If we select a random CEO or CFO from around the globe, there is a high probability that we will hear a statement mentioning competitive advantages. However, great gurus such as Charlie Munger (Trades, Portfolio), Bruce Greenwald and Warren Buffett (Trades, Portfolio) have laid out quick and simple ways to identify true competitive advantages, which eliminates the vast majority of what companies claim to have.
In his book Competition Demystified, Bruce Greenwald mentions the following: “There are really only a few types of genuine competitive advantages. Competitive advantages may be due to superior production technology and/or privileged access to resources (supply advantages). They may be due to customer preference (demand advantages), or they may be combinations of economies of scale with some level of customer preference (the interaction of supply-and-demand advantages) Measured by potency and durability, production advantages are the weakest barrier to entry; economies of scale, when combined with some customer captivity, are the strongest.”
“In addition, there are also advantages emanating from governmental interventions, such as licenses, tariffs and quotas, authorized monopolies, patents, direct subsidies, and various kinds of regulation.”
Warren Buffett (Trades, Portfolio), in his 1991 letter to Shareholders, laid out the principles of franchise value, or in other words, a business castle protected by a moat.
“An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.”
Based on this, how many of the statements made by CEOs and CFOs around the globe are valid? Even though state-of-the-art technology can create advantages, these are available to other competitors. Offering products and services at low prices could suffocate a company and eventually kill it unless demand can be sustained and fixed costs are well spread among sales. (Here is Damodaran’s article on Amazon’s problems with this.) Innovation is useless unless it is protected by durable patents, and even patents can’t stop new and better innovations from coming along. Just look at what Apple (AAPL, Financial) did to MP3 players.
With these basic ideas, we can filter and get down to the best businesses. Charlie Munger (Trades, Portfolio) as usual, sums it up pretty well:
“Part of having uncommon sense is being able to tune out folly, as opposed to recognizing wisdom. If you bat away many things, you don’t clutter yourself. People get frustrated because they start to pitch something to us and when they get halfway through the first sentence, we say we’re not interested. We don’t waste a lot of time on bad ideas.”
