What is Durable Competitive Advantage?

What is Durable Competitive Advantage?

“The key to successful investing is to determine if a company has durable competitive advantage. Companies with durable competitive advantage consistently deliver outstanding results for investors.” – Warren Buffett

Durable competitive advantage is a fundamental concept of value investing. Value investors acquire companies with durable competitive advantage because the quality of their earnings are sustained over the long-term. What is durable competitive advantage?  Durable competitive advantage is the sustainable factor(s) that protect a company’s earning power from competitors. In discussing durable competitive advantage, Warren Buffett coined the phrase “economic moat.” He analogized that economic moats protect companies the same way moats protected castles. The wider the moat around a castle, the more it was protected from invaders. The same is true for companies. The wider the economic moat around a company, the more it is protected from competitors. As a result, companies with durable competitive advantage consistently deliver outstanding growth, profits and returns for their owners. Below are twelve of the key factors of durable competitive advantage. Companies with a durable competitive advantage often have one or more of these factors in their business.

Brand. A strong brand can create a durable competitive advantage if it increases a customer’s desire to purchase a product or service and provides pricing power. Example: Tempur-Pedic International (TPX) is the most profitable manufacturer of premium sleep mattress in the world. It has 89% brand awareness with all consumers. Consumers associate quality and therapy with the company. Companies must also continue to invest in their brands to maintain differentiation. Example: Kraft Foods’ (KFT) earnings decreased with the introduction of private label products.

Distribution.Distribution can create durable competitive advantage if it is difficult to duplicate by competitors. A company’s profitability increases substantially once the fixed costs of distribution are covered. A company’s variable costs for additional distribution are minimal. Example: United Parcel Service (UPS) provides package shipping services for consumers. The company’s profitability increases each day once the fixed costs of the driver and truck are covered and additional products are delivered throughout the day.

Intellectual Property. Intellectual property (IP) can create a durable competitive advantage if a company consistently releases innovative products or services. IP generally consists of copyrights, patents and trademarks, which provide exclusive rights. To illustrate: Patents provide pharmaceutical companies the exclusive right to manufacture a product for a specific period. Caveat: In addition to the specific period, patents and other IP can be challenged. Example: When Ely Lilly (LLY) lost its patent for Prozac, sales declined 80%, as generic versions of it were introduced.

Location. Location can create a durable competitive advantage if it is difficult to duplicate by competitors. Moving a company’s call center to India is not a durable competitive advantage because the option is available to all companies. Location is important for commodity businesses that transport heavy materials. Example: Waste Management (WMI) provides garbage collection, disposal and recycling services for consumers. The company’s profitability will decrease or increase based upon the distance between the garbage collection and the landfill.

Management. Management can create a durable competitive advantage with an innovative vision. Example: Howard Schultz of Starbucks (SBUX) transformed drinking coffee into a unique experience. However, without an innovative vision, management does not create a sustainable durable competitive advantage. While strong management can increase a company’s performance, certain industries are more competitive than others. The characteristics of the specific industry have a greater impact on durable competitive advantage than management.

Manufacturing. Manufacturing can create a durable competitive advantage if a company’s production capacity is greater than its competitors. The greater a company’s production capacity, the greater its profitability, as fixed costs are spread over more units. In addition to production capacity, the fixed costs of development can be spread over sales, which benefits non-manufacturing companies. Example: Electronic Arts (ERTS) spreads the cost of developing its video games over the company’s annual sales.

Networking. Networking can create a durable competitive advantage if the value of a product or service increases with the number of users. The more users that leverage the network, the greater its value. Durable competitive advantage is often created by closed networks that exchange information and knowledge. Example: The more locations that offer American Express (AXP), the more valuable it is to customers. A competitor would need to duplicate the size of American Express’ merchant network before customers would consider changing companies.

Process. A process can create a durable competitive advantage if it cannot be duplicated by competitors. A company’s successful process, which is know by competitors, can require a long period of time to duplicate. Example: Dell (DELL) eliminated distributors and sold direct to customers. It also kept its inventory low by building computers to order. While Dell’s process is known, its competitors have had difficulty duplicating it. Greater efficiency through process does not create a durable competitive advantage. The process must be difficult for competitors to duplicate.

Product. A product or service can create a durable competitive advantage if its performance or quality is superior to the competition. Example: Google (GOOG), Internet search. If it is not superior, it can be duplicated by competitors. Example: Chrysler (DAI), mini-van. Companies with successful products and services can also leverage one of the factors of durable competitive advantage to help protect earnings from competitors. Example: Hansen Natural (HANS) entered into an agreement with Anheuser Busch to distribute its Monster energy drinks.

Regulation. Regulation can create a durable competitive advantage if the barrier to enter a specific market is high because business approval is difficult to receive from the government. However, regulation can be a double-edge sword. Governments can control pricing through regulation (utilities) or they can leave it to the market. The best-case-scenario is for companies to need regulatory approval to operate within a specific market, but not be subjected to economic oversight in regards to pricing products or services. Example: Moody’s (MCO), bond rating services.

Strategic Asset. A strategic asset can create a durable competitive advantage if it provides business benefits or cost savings that cannot be duplicated by the competition. Strategic assets can include natural deposits (gold), as well as natural resources (oil). Example: Aracruz Celulose (ARA) is the larger manufacturer of bleached eucalyptus pulp in the world. Its strategic assets are its native forest reserves and plantations in Brazil. Eucalyptus trees grow faster in Brazil than in North America, which increases and protects the company’s profits and returns.

Switching Costs. Switching costs can create a durable competitive advantage if they are high. Switching occurs when the benefit of changing from Company A to Company B is less than the cost. Example: Customers using Oracle’s (ORCL) database software would incur high switching costs for changing to a competitive product. The infrastructure, testing and training costs would be substantial. Restaurants and retailers often have difficulty creating a durable competitive advantage because the switching costs are low and their products and services can be easily duplicated.

The process for identifying companies with a durable competitive advantage involves three questions. The three questions include: (1) Has the company generated strong growth, profits and returns over the long-term? If no, it does not have an economic moat. If yes, step two. (2) What factors of durable competitive advantage are present? If none, it does not have an economic moat. If present, step three. (3) How strong is the company’s durable competitive advantage? Is the economic moat narrow or wide? Is it sustainable over the long-term?

It is important to note that a company’s durable competitive advantage can be constantly challenged by existing and new competitors, as well as by structural shifts within industries. A company’s success can also be challenged by entering into new or unknown markets where it currently does not have a durable competitive advantage. These types of issues and scenarios can decrease a company’s long-term growth, profits and returns. Thus, it is critical for an investor to monitor his or her investments on an on-going basis.

All contents copyright © 2008, Josh Lowry. All rights reserved.

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One Response to What is Durable Competitive Advantage?

  1. Sonia Scott says:

    Great information! Good Post. It is good to see valuable information from a person who obviously has a good grasp of the subject.

    Like

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