Finding a business with a sustainable moat is tough, really tough. In reality, there are only ever going to be a handful of these businesses. Many more companies will gain and lose their competitive advantages over time.
To truly understand these ideas, we first have to go back to understand what drives a competitive advantage.
What drives competitive advantages
Charlie Munger (Trades, Portfolio) has explained there are two ways a company can build a competitive advantage: through economies of scale or with network effects.
I'm simplifying Munger's comments here, but the overarching lesson remains the same. Economies of scale help large companies achieve efficiencies over smaller peers. Munger once gave the example of chain stores:
"The concept of a chain store was a fascinating invention. You get this huge purchasing power β which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization. If one little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he's going to make a lot of dumb decisions. But if you're buying is done in headquarters for a huge bunch of stores, you can get very bright people who know a lot about refrigerators and so forth to do the buying."
Network effects draw consumers to use a company's product either because of its size or the fact that they can't find it elsewhere, think Alphabet Inc.'s Google (GOOG, Financial) and Coca-Cola Co. (KO, Financial). These demand-side factors reinforce a company's moat.
Concentrating on the economies of scale factor, we can see how hard it is for a business to maintain this competitive advantage by looking at past examples.
Using examples Munger himself has provided, we can see how Procter & Gamble Co. (PG, Financial), which was able to use its size to dominate the TV advertising market, gained a competitive advantage:
"You can get advantages of scale from TV advertising. When TV advertising first arrived β when talking color pictures first came into our living rooms β it was an unbelievably powerful thing. And in the early days, we had three networks that had whatever it was β say 90% of the audience. Well, if you were Procter & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so damn many cans and bottles. Some little guy couldn't."
However, this competitive advantage has disappeared in the past few decades. It has become easier for smaller companies to advertise, eroding P&G's competitive advantage.
In another example, General Electric Co.'s (GE, Financial) most significant competitive advantage was its size, which allowed the company to make sure it was the best in every sector. As Munger once explained:
"In some businesses, the very nature of things cascades toward the overwhelming dominance of one firm. It tends to cascade to a winner take all result. And these advantages of scale are so great, for example, that when Jack Welch came into General Electric, he just said, 'to hell with it. We're either going to be number one or two in every field we're in or we're going to be out'. That was a very tough-minded thing to do, but I think it was a correct decision if you're thinking about maximizing shareholder wealth."
General Electric lost its advantage because the company lost a good manager. To maintain a competitive advantage, management has to be agile with capital, taking money out of struggling divisions and redeploying into faster-growing business lines.
The list of companies that had an advantage and subsequently lost it is long. Procter & Gamble and General Electric have both featured in the portfolio of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) in the past. Other companies such as International Business Machines Corp. (IBM, Financial) and U.K. retailer Tesco PLC (LSE:TSCO, Financial) had similar traits, but as their advantages have been eroded, Berkshire has moved on.
It's incredibly challenging to determine which companies have a competitive advantage and which don't. This discussion just scratches the surface.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Charlie Munger, The Daily Journal and Alibaba
- Reviewing Warren Buffett's Small Position in Globe Life
- Charlie Munger's Daily Journal Buys Alibaba
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