A properly functioning market imposes tremendous competitive pressures on its participants. If a company or industry delivers above average profitability and returns in excess of the cost of capital, an incentive is created for outsiders to participate in the market. The term competitive advantage was coined by Michael Porter, who divided it into differentiation advantages and cost advantages. The company with high product benefits and qualities which exceed those of substitute products of competitors has a differentiation advantage while low cost providers have a cost advantage. In 1991, Jay Barney suggested four characteristics integral to the development of a sustainable competitive advantage; the products or services must be valuable, rare, non-substitutable, and imperfectly imitable.
Why is this important to investors? Before getting into real-world details, let’s look at a hypothetical company to illustrate the key points. Let’s say I was at a Red Sox game this past summer and, inside of Gate D at Fenway, I see a mass of rabid and inebriated Sox fans next to the Sam Adams (SAM) beer stand. My brain starts thinking, a few cold Sam Adams at Fenway has the tendency to lower a guy’s price sensitivity and we all know how tempting a juicy hot dog can be after a few cold ones. I envision a profitable, simple enterprise and a market with low entry barriers. Being an enterprising individual, I write up a business plan and determine that I can set up a hot dog stand on the other side of the beer stand and have a tremendously profitable business selling hot dogs at $5 a dog under the business name “Dan’s Dogs.” I buy a hot dog cart in addition to dogs, buns, and condiments.
I start my business and turn a nice profit during the first few games in operation. Wow, this is the easiest money I’ve ever made. I started thinking about buying a second home or car but, before I know it, it’s September, the Sox have collapsed and there’s a Dave’s Dogs, Doug’s Dog’s and Dwight’s Dog’s dispersed throughout Fenway selling $3 dogs. I’m forced to lower my prices and find myself running a cash-flow negative business. What happened? Well, this is the result of running a business with no competitive advantage and competition arising from an efficient market.
If I could do it again, what are some ways I could have warded off these new competitors and retained the profitability of my enterprise? Here are three quick examples that come to mind. First, I could have created a barrier to entry by approaching the appropriate Boston zoning board and lobbying them to restrict the number of vendor permits to sell hot dogs at Fenway. Otherwise, I could have approached the stadium owners to secure an exclusive license to sell hot dogs. It is remarkable how many “free market capitalists” have resorted to such lobbying to impose barriers to entry on their competition. Second, I could come up with a secret formula for seasoning for my dogs which, when combined with the salt and grease of the dog, truly tastes better than any other dogs and use that trade secret to build a strong brand name amongst Sox fans. I would subsequently leverage this trade secret to gain market share while maintaining pricing power. Third, I could go to Costco (COST, Financial) and buy my goods in bulk so as to have a low cost advantage over my competitors and profitability sell hot dogs for $2.50.
Granted these are greatly simplified examples but the concepts are fundamental to businesses that have a durable competitive advantage. The fact is that a competitive advantage is easy to create; it is a durable competitive advantage that can fend off outsiders eager to enter a profitable industry that is difficult to achieve. Let’s look at some real world examples of categories of competitive advantages and look at examples of companies with these attributes.
Barriers to Entry:
Pharmaceutical companies with product patents secure monopolies for a chemical entity or a therapeutic area. Pfizer (PFE) became the biggest drug company in the world on the back of its $12 billion dollar blockbuster cholesterol-lowering drug Lipitor; giving them a first mover advantage and erecting tremendous barriers to entry into a multi-billion-dollar cardiovascular marketplace. Moreover, a sustainable competitive advantage can also be realized through special access to limited resources such as DeBeers’ (LVMH owns a 50% stake) ability to control the global supply of diamonds or OPEC’s controlling of the supply of oil.
High Switching Costs:
I wrote about high switching costs here. Successful businesses can manage to retain a high percentage of their customers by employing strategies that incur high costs for their customers who intend to switch over to their competitors. Such “high switching costs” dissuades their customers from crossing over to their competitors. High switching costs provide the organization with a “lock-in” mechanism for retaining their customers. This is also known as “Customer Lock-In” or “Vendor Lock-In.” In other words, switching costs are such costs that consumers incur when shifting from one supplier to another.
Switching costs can be of different types such as capital investment in equipment, cancellation fees, learning and training costs, psychological and social risks, searching costs, cognitive effort, installation and start-up costs or uncertainty. High switching costs created by an enterprise in a particular market segment also act as an “entry barrier” for competitors who may be considering entry into that market segment.
Network Effect: Both EBAY (EBAY, Financial) and UnitedHealthcare (UNH, Financial) have formidable advantages due to the network effect. For example, as managed care giant UnitedHealthcare’s membership base grows, more providers are attracted, allowing UNH to negotiate favorable discounts. In addition, the more providers that join the network, the more attractive UNH is to consumers. Through UnitedHealthcare’s network effects, it’s products and services across segments increase in value as more customers use them. Indeed, recreating this network poses significant challenges to competitors. In the era of healthcare reform, the barriers to entry are even higher.
