What is competitive advantage? I’ve written that it should be on your investment checklist along with circle of competence, able management and price.
Competitive advantage is an intrinsic characteristic that gives a firm an edge over the competition. A firm is an economic castle, preferably with a competent duke in charge. The firms competitive advantage is the moat surrounding the castle. You want the moat to be as deep as possible, infested with piranhas and sharks. Lets take a look at some sources of competitive advantage.
Brand
Brands are built over time. The player who’s been on court for a long time has a reputation. Some well known examples of firms with a brand as competitive advantage are: Coca Cola, Apple and Nike. Even if you don’t consume these products, you know why people choose Coke instead of the store brand. Once a brand is built, maintaining it is key. It may take decades to build a reputation, but it can be destroyed much faster. You can check out Forbes’ list on the most valuable brands here.
Economies of Scale
When firms grow, they gain pricing power in the market. This is what economies of scale refers to. The larger the firm, the better their bargaining power is with suppliers and customers. During market downturns, the low-cost firm is the one that will survive less scarred.
Perhaps the most famous example is IKEA. Many case studies have been written about them on the subject, and they go to extreme measures in keeping their prices low. Hot dogs for pennies, self-assembly and good design keeps customers coming back. Their executives fly economy, and the late founder Ingvar Kamprad was known for his frugality.
Toll Bridge
The toll bridge moat usually lasts very long. What this means is that firms must pay a “fee” to the toll bridge in order to compete. Monopolies, duopolies and oligopolies may have toll bridge moats. One example is newspapers before the internet. If there’s only one or two large papers in town, advertisers have no choice but to pay them. Today, Google, Facebook and Amazon are the toll bridges for advertisers on the internet. Monopolies are rarely preferred, and the advertiser toll bridge market share is shakier.
Culture
Peter Drucker has said that culture eats strategy for breakfast. If employees are loyal, treated justly, and work for a common goal, there is a possibility to gain competitive advantage. Corporate culture is harder for an outside investor to measure. This is usually something you as an investor know more personally. The commercial airline industry is notoriously competitive and has disappointed investors time and time again. The Wright brothers made a huge service to humanity, but investors not so much. Ironically, a great example of culture as a competitive advantage is Southwest Airlines. The company put its sole focus on the well-being of its employees, which reaped rewards for itself and its investors. You can read more on Southwest here.
Can Moats Be Measured?
Now that we know some sources of competitive advantage, is there any way we can quantify them? This question is hard to answer, though there are a few keys.
The first thing you want to look at is Return on Invested Capital (ROIC). Over many years. If this number is north of 10% consistently, chances are they are allocating capital intelligently. It should be noted that today many silicon valley firms have much higher ROIC numbers, and thus you should compare a potential investment’s ROIC to its competitors.
Next, you want to look at the managements track record. Read the shareholder letters from years past. In them, they usually state their goals for the upcoming year(s). Have they been able to deliver on these? Beware if the offices of top management have revolving doors, and the people in charge change frequently. Chances are there’s something wrong with the business itself.
Widening the moat should be managements top priority. If the per-share value of a business can be compounded organically, its much more preferable than paying dividends. Dividends have long been established as a sign of a healthy business, but its not always the case. Just look at General Motors’ behavior. The company raised debt in order to keep paying them, a disaster waiting to unfold.
Thanks for reading and leave your thoughts on competitive advantage below!
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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