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Competition Demystified: What is a Moat?

August 10, 2010 | About:
Many times one can hear people saying that they try to look for companies with “moats”. These are companies that for various reasons will have advantages over their competitors. However, many investors do not know or fully understand what defines a moat. and what gives a company advantages over its competitors.

In Competition Demystified, Prof. Bruce Greenwald focuses on one of the main themes of Michael Porter’s Competitive Strategy; potential entrants, and barriers to entry. Greenwald discusses a number of cases that result in barriers to entry including- captive customers, economies of scale, patents and copyrights, and Government regulation. The book really is excellent at explaining what gives companies true moats. Numerous real case studies are discussed in the book including; Walmart vs Kmart, Pepsi vs. Coke, Kodak and Polaroid etc.

One area where people think companies have a moat is in a case of product differentiation. Greenwald says this belief is entirely mistaken. While it is good for a company to possess product differentiation, it is not a barrier to entry and therefore should be treated similar to a commodity business. Greenwald states that the company that possessed the greatest product differentiation is Mercedes-Benz. Greenwald believes that the Mercedes-Benz star “may be the most widely recognized symbol for quality in the global marketplace.” Mercedes-Benz was able to earn exceptional profits, however this only attracted other entrants looking to also make high profits. In the 1970s Mercedes, Jaguar, and BMW entered the luxury car market, followed by Acura, Lexus, and Infiniti in the 1980s. Eventually, the exceptional returns for Mercedes-Benz eroded and the luxury car maker was only producing average returns.

On the other hand, captive customers are very important factor for a company to maintain a moat. Captive customers can come in different forms. One of the strongest forms of customer captivity is in cases where switching costs are high. For example a local alarm company dominates an area and uses a certain technology for its wiring, and a rival wants to come in with different technology. A customer who wants to switch will have to reroute the entire house which will cost a lot of money. In such a case customer captivity exists and the rival will not be able to make inroads. No one will want to switch to another alarm company for thousands of dollars, unless the first alarm company offers terrible service.

There probably is no greater company with customer captivity than Coca Cola, and Pepsi. Many customers will not switch to other brands even if they are cheaper. These firms likely have captive customers due to their secret ingredients. Greenwald gives another good example of how dominant these two beverage makers are. If you love Heineken and go to a local Japanese restaurant you are likely to order the Japanese beer and not the Heineken. However, no one would order the Japanese imitation brand of Soda of Coke or Pepsi.

Finally, economies of scale can be a powerful moat. One of the best examples Greenwald offers is the case of Wal-Mart versus Kmart. Wal-Mart was able to obtain higher operating margins than Kmart, even when Kmart was earning ten times as much revenue as Wal-Mart (the chapter on Wal-Mart is superb, and I hope to include it in a separate article). Economies of scale allow much smaller companies that operate locally, and efficiently to produce higher returns on capital than large companies that operate across the globe. Companies that focus on local markets have lower advertising costs, lower shipping costs, and other costs that can help produce higher margins.

At the end of the book Greenwald talks a little bit about valuation, and companies that many times make decisions which cause their investments to cost them much more than their cost of capital. Greenwald talks about evaluating acquisitions, and how to evaluate a company’s intrinsic value. This section of the book is explained much more in depth, in Greenwald’s superb book Value Investing: From Graham to Buffett and Beyond.

One criticism of the book is it is a bit lengthy, and gets bit academic. However, some readers might prefer the lengthy and academic aspects. Greenwald discusses game theory, prisoner’s dilemma, and other concepts that effect a company’s pricing decision.

Despite the minor criticism the book is a fantastic read. If you want to know what a moat really is this book will explain it to you. Again many people have misconceived notions about what creates a moat; Greenwald shows the reader how to evaluate whether a company truly has a moat, and competitive advantages.

To purchase the book on Amazon.com click on the following link- Competition Demystified: A Radically Simplified Approach to Business Strategy

Disclosure: I received a free copy of this book to review. I have a material connection because I received a free copy of this book from the publisher. In addition I receive a small commission if you click on the above link and buy the book (or anything else) from Amazon.com It does not cost you a penny more. So I get a commission, Amazon gets a sale, and you get your book so it is a win for everyone.

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

Visit Jacob Wolinsky's Website


Rating: 4.4/5 (22 votes)

Comments

LwC
LwC - 4 years ago
I don't know if Greenwald writes about Intel in the book, as I have not read it yet. In class Greenwald explained how Intel's economy of scale is an effective competitive advantage by pointing out that the second largest producer of micro computer chips, AMD, has (at least at that time) total annual revenues that are less than the amount that Intel spends on R&D in a year. AMD's R&D expenditures are burdened by large debt service requirements and uneven profitability, and are literally a small fraction of what Intel is able to spend on R&D. He asked the rhetorical question: how can AMD ever become a serious competitor to Intel under those circumstances? And if not AMD, who?

greine12
Greine12 - 4 years ago
Texas Instruments
LwC
LwC - 4 years ago
Here is an excerpt from TI's 2009 10-K:

Competitive landscape

In each segment, we face significant global competition from numerous large and small companies, including both broad-based suppliers and niche suppliers. We believe that competitive performance in the semiconductor market generally depends on several factors, including the breadth of a company’s product line, technological innovation, technical support, customer service, quality, reliability, price and scale. With expertise in both analog and embedded processing , we believe we are capable of providing best-in-class solutions and system-level knowledge to help our customers create more advanced systems and products and bring their products to market sooner.