Economies of Scale:
Much like my hot dog example. A company with a low-cost advantage over other companies can secure a tremendous advantage. Walmart (WMT, Financial) is the quintessential example of leveraging economies of scale as a competitive advantage. As an example, let us say that Walmart acquires DVDs from suppliers for $4/DVD while other firms purchase them for $5. In turn, Walmart only pays $5 for distribution of each DVD while competitors pay $6. As a result, Walmart is able to sustain a competitive advantage by selling its DVDs for $9.50, still earning a profit, while others have to sell it for $11 in order to cover costs. The 1-3 day delivery service of FedEx (FDX, Financial) is another example of a low-cost advantage as neither UPS nor USPS have been able to imitate strategies that allow them to offer such quick services at comparably low costs. The key to building economies of scale for Walmart and Fedex advantages was the development of efficient distribution networks that leveraged cutting-edge technology and their scale that allows for leverage in pricing negotiation for supplies.
Brand Equity:
Coca-Cola (KO, Financial) has secured a durable competitive advantage through a variety of the aforementioned mechanisms. Their business model is simple: Build one of the strongest brand names in the world, and be a low-cost producer and distributor of a secret formula for sugary water whose consumption becomes a habit for billions worldwide. It sounds very simple but if you were to give the top businessmen in the world $500 billion in start-up capital, they would not be able to penetrate Coke’s moat and match their success as a beverage producer and distributor. Other examples of prominent firms with a durable competitive advantage from strong brand equity are the coffee chain Starbucks (SBUX, Financial) and healthcare/consumer products conglomerate Johnson and Johnson (JNJ, Financial) with its strong consumer products brand.
Implications for Investors:
As part of Warren Buffet’s and Charlie Munger’s Four Filters, one should only buy stock in companies that have a durable competitive advantage, as these great businesses are the only ones that can earn returns on invested capital in excess of the cost of capital for prolonged periods of time. The net effect of this over time is that these companies create economic value for the company and shareholders. Warren Buffet stated of these companies that time is on their side whereas, for companies with no durable competitive advantage, time is against them. The laws of economics exert enormous pressure to revert to the mean. As a shareholder of a company with a durable competitive advantage, you benefit from the economic value generated by the company that is manifested by equity growth, distributions to shareholders through dividends or share repurchases and, eventually, capital appreciation. By buying these companies during dips and securing a discount to intrinsic value, one can achieve above-average investment returns in the long run.
Note: For additional reading and a great resource on this topic, I highly recommend Pat Dorsey’s "The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments (Little Books. Big Profits)."
Why is this important to investors? Before getting into real-world details, let’s look at a hypothetical company to illustrate the key points. Let’s say I was at a Red Sox game this past summer and, inside of Gate D at Fenway, I see a mass of rabid and inebriated Sox fans next to the Sam Adams (SAM) beer stand. My brain starts thinking, a few cold Sam Adams at Fenway has the tendency to lower a guy’s price sensitivity and we all know how tempting a juicy hot dog can be after a few cold ones. I envision a profitable, simple enterprise and a market with low entry barriers. Being an enterprising individual, I write up a business plan and determine that I can set up a hot dog stand on the other side of the beer stand and have a tremendously profitable business selling hot dogs at $5 a dog under the business name “Dan’s Dogs.” I buy a hot dog cart in addition to dogs, buns, and condiments.
I start my business and turn a nice profit during the first few games in operation. Wow, this is the easiest money I’ve ever made. I started thinking about buying a second home or car but, before I know it, it’s September, the Sox have collapsed and there’s a Dave’s Dogs, Doug’s Dog’s and Dwight’s Dog’s dispersed throughout Fenway selling $3 dogs. I’m forced to lower my prices and find myself running a cash-flow negative business. What happened? Well, this is the result of running a business with no competitive advantage and competition arising from an efficient market.
If I could do it again, what are some ways I could have warded off these new competitors and retained the profitability of my enterprise? Here are three quick examples that come to mind. First, I could have created a barrier to entry by approaching the appropriate Boston zoning board and lobbying them to restrict the number of vendor permits to sell hot dogs at Fenway. Otherwise, I could have approached the stadium owners to secure an exclusive license to sell hot dogs. It is remarkable how many “free market capitalists” have resorted to such lobbying to impose barriers to entry on their competition. Second, I could come up with a secret formula for seasoning for my dogs which, when combined with the salt and grease of the dog, truly tastes better than any other dogs and use that trade secret to build a strong brand name amongst Sox fans. I would subsequently leverage this trade secret to gain market share while maintaining pricing power. Third, I could go to Costco (COST, Financial) and buy my goods in bulk so as to have a low cost advantage over my competitors and profitability sell hot dogs for $2.50.
