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Competitive
Advantage
In general there are 5 ways for a company to build a competitive advantage over its peers. Warren Buffet calls this competitive advantage as “economic moat”. An economic moat is the ability of the company to keep its competitors at bay from hurting its profits.
In general there are 5 ways for a company to build a competitive advantage over its peers. Warren Buffet calls this competitive advantage as “economic moat”. An economic moat is the ability of the company to keep its competitors at bay from hurting its profits.
The
wider
the moat, the longer the company can protect its profits. The deeper
the moat,
the more profitable is the company.
A
company
can build its competitive advantage in one or more of the following
ways.
- Product differentiation.
– Market Leader in new innovative products
- Branding. –
leading to customer loyalty
- Low costs or prices. Huge Economics
to Scale
- Locking in customers.
- High
Consumer Switching Cost
- Locking out competitors.
– High Barriers to Entry (patent, legal)
Product Differentiation
A
company
could produce and market a product with superior technology or features
not
found among its competitors. And usually these products are introduced
to the
market at a premium price, which makes the products very profitable.
There are
customers who will be willing to pay more to get products with the
latest
technology or best features.
Unfortunately,
this type of competitive advantage is usually short-lived. Technology
is
constantly advancing and today's market leader could become obsolete
tomorrow.
Competitors are always churning out superior products by adding or
improving
features. In short, it is difficult to constantly stay one step ahead
of the
competitors.
Although
companies can occasionally generate excess profits by staying one step
ahead,
these profits are however, not sustainable. We call this competitive
advantage
a narrow economic moat.
Branding
The
advertising industry is a multi-billion dollar industry. Companies
spend
enormous amount of money to build their brands. The aim is to deliver
the
message that their products or services are better than the competitors.
A
strong
brand can be a wide and deep economic moat. Consider designer label
apparel and
accessories. People are willing to pay much more for the branded
apparel than
an identical item minus the brand that is selling in the local store.
And
as
long as people perceive that the items associated with the brand is of
superior
quality, it doesn't really matter if the product is actually better or
not.
This fact that people are willing to pay more is what defines the value
of the
brand. A brand that can significantly increase profit margin is known
as a deep
economic moat.
Not
all
strong brands can help boost profitability. Brands are not useful in
some
industry. Consumers are unlikely to pay much more for a branded
computer than a
clone computer with the same specifications and features.
Assessing
brands this way helps to separate valuable brands and less valuable
brands. A
brand that lasts for a long time will create a wide economic
moat.
Low Costs or Prices
Offering the same or similar product or service at a lower price can be a powerful economic moat, especially in commodity industries. Airlines and PCs are a couple of commodity industries.
Cost advantages are created by either inventing a better process or achieving a larger scale.
Dell is an example how a better process can reduce costs. Dell PCs are built only after purchase orders are received. This way Dell could avoid stocking up on inventory and letting the inventory value erode while waiting for orders to come in.
At the same time, Dell could take advantage of the rapid price decrease of PC components. This allows Dell to do one of 2 things. Keep the selling price the same, thus increasing margin, or lower the selling price as the price of components fall.
Scale advantages are difficult to beat because they build on themselves. Consider Wal-Mart. Its strength is in the sales volume. Manufacturers are desperate to get their products displayed on the shelves. Hence, this gives Wal-Mart the strength to negotiate lower costs from the manufacturers which is then pass on to consumers through lower pricing or better deals. This in turn attracts even more consumers and more sales resulting in stronger negotiation power for Wal-Mart.
Locking In Customers
Companies can deter customers from switching to competitors' products by creating high customer switching costs.
If the customer has to undergo significant amount of training and incur lost productivity during the training period, then the customer will be reluctant to switch.
If a company's product is tightly integrated with the customer's business, then the customer will be reluctant to switch. Example, a customer manufactures food and buys an ingredient, such as a sauce, from a company. Switching supplier and buying the sauce from another company may result in the finished product having a different taste and texture which may negatively affect consumer preference.
Locking Out Competitors
Companies holding patents of popular and lucrative products have deep and wide economic moats. Patents protect the patent holder from direct competition. A great example is Pfizer and its line of top-selling drugs in the world.
Majority of the cities cannot support more than one large daily newspaper. This means the incumbent holds an advantage. It is difficult for a competitor to enter the market and grab a sizable market share from the incumbent and at the same time still make a decent profit.
Conclusion
The first filter in the funnel is to sift out companies with Economic Moat from those that do not have economic moat.
When researching the company, use the 5 Economic as a basis for a checklist and ask if the company has either any of the advantages. Also ask if the advantage can be easily duplicable within years.
If the answer is uncertain, we rather give this company as miss. Being able to identify the Moat of the company takes a bit of practice and conditioning. But after a while, the difference should be obvious.
Low Costs or Prices
Offering the same or similar product or service at a lower price can be a powerful economic moat, especially in commodity industries. Airlines and PCs are a couple of commodity industries.
Cost advantages are created by either inventing a better process or achieving a larger scale.
Dell is an example how a better process can reduce costs. Dell PCs are built only after purchase orders are received. This way Dell could avoid stocking up on inventory and letting the inventory value erode while waiting for orders to come in.
At the same time, Dell could take advantage of the rapid price decrease of PC components. This allows Dell to do one of 2 things. Keep the selling price the same, thus increasing margin, or lower the selling price as the price of components fall.
Scale advantages are difficult to beat because they build on themselves. Consider Wal-Mart. Its strength is in the sales volume. Manufacturers are desperate to get their products displayed on the shelves. Hence, this gives Wal-Mart the strength to negotiate lower costs from the manufacturers which is then pass on to consumers through lower pricing or better deals. This in turn attracts even more consumers and more sales resulting in stronger negotiation power for Wal-Mart.
Locking In Customers
Companies can deter customers from switching to competitors' products by creating high customer switching costs.
If the customer has to undergo significant amount of training and incur lost productivity during the training period, then the customer will be reluctant to switch.
If a company's product is tightly integrated with the customer's business, then the customer will be reluctant to switch. Example, a customer manufactures food and buys an ingredient, such as a sauce, from a company. Switching supplier and buying the sauce from another company may result in the finished product having a different taste and texture which may negatively affect consumer preference.
Locking Out Competitors
Companies holding patents of popular and lucrative products have deep and wide economic moats. Patents protect the patent holder from direct competition. A great example is Pfizer and its line of top-selling drugs in the world.
Majority of the cities cannot support more than one large daily newspaper. This means the incumbent holds an advantage. It is difficult for a competitor to enter the market and grab a sizable market share from the incumbent and at the same time still make a decent profit.
Conclusion
The first filter in the funnel is to sift out companies with Economic Moat from those that do not have economic moat.
When researching the company, use the 5 Economic as a basis for a checklist and ask if the company has either any of the advantages. Also ask if the advantage can be easily duplicable within years.
If the answer is uncertain, we rather give this company as miss. Being able to identify the Moat of the company takes a bit of practice and conditioning. But after a while, the difference should be obvious.
Article written by Sean Seah. No reproduction or copy of this material by any means is allow without the prior permission of the author. Any violation will be serverly dealt with.