Virtuous circles create wealth

THE expression "success breeds success" is often used to explain how leaders emerge in their respective fields.

THE expression "success breeds success" is often used to explain how leaders emerge in their respective fields. Winners can experience an exponential rise because of their ability to build on past achievements: with each win comes new knowledge, which in turn can spur further success in a positive feedback loop.

The same phenomenon is observed in economics, but it is referred to as a "virtuous circle". Companies that focus on continually improving their product or service are likely to see an increase in earnings, which in turn can be reinvested in further innovation.

Virtuous circles can endow companies with sustainable advantages that not only make it difficult for competitors to win market share, but can also protect earnings during turbulence. Over time, this feedback loop can have a considerable impact on earnings, in much the same way compounding interest ultimately produces exponential returns.

Resmed is a good example of a company that is generating a positive feedback loop. The company has become a global leader in the production of flow generators and masks for sleep-disordered breathing by focusing solely on building a culture of innovation.

Resmed has historically dedicated 8 per cent of sales to research and development. This drives the creation of more valuable products, which in turn further increases sales. This positive loop has contributed to the company growing revenues by more than 18 per cent each year for the past decade.

The dollar-spend on research and development does not in itself guarantee technological breakthroughs - the depth of knowledge is just as important to drive innovation.

Resmed has been producing sleep devices for more than 20 years, and during this time it has developed a considerable knowledge.

One advantage of this knowledge base is Resmed's ability to tailor algorithms in its machines to collect higher quality data from users - at any time the company knows if a device is turned on, how the patient is breathing and the efficacy of the air pressure. This data not only aids in furthering the comfort for patients, it is also highly valuable for distributors and insurers who wish to track user compliance. This increases the reliance of these parties on Resmed devices, which in turn deepens the knowledge base and raises switching costs.

Virtuous circles can drive cost reductions as well, and Resmed is seeking further efficiencies by putting its data online. Historically, the company had to send CDs to each of its customers in order to upgrade software. Today, the machines update automatically online. This migration also requires fewer representatives to visit distributors. Once again, the virtuous circle is reinforced as cost reductions are reinvested into the business to drive further efficiencies. This virtuous circle of innovation has endowed Resmed with considerable pricing power. Not only is Resmed able to charge premium prices, this circle has also provided it with a stronger bargaining position over distributors during industry turbulence. Medicare in the US recently cut reimbursements to distributors by 40 per cent. While this has caused consolidation among distributors, Resmed's market position has remained strong. Virtuous circles can only endow companies with sustainable advantages if the feedback is reinforced. A company that rests on its successes, rather than leveraging them, can provide gaps for competitors. Management at Resmed is aware of this and, while the company has a running start over its competitors, directors are careful to note "it's only the first mile of a marathon".

As value investors, it is important to search for companies that are generating strong virtuous circles, and this is one of the reasons why Resmed holds a position in our funds here at Montgomery Investment Management. Resmed is leading at the first corner and, even though it is early in the race, we are expecting this lead to be sustained.

Roger Montgomery is the founder of Montgomery Investment Management and the author of Value.able: How to Value the Best Stocks and Buy Them for Less Than They're Worth, available at www.rogermontgomery.com