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.
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.
