Warren Buffett prefers to invest in companies with a sustainable competitive advantage. Or a wide moat, as he calls it. What Buffett means by this is a component of the business model that makes a company's market position very very difficult to attack and therefore provides him as an investor with attractive returns over a very long period of time.

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The question now is how do we recognize such companies or business models?

Of course, every business model has its own specific success factors. Nevertheless, I think we can make a very rough classification of business models into certain "drawers" ... and this would at least give us a starting point when we are dealing with a new company with a business model that was previously unknown to us.

What you will learn in this article

  • What a sustainable competitive advantage is
  • What types of competitive advantage there are
  • How we can recognise a company with a sustainable competitive advantage

When is a competitive advantage sustainable?

In general, a sustainable or structural competitive advantage is something that shields a company from the competition. Companies with a structural competitive advantage have often above-average margins and returns over long periods of time and for this reason are very interesting for long-term oriented value investors.

Market entry barrier vs. sustainable competitive advantage

In analogy to Michael Porter's 5 Forces Model, we could also speak of very high barriers to market entry in the case of a competitive advantage. However, in my view this would not be thinking far enough.

For example, I would say that there are quite high barriers to entry in the mining industry or the steel industry. After all, every new plant or mine costs a few billion dollars. And the production is also technically demanding. Nevertheless, it is precisely these industries that are regularly plagued by overcapacity and price wars.

So the barriers to market entry are not so high after all and a structural competitive advantage is something else?

I think the little word "sustainable" or "structural" makes the difference. The companies in the steel industry do not have a structural advantage. There are a few companies that operate in a quite attractive niche and therefore have higher margins over a certain period of time.

But only until the first competitors have built up the same abilities.

Non-structural competitive advantages disappear over time

If a competitive advantage is not structural, it will usually disappear after a few years because new competitors enter the market with new volumes, putting pressure on prices and margins.

The iPhone is a good example of this. In terms of technology, other smartphones are probably almost as good by now or the iPhone at most marginally better. The competition has clearly caught up. That is exactly what is becoming clear in the financial figures of Apple (AAPL). The average price of the iPhone fell below USD 600 for the first time in the third quarter of the 2015/16 financial year and sales figures are currently stagnating.

Nevertheless, in my opinion, Apple has a sustainable competitive advantage. However, that lies elsewhere, but more on that later.

What types of competitive advantages are there?

In the course of my research, I have identified 6 different types of structural competitive advantages (if you know of any others, please write to me or comment below), which I would now like to go through individually and explain with the help of an example:

  • Intangible competitive advantages (brand, patents, accreditations, etc.)
  • High switching costs
  • High benefit-cost ratio
  • Network effect
  • Cost advantage (process cost and economies of scale)
  • Inflation protection

Incidentally, the competitive advantages are not exclusive of each other. In fact, some companies that have several of the above competitive advantages at the same time (e.g. General Dynamics Corporation, GD in the aerospace components sector).

1. Intangible competitive advantage

Intangible competitive advantages are always difficult to capture, but they can certainly be valued as a sustainable advantage. However, I would not assign an additional value to, for example, a brand or a patent in a company valuation, because I assume that this is already taken into account via the return (ROC or ROE).

Under the heading of intangible competitive advantages, three main factors come to mind:

  • a strong brand name
  • a well-defined set of patents
  • an accreditation

Brand

A strong brand can be a sustainable competitive advantage, see for example Coca Cola (KO) or Apple (AAPL). Whether a brand is actually strong enough (and remains so) to establish such a competitive advantage, however, depends on several factors.

First, the brand itself must be so strong or well known that it can

  • change consumer behaviour
  • significantly reduces the search costs for a product

One characteristic of a brand with a sustainable competitive advantage is a positive correlation between price and demand, i.e. the demand for a product is higher when the price is higher. We are talking about an inverse price-demand function, so to speak.