The primary competitive factors for our Analog products include design proficiency, a diverse product portfolio to meet wide-ranging customer needs, manufacturing process technologies that provide differentiated levels of performance and manufacturing expertise. Our primary Analog competitors include Analog Devices, Inc.; Freescale Semiconductor, Inc.; Infineon Technologies AG; Intersil Corporation; Linear Technology Corporation; Maxim Integrated Products, Inc.; National Semiconductor Corporation; NXP B.V.; Richtek Technology Corporation; and STMicroelectronics NV.

The primary competitive factors for our Embedded Processing products are the ability to design and cost-effectively manufacture products, system-level knowledge about targeted end markets, installed base of software, software expertise, applications support and a product’s performance and power characteristics. Primary competitors of our Embedded Processing segment include Atmel Corporation; Freescale Semiconductor, Inc.; Microchip Technology, Inc.; NEC Electronics; Renesas Technology Corp.; and STMicroelectronics NV.

The primary competitive factors for our Wireless products are the ability to design and cost-effectively manufacture products, system-level knowledge about targeted end markets, installed base of software, software expertise, applications support and a product’s performance and power characteristics. Primary Wireless competitors include Broadcom Corp.; CSR plc; Freescale Semiconductor, Inc.; Infineon Technologies AG; Intel Corporation; Marvell Technology Group, Ltd.; NVIDIA Corporation; QUALCOMM Incorporated and ST-Ericsson. (Bold emphasis added by me.)

Please note that according to TI the only area in which it considers itself to compete with Intel is in certain wireless products; and that elsewhere in the 10-K TI reports that they will shrink their wireless business, which was 25% of total 2009 revenues, by discontinuing "baseband" product which generated more than two-thirds of TI's wireless revenue in 2009. That means that after 2012 wireless products will generate less than 10% of TI's revenues and that amount will be equivalent to less than two percent of Intel's revenues. [edited: corrected "two-tenths of a" percent to "two" percent]

Finally, here are some 2009 comparisons:

Intel - Rev 35.1 bil, NI 4.4 bil, R&D 5.7 bil

TI - Rev 10.4 bil, NI 1.5 bil, R&D 1.5 bil

AMD - Rev 5.4 bil, NI 0.3 bil, R&D 1.7 bil

"Tis better to be silent and be thought a fool, than to speak and remove all doubt." - Abraham Lincoln

greine12
Greine12 - 4 years ago
I agree with you that Intel has a moat and durable competitive advantage; however, the same advantages are also weaknesses when they pertain to antitrust litigation.

Intel Settles with F.T.C

FTC Antitrust Settlement

A couple of follow up questions:

Will ongoing litigation erode Intel's durable advantages?

How likely is it that AMD will gain more market share given the outcomes of the recent F.T.C. settlement? What is the likely cap?

Are there any likely participants that may join the microprocessor market under duress or disruption? Global competitors?

What would happen if AMD liquidated or filed for bankruptcy protection?

greine12
Greine12 - 4 years ago
Another likely participant could be IBM, although I would expect that they would use their proprietary semiconductor technologies to enhance value to clients. At over 90% market share in the PC microprocessor market, Intel clearly has a dominant position, thus I will not even attempt to refute your analysis. My recommendation was a simple attempt to at least look outside AMD and Intel to identify additional competitive pressure that may not seem immediately apparent. Currently, it is a great value opportunity; however, when buying and holding for the long run, I prefer to consider as many unfavorable scenarios as possible.

Below is some additional information from the 10K:

"Other

Our Other segment includes revenue from sales from our smaller semiconductor product lines and of our handheld graphing and scientific calculators, as well as royalties received for our patented technology that we license to other electronics companies. The semiconductor products in our Other segment include DLP® products (primarily used in projectors to create high-definition images), reduced-instruction set computing (RISC) microprocessors (designed to provide very fast computing and often implemented in servers) and custom semiconductors known as application-specific integrated circuits (ASICs). This segment generated about 20 percent of our revenue in 2009."

also,

"Wireless – consists of DSPs and analog used in basebands for handsets, OMAP™ applications processors and connectivity products for wireless applications."

If I have interpreted correctly implies that they discontinued the basebands business; however, I assume they are going to continue producing application processors. Either way, it would require major disruption or a significant catalyst to lead other firms to compete directly with Intel.

LwC
LwC - 4 years ago
I guess that the fact that TI may be viewed as not being a competitor to Intel could be viewed as a good thing - for TI.
kuuks
Kuuks - 4 years ago
I'm really looking forward to reading this book as I think "Value investing: from ..." is one of the best investing books out, but I'm worried at his attempt to integrate game theory into investing. Having studied game theory at a relatively advanced level I can say that it's rarely valuable in terms of investing and talking about prisoner's dilemma is a bit of a joke (it's common sense). Jacob, if you could shed some more light on these "academic" aspects that would be great. Cheers.
yswolinsky
Yswolinsky - 4 years ago
LwC you are truly lucky to have taken his class. He talks a lot about Intel in his book and mentions the same exact point you stated. The book was 400 pages so I obviously could not cover every single detail.

http://www.valuewalk.com/

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