In equity investing with stocks that don’t pay a dividend, a stock’s value is often unrelated to the fundamental value of the corporation it represents.  Because equity investors are investing for capital gains, the only thing that matters is how likely the stock is to have a positive return over the time period during which they plan to hold it.

With dividend paying stocks, the size and sustainability of the dividend is of primary concern.  Although long term capital gains are certainly possible with dividend stocks, it’s the quarterly dividend payments that motivate investors.  And, because dividends represent actual revenue that the corporation is distributing to shareholders, the health and competitive advantage of the company is what establishes its value to those shareholders.

There are four categories of competitive advantage that market analysis company Morningstar defines and each can signal a company that has solid prospects for sustainable and growing dividend payments.

Intangible Assets
Intangible assets represent competitive advantages that are unique to a single company.  Especially valuable are the legal restrictions offered by patents and licensing that prohibits would be competitors from entering a market.  If a particular company is the only one permitted to open a certain kind of business like a private prison or operate in a geographical area with oil drilling rights or use a specific formula or manufacturing process that provides a competitive advantage in its market it will enjoy that advantage as long as the patent or exclusive license persists.

Brands can also be intangible assets that make it more difficult for competition to take away market share.  Corporations like McDonalds, Starbucks, and Anheuser-Busch either are brands or own brands that are so familiar to their target markets that potential competitors have a hard time even getting noticed in their markets much less taking away market share.

Economies of Scale
Buying power lowers costs as does a well developed supply chain and a network of affordable sales outlets for goods and services.  Corporations that can buy, transport, and sell their wares more cheaply than their competition not only outperform them but also create a barrier to entry for new competitors.  They can charge less and still generate more profit and therefore more dividends than comparable corporations that have higher costs of doing business.

It’s also important to note that size alone doesn’t mean that a corporation enjoys economies of scale.  In some industries like auto manufacturing and running an airline, having a large supply chain and huge workforce is simply the cost of doing business and doesn’t represent a competitive advantage.  If everyone in the market has to be a similar size based on practicality alone, it’s difficult for any one of them to gain advantage through economies of scale alone.

Switching Costs
When it’s difficult or expensive for customers to change service providers that provides a competitive advantage for the company that can attract the most customers.  Changing from one bank or brokerage to another is a hassle.  Changing from one satellite television provider or home alarm company to another can damage a home as old equipment is removed and new equipment is installed.

Learning how to use a different software program to run your computer or do your taxes requires an investment not only in money but also in the time required to become proficient.  Not to mention the frustration that comes from needing to figure out every step of a process that used to be more or less automatic.

If a business operates in a market where customers are unlikely to change providers due to cost or inconvenience, its customer base and therefore its profits and dividends will be much more consistent and sustainable.  Not to mention the barrier to entry for new competitors given the difficulty of prying away the customers of other companies to gain market share.

Network Effects
If you want a place to connect to your family and friends online where will you go?  Will you choose a new social media site that nobody has ever heard of and try to convince them to join you there?

Probably not.

You’re going to go to Facebook or Twitter because the people you want to connect with are already there.

If you own a website you want to sell are you going to put an ad in your local classifieds or are you going to find a market on the internet specifically devoted to people who buy and sell websites?  In the first instance you’ll be lucky to find anyone who even understands what you’re trying to sell and in the second you’re dealing with the kind of buyers who will value what you have to offer.

This competitive advantage makes the products or services a company offers become more beneficial with each additional person using them.  The more people that use a particular software file format like PDF for documents or PSD for image design files the greater the competitive advantage that Adobe, the company that produces software that uses those formats, becomes.  The more people that want to connect with you via Skype or GoToMeeting the better positioned the companies that offer those services are compared to their competition.

Creating Sustainable Dividends
In each of these categories lies the opportunity for a corporation to earn a competitive advantage that will solidify their earnings and the return on equity that fuels dividend payments.  Newcomers or also-rans that try to compete with these companies face an uphill climb as these kind of advantages are neither easy or quick to build and difficult to profitably compete against when they’re benefiting the competition.