Competitive Advantage

Our primary focus as investors centers on identifying a company’s competitive advantage. In today’s fiercely competitive market, highly profitable businesses inevitably draw interest from potential competitors. To sustain profitability in the long run, it is crucial for a company to possess a distinct competitive edge or a ‘moat’ that effectively deters rival entrants.

Various factors contribute to a company’s competitive advantage. We outline the key sources that are instrumental in securing this edge:

Possessing a significant market share can endow a company with a competitive advantage as it allows the distribution of fixed costs across a broader base, resulting in a cost advantage over competitors. A prime example of this is Amazon’s strategy of “scale economies shared.” By distributing these economies of scale to its customers, Amazon has maintained its position as a cost leader and a dominant force in its industry.

These are intangible assets that significantly contribute to a company’s market position and cannot be easily replicated by competitors. Examples of these intangibles include strong brands, exclusive patents, and proprietary licenses.

Brands

A powerful brand resonates emotionally with consumers, often leading to a significant market share and the capacity to command premium prices over competitors. Companies with dominant brands typically enjoy high profitability, as reflected in their return on equity.

The profound, and often surprising, connection between a brand and its consumers is exemplified in the case of Nestle’s Maggi instant noodles. In 2015, Nestle faced an existential crisis when government food inspectors reported finding Monosodium Glutamate (MSG) and lead in levels exceeding permissible limits in Maggi noodles samples. This led to a nationwide ban in May 2015, resulting in Maggi being pulled from the shelves for about six months until its reinstatement in November 2015. Such an incident could have been catastrophic for most brands, yet Maggi managed to swiftly regain most of its market share. This remarkable recovery underscores the enduring bond and loyalty Maggi has cultivated with its consumers since its debut in India in the 1980s.

Patents

Acting as critical barriers to competition, patents effectively prevent competitors from duplicating a company’s unique innovations. This protection grants a significant edge and establishes a monopoly over specific products or processes. It is essential for companies to engage in ongoing innovation to preserve this edge in a rapidly evolving market.

For instance, 3M, with its array of patented, technologically superior products, dominates several niche markets. In the pharmaceutical industry, companies like Pfizer utilize patents not just as a shield against competition, but as a foundation for maintaining their market leadership, underscoring patents’ pivotal role in competitive strategy.

A fascinating example of the value of patents is Google’s acquisition of Motorola Mobility in 2012 for approximately $12.5 billion, largely to gain access to Motorola’s extensive patent portfolio, which included around 17,000 patents and an additional 6,800 pending patents. These patents were crucial for Google to protect its Android operating system from legal challenges from competitors in the mobile technology industry such as Apple. Two years later, in 2014, Google sold Motorola Mobility to Lenovo for about $2.9 billion, but it astutely retained most of these patents, highlighting their enduring value and importance in Google’s technological and legal arsenal​.

Licenses

Licenses can create a competitive edge by limiting market entry, as seen in industries like credit rating agencies, depositories, and stock exchanges. This restricted market access can result in situations where a few companies control a significant market share, leading to consistently high profitability over extended periods.

However, there’s an inherent risk known as ‘stroke of the pen’ risk, which refers to the possibility of licenses being revoked or regulations changing unexpectedly, potentially altering the business landscape drastically.

This refers to the costs incurred when a customer shifts from one supplier or brand to another. These costs may not always be ‘real’ monetary costs, but may include costs which may be psychological, effort-based, or time-based. Such costs create a strong customer retention factor, offering a significant competitive advantage.

For instance, consider a savings account at a bank, which not only handles salary deposits and ad-hoc withdrawals but also manages automatic payments like home loans and subscription debits, as well as receiving income tax refunds. While opening a new account with another bank is straightforward, customers often resist switching due to the hassle it entails. Customers’ reluctance to switch banks results in them maintaining significant balances in their savings accounts, which are a source of low-cost funds for the banks.

This phenomenon occurs when the value of a product, service, or platform increases as more people use it, providing a significant competitive edge. A classic example is WhatsApp, which, despite a backlash over its privacy policy, retained its user base; users who initially switched to alternatives like Signal often returned due to WhatsApp’s larger network. Similarly, a dominant stock exchange benefits from network effects; higher trading volumes lead to narrower bid-ask spreads, attracting even more users and solidifying its market position.

As we do down from 1 to 4 in above sources, those later in the list tend to subsume those sources that are above them. We find that a company that has network effects, will also have the first 3 in some form. Similarly, if a company has switching costs, it will usually have some measure of economies of scale and intangibles. When a company derives a competitive edge based on multiple sources, it makes the competitive edge of the company stronger.

Whether a business has a competitive edge or not, is often debated by investors. The true test of whether a business has a competitive edge or not are:

1. Does the business have high return on capital employed?
2. Are the relative market shares of the different players in the industry stable over time?

A strong competitive edge leads to:

1. Profitability – able to sustain high rates of return on equity
2. Scale – able to grow faster than the industry and achieve higher scale
3. Sustainability – able to grow profitably for a longer period

As such, these can result in tremendous wealth creation for shareholders over the long term.

While judging the competitive edge of a business, it is important to think about how the competitive edge is strengthening or weakening. The best companies are razor focused on increasing their competitive edge and they keep working at it continuously.