distinction between it and its competitors.

Which brings us to the ASX.

What companies are genuinely building, sustaining and protecting their competitive ‘moats’ on the ASX today and what are the prospects for such businesses over the next 5, 10 and 20 years?

Here are three businesses that invest substantial sums of money into their key products in a bid to sustainably and profitably grow their businesses well into the future.

CSL Limited (ASX: CSL)

CSL describes itself as a global specialty bio-therapeutics company that develops and innovates particular products in blood plasma, vaccines, and pharmaceuticals.

The amounts invested by the company are substantial and, as can be seen below, the research and development (R&D) costs of the company have grown at a compound annual growth rate (CAGR) of more than twice that of sales revenue over the last five years.

2011-12 2012-13 2013-14 2014-15 2015-16 CAGR (%)
Sales revenue (US$m) 4,616.4 4,950.4 5,334.8 5,458.6 5,909.5 5.05
R&D (US$m) 369.7 426.8 466.4 462.7 613.8 10.67
R&D/Sales revenue (%) 8.01 8.62 8.74 8.48 10.39

Similarly, here are the equivalent tables for Cochlear Limited (ASX: COH) and Nanosonics Ltd. (ASX: NAN)

Cochlear Limited (ASX: COH)

2011-12 2012-13 2013-14 2014-15 2015-16 CAGR (%)
Sales revenue ($‘000) 778,996 752,721 804,936 925,630 1,130,552 7.73
R&D ($‘000) 119,322 124,715 127,562 127,985 143,134 3.71
R&D/Revenue (%) 15.32 16.57 15.85 13.83 12.66

Nanosonics Ltd. (ASX: NAN)

2011-12 2012-13 2013-14 2014-15 2015-16 CAGR (%)
Sales revenue ($‘000) 12,301 14,899 21,492 22,214 42,796 28.32
R&D ($‘000) 3,135 3,167 4,103 4,902 7,297 18.41
R&D/Revenue (%) 25.49 21.26 19.09 22.07 17.05

Cochlear, like CSL, is global in its operations but focuses on the design, manufacturing and supply of hearing implants into hearing-challenged patients, whereas Nanosonics is a developer of infection control technologies via its ultrasound probe disinfection systems and intellectual property.

From the above, I’ve concluded the following:

  • CSL’s investment in R&D is growing at twice the rate of its sales revenue and has accelerated substantially between 2014-15 and 2015-16. This could imply greater sales and profit growth in the next 3-5 years as new and improved products come to market (assuming the R&D is spent wisely)
  • Cochlear’s investment in R&D has also increased dramatically between 2014-15 and 2015-16, but continues to decline as a proportion of its sales revenue. Whilst this could be a concern, more research into Cochlear is needed before determining if the slower growth in R&D spending is a potentially fatal shortcoming in management’s strategic direction
  • Nanosonics’ pattern of growth and R&D spending indicates it’s perhaps a less mature business with brighter-than-average prospects for sales growth in the years ahead. A tapering off of this growth is expected at some point in the future but this could still be some time away

For the record here are the respective companies’ returns to shareholders over the last five years:

Company 5 year CAGR (14 October 2011 – 14 October 2016)
CSL Limited 27.83
Cochlear Limited 25.08
Nanosonics Ltd. 42.92

Foolish takeaway

R&D spending if of course only one aspect to company analysis amongst a myriad number of ways to determine whether or not its shares are worth buying today, but it’s certainly an important facet to be examined when looking at the quality of a company, its management and their commitment to building a sustainable competitive advantage.

With regard to the three companies above, I believe the business models, management quality and effectiveness of R&D spending are good indicators of business quality.

If you’re looking to invest your own money for the next 10-20 years, then you should expect the prudent handling of shareholder funds.

Given their track record to date, I’m comfortable in suggesting that each of these businesses are worthy of inclusion in most investors’ portfolios, with the caveat that Nanosonics has a lower weighting to account for its smaller size and greater execution-risk.

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Motley Fool contributor Edward Vesely owns shares of CSL Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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