Granted these are greatly simplified examples but the concepts are fundamental to businesses that have a durable competitive advantage. The fact is that a competitive advantage is easy to create; it is a durable competitive advantage that can fend off outsiders eager to enter a profitable industry that is difficult to achieve. Let’s look at some real world examples of categories of competitive advantages and look at examples of companies with these attributes.
Barriers to Entry:
Pharmaceutical companies with product patents secure monopolies for a chemical entity or a therapeutic area. Pfizer (PFE) became the biggest drug company in the world on the back of its $12 billion dollar blockbuster cholesterol-lowering drug Lipitor; giving them a first mover advantage and erecting tremendous barriers to entry into a multi-billion-dollar cardiovascular marketplace. Moreover, a sustainable competitive advantage can also be realized through special access to limited resources such as DeBeers’ (LVMH owns a 50% stake) ability to control the global supply of diamonds or OPEC’s controlling of the supply of oil.
High Switching Costs:
I wrote about high switching costs here. Successful businesses can manage to retain a high percentage of their customers by employing strategies that incur high costs for their customers who intend to switch over to their competitors. Such “high switching costs” dissuades their customers from crossing over to their competitors. High switching costs provide the organization with a “lock-in” mechanism for retaining their customers. This is also known as “Customer Lock-In” or “Vendor Lock-In.” In other words, switching costs are such costs that consumers incur when shifting from one supplier to another.
Switching costs can be of different types such as capital investment in equipment, cancellation fees, learning and training costs, psychological and social risks, searching costs, cognitive effort, installation and start-up costs or uncertainty. High switching costs created by an enterprise in a particular market segment also act as an “entry barrier” for competitors who may be considering entry into that market segment.
Network Effect: Both EBAY (EBAY, Financial) and UnitedHealthcare (UNH, Financial) have formidable advantages due to the network effect. For example, as managed care giant UnitedHealthcare’s membership base grows, more providers are attracted, allowing UNH to negotiate favorable discounts. In addition, the more providers that join the network, the more attractive UNH is to consumers. Through UnitedHealthcare’s network effects, it’s products and services across segments increase in value as more customers use them. Indeed, recreating this network poses significant challenges to competitors. In the era of healthcare reform, the barriers to entry are even higher.
Economies of Scale:
Much like my hot dog example. A company with a low-cost advantage over other companies can secure a tremendous advantage. Walmart (WMT, Financial) is the quintessential example of leveraging economies of scale as a competitive advantage. As an example, let us say that Walmart acquires DVDs from suppliers for $4/DVD while other firms purchase them for $5. In turn, Walmart only pays $5 for distribution of each DVD while competitors pay $6. As a result, Walmart is able to sustain a competitive advantage by selling its DVDs for $9.50, still earning a profit, while others have to sell it for $11 in order to cover costs. The 1-3 day delivery service of FedEx (FDX, Financial) is another example of a low-cost advantage as neither UPS nor USPS have been able to imitate strategies that allow them to offer such quick services at comparably low costs. The key to building economies of scale for Walmart and Fedex advantages was the development of efficient distribution networks that leveraged cutting-edge technology and their scale that allows for leverage in pricing negotiation for supplies.
Brand Equity:
Coca-Cola (KO, Financial) has secured a durable competitive advantage through a variety of the aforementioned mechanisms. Their business model is simple: Build one of the strongest brand names in the world, and be a low-cost producer and distributor of a secret formula for sugary water whose consumption becomes a habit for billions worldwide. It sounds very simple but if you were to give the top businessmen in the world $500 billion in start-up capital, they would not be able to penetrate Coke’s moat and match their success as a beverage producer and distributor. Other examples of prominent firms with a durable competitive advantage from strong brand equity are the coffee chain Starbucks (SBUX, Financial) and healthcare/consumer products conglomerate Johnson and Johnson (JNJ, Financial) with its strong consumer products brand.
Implications for Investors:
As part of Warren Buffet’s and Charlie Munger’s Four Filters, one should only buy stock in companies that have a durable competitive advantage, as these great businesses are the only ones that can earn returns on invested capital in excess of the cost of capital for prolonged periods of time. The net effect of this over time is that these companies create economic value for the company and shareholders. Warren Buffet stated of these companies that time is on their side whereas, for companies with no durable competitive advantage, time is against them. The laws of economics exert enormous pressure to revert to the mean. As a shareholder of a company with a durable competitive advantage, you benefit from the economic value generated by the company that is manifested by equity growth, distributions to shareholders through dividends or share repurchases and, eventually, capital appreciation. By buying these companies during dips and securing a discount to intrinsic value, one can achieve above-average investment returns in the long run.
Note: For additional reading and a great resource on this topic, I highly recommend Pat Dorsey’s "The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments (Little Books. Big Profits)."