Furthermore, the company that owns the brand must have sufficient funds available to invest in the brand equity or brand capital. For example, Absolut Vodka had a very good and popular brand a few years ago. Unfortunately, however, the company did not have enough resources to continue building the brand.

A brand therefore requires constant maintenance and further development, e.g. through its own shops or control over the customer experience.

For this reason, companies with well-known brands in the premium segment often establish an additional sales channel in the form of their own stores (e.g. Apple, Hilfiger, Boss) and at the same time avoid distribution via supermarket chains or similar.

When analysing shares with a strong brand name, we should therefore look at consumer behaviour, search costs and also marketing expenditure or strategy.

Patents

Patents can also be a structural competitive advantage.

However, it is important that a company owns a whole set of patents, ideally covering a specific field or technology. Individual patents in different fields are often no real protection against competitors.

In my view, it is quite difficult for a value investor to really assess a competitive advantage from patents, simply because there are far too many patents and there is no real transparency regarding the contents. Even with a professional tool like the Thomson Reuters patent database (cost > USD 100,000 per year), it will be difficult to derive a competitive advantage directly.

I would therefore consider the existence of patents and technologies as a positive side effect, so to speak, but not base my investment thesis exclusively on such an advantage.

Accreditation

In some industries, e.g. aircraft manufacturing, accreditation can be a sustainable competitive advantage. Accreditation essentially means that a product (or even a production facility) meets the necessary quality requirements of the OEM (Original Equipment Manufacturer, e.g. Boeing or Airbus).

As in cars, many parts in aircraft are safety-relevant and must therefore usually undergo a lengthy series of tests before they can or may actually be installed and used.

Due to the high effort and costs involved, OEMs often have no incentive at first to accredit another alternative supplier for a particular part. In addition, since aircraft are in service for more than 30 years on average, such accreditation can guarantee a relatively secure turnover from spare parts and maintenance business for a very long period of time.

2. High switching costs

Somewhat related to accreditation are high switching costs as a competitive advantage. Because many parts in the aerospace sector are safety-relevant and therefore have to go through a lengthy accreditation process, OEMs tend not to switch easily to a new supplier. This means that once a company has placed a part in an aircraft, it has a quasi-monopoly position over a long period of time.

Another good example of high switching costs is software. With the introduction of an ERP system, e.g. from SAP (SAP.DE), all important processes and procedures of a company are precisely aligned to this system, which makes a later switch extremely costly.

An important success factor in such a business model is to first get a foot in the door, i.e. to install the part or the software once at the customer's premises. This is often done at cost price (in the aerospace sector), via a free basic version, etc.

Incidentally, companies with such competitive advantages often have high development costs, which then appear on the balance sheet as intangible assets. The margins are therefore often high, but the return on capital is not necessarily. We should then also pay attention to this in our stock analysis.

3. High benefit-cost ratio

A high margin depends on how well a company is able to raise its prices over time. This has been shown to be particularly successful for companies that offer products with a high benefit-cost ratio for the customer.

This means that important components for the final product are involved here, but they are rather negligible in the customer's cost structure. As a result, the customer usually does not even notice a price increase (or does not care, because the product does not cause large costs in relative terms).

Good examples of business models with this competitive advantage can be found again in the aviation industry, but also, for example, in the food and cosmetics sectors.

In aerospace, a company like Transdigm supplies a large number of low-cost components that are of little importance to Airbus or Boeing compared to the cost of other parts such as the structure, wing, engine, etc. This is why Transdigm has been able to produce a large number of low-cost components for Airbus or Boeing. This is why Transdigm has been able to increase prices by 5-10% annually over a long period of time (which, by the way, is also reflected in the EBIT margin or ROC).

In the food sector (and also in cosmetics), companies such as Symrise (SY1.DE) or DSM (DSM2.DE) produce ingredients such as flavours and fragrances, which are essential for food or cosmetics manufacturers, but at the same time are not a major cost factor.

