Michael Porter: Competitive Advantage

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

In 1985, Michael Porter, Professor at Harvard University, wrote Competitive Advantage.  In the book, Porter said, companies have competitive advantage when they develop attributes that allow them to outperform the competition (determined by profits exceeding industry averages over the long-term).  Value investors like Warren Buffett are attracted to companies with durable competitive advantage (DCA) because of the quality of their earnings.

In discussing DCA, Buffet coined the phrase “economic moat.” He analogized that economic moats protect companies the same way moats protect castles.  The wider the moat around a castle, the more protection it has from invaders. The same is true for companies. The more attributes of DCA,  the more protection a company has against competition.  Accordingly, below are ten common attributes of DCA related to the technology industry.

1 – Brand. A strong brand can create DCA if it increases a customer’s desire to purchase and provides pricing power. Example: VMware is the industry leader in virtualization. The company has become the enterprise standard for virtualizing both desktops and servers. VMware “owns” virtualization in the mind of the customer. Consequently, it is able to command prices that are often two-thirds higher than Microsoft’s virtualization offerings.

2 – Distribution. Distribution can create DCA if it is difficult to duplicate by competitors. Example: EquaShip, a Seattle startup, sought to offer shippers great service at prices 27%-80% less than the residential ground rates offered by FedEx and UPS. However, the company struggled to deliver packages to customers by specific times and has since suspended its operations. The distribution channels at FedEx and UPS were difficult to duplicate.

3 – Intellectual Property. Intellectual property, including copyrights, patents and trademarks, can create DCA for companies.  Example: Microsoft signed Android patent deals with Acer, HTC, Samsung, etc.  Under the agreements, these companies must pay Microsoft a royalty fee on every Android smartphone or tablet manufactured.  These deals were in response to Microsoft’s claim that Google’s Android OS infringed on one or more of its patents.

4 – Location. Location can create DCA if it is difficult to duplicate by competitors. Example: The mission of Hulu is to help the world enjoy and find video content.  Hulu is headquartered in Los Angeles, CA, where the majority of entertainment companies are also headquartered.  Companies not based in LA are at a disadvantage. Note moving a company’s call center to India is not DCA because the option is available to all companies.

5 – Management.  Companies can create DCA with effective management.  Example: Tony Hsieh, CEO of Zappos, helped implement a customer service program that rivals Nordstrom.  It offers a 24/7 call center, a 365-day return policy and free shipping both ways.  Zappos’ exceptional customer service and return policy have spread like wildfire via the Internet and word of mouth, helping to significantly accelerate its growth.

6 – Manufacturing. Manufacturing can create DCA if a company’s production capacity is greater and more cost-efficient than its competition.  Example: Apple standardized the components of its products as much as possible.  Apple signed long-term agreements with component manufactures to guaranty supply for itself, limiting supply for its competitors.  The competition subsequently has been forced to buy components at significantly higher prices.

7 – Networking. Networking can create DCA if the value of a product or service increases with the total number of customers or users. Example: The more users that sign-up for Facebook, the more valuable the company’s platform becomes to them.  A competitor would have to duplicate the size of Facebook’s network before its users would consider changing to another platform.

8 – Process. A process can create DCA if it cannot be duplicated by competitors.  Example: Dell eliminated distributors and sold direct to customers. It also kept its inventory low by building computers to order. While Dell’s manufacturing process is known, its competitors have had difficulty duplicating it.  Note greater efficiency through process does not create DCA; the process must be difficult or impossible for competitors to duplicate.

9 – Product. A product or service can create DCA if its performance or quality is superior to the competition.  Example: Google in consumer search. Google made it easier for consumers to plug in search terms and get results over the Internet.  Yahoo! made consumers scan through their homepage to complete a search.  Google won in both ease of use and search results.  If a product or service is not superior, it can be duplicated by the competition.

10 – Switching Costs. Switching costs can create DCA if they are high.  Example: Companies using a CRM solution from Salesforce.com would incur high switching costs by changing to a competitive offering from Microsoft, Oracle, etc.  The infrastructure, testing and training costs would be substantial.  Switching occurs when the benefit of changing from Company A to Company B is less than the cost.

It is important to note that a company’s DCA can always be challenged by competitors, as well as by structural shifts within industries.  A company’s success can also be challenged by entering markets where it does not have DCA.  Consequently, leaders must continually ask, how strong is the company’s DCA?  Is the company’s economic moat narrow or wide?  Is it sustainable over the long-term?  Economic moats protect a company’s earning power.

All contents copyright © 2012, Josh Lowry. All rights reserved.


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