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When a firm enjoys a competitive advantage over its peers, management has the opportunity to provide excess returns to shareholders. Competitive advantage, however, is usually short lived, because the high returns on capital attract both new investors and increased competition (Mauboussin and Johnson [1997]; Cassia et al. [2007]). For these reasons, investing in firms with a competitive advantage does not guarantee excess returns for shareholders, because the firm's competitive advantage may well be reflected in the current share price. If investors can identify those firms that can maintain or expand their competitive advantage beyond the market's expectation, however, those investors can secure abnormal returns. Underestimating a firm's competitive advantage period (CAP) may lead to mispricing in the short term and allow responsive investors to identify undervalued securities before prices adjust to the firm's new cash flow pattern. Within this scenario, accurate identification of a firm's CAP may serve as a parameter for portfolio selection. This study develops a method suggested by Rappaport [1986, 1998] for estimating a firm's implied CAP and examines whether abnormal returns are available to astute investors armed with this information.
A firm's CAP represents the period during which the firm's return on capital is expected to exceed its cost of capital. The concept of CAP originates from Miller and Modigliani [1961], yet the investment literature has largely ignored the influence of CAP on the valuation of a firm's shares or how to use the CAP in an investment strategy. In similar fashion, textbooks discuss CAP as a significant input in discounted cash flow models, but the authors largely use arbitrary values for the CAP rather than any calculated or implied values. Using an approach recommended by Rappaport [1986, 1998] and refined by Mauboussin and Johnson [1997], we determine the CAP implied by available market data: the market-implied competitive advantage period, or MICAP. To evaluate the wealth effects of the CAP that accrue to investors, we examine the returns of firms and their MICAPs from 1976 through 2007. We develop MICAP quintile portfolios and find that firms in the longest-MICAP quintile provide greater trailing-four-quarter returns than do the shortest-MICAP-quintile firms. As we focus on future one-year returns, however, the shortest-MICAP quintile outperforms the longest-MICAP quintile by...