4. Network effect

Network effects are probably the most discussed competitive advantages at the moment, because the success of many new tech companies like Facebook or LinkedIn is based on a structural network effect. The question we have to ask ourselves as investors here is to what extent these network advantages are actually sustainable and structural in nature.

But let's take a step back again. Basically, there are two types of networks that can establish a competitive advantage:

  • Radial networks
  • Individual nodes

Radial networks

Radial networks are networks that consist of individual hubs but do not add value to each other.

Companies with a network of locations or branches belong to this category. These can be banks, but also other service companies.

Such networks represent a competitive advantage, but could theoretically be replicated quite easily by a potential competitor. Depending on the size of the network, however, this would of course be time-consuming and costly.

Another important point is: for the customer, a global network does not actually offer much added value. Here it depends more on the local density of branches (see smaller banks).

Individual nodes

The second type of network advantage only emerges with a growing number of customers using the network.

A good example of a company with such a network advantage is MasterCard, for example. It is precisely because MasterCard’s credit cards are actually accepted everywhere that they are of such great value to customers and the market is so difficult for competitors to attack.

Interestingly, many of the new, alternative payment methods (PayPal, Stripe and many others) also work indirectly via the big credit card companies. Apparently, it has also become clear to the startups that MasterCard or Visa should be brought on board rather than attacking them directly.

A company like Facebook also falls into the category of companies with a structural competitive advantage from network effects. The advantage of Facebook (and also the associated messenger service WhatsApp) simply comes from the sheer mass of people who use the platform.

Once a company has built up such a competitive advantage, it is far more difficult to copy than, for example, a bank's branch network.

The possibility that customers will switch to a newly emerging competitor is therefore much lower. For example, to switch from WhatsApp to an alternative provider, we would have to convince all the people in our network to do the same.

From my point of view, the most important point here: When we analyse a firm with a structural network effect, we should form an opinion about how likely we think it is that a new competitor will enter or that users will switch to such a competitor.

5. Cost advantage

Cost advantages can also be a (more or less) sustainable competitive advantage. Here, however, we should distinguish between process cost advantages (easier to copy) and economies of scale.

Process cost advantage

Process cost advantages are competitive advantages that arise, for example, from production that is more efficient or from leaner processes. This can mean a competitive advantage for a time, but will eventually be replicated by competitors.

The computer manufacturer Dell, for example, had a very low cost position compared to all major competitors in the late 1990s (due to the standardised production of computers as well as the direct distribution channel via the internet), but was eventually caught up again by the competition.

Economies of scale

Economies of scale arise as the size of production facilities increases, mainly through regression of fixed costs. For example, to operate a production facility based on a particular technology; in many cases, one needs roughly the same amount of personnel, regardless of whether the facility is small or large. Such economies of scale tend to be more persistent than process cost economies.

However, economies of scale are more important at the plant level. A company like GM, of course, has no (or few) direct economies of scale from its size because it operates a large number of independent and decentralised production facilities.

In my view, when investing in companies with cost advantages, the time horizon of the investment matters. We should therefore form an opinion on how long the company can maintain the competitive advantage (or on what the continuance of the competitive advantage depends).

6. Inflation protection

Built-in inflation protection can also be a competitive advantage.

MasterCard is again a good example of this: the company's business model works through commissions that the company receives on every credit card payment. Since this commission is calculated via a fixed percentage of the purchase price, the turnover (and also the profit) increases proportionally with the general price increase.

MasterCard therefore does not have to enter into negotiations with its customers in order to successfully pass on increased costs to them, for example.

Important factors: management and corporate culture

So far, we have mainly talked about structural competitive advantage and what the key reasons are for the sustainability of such advantages.

When it comes to the durability of competitive advantage, we should not completely neglect two other factors:

Both factors can have a strong individual influence on how sustainable a competitive advantage is, or sometimes even on whether a competitive advantage is created in the first place.

Very capable managers are in fact able to build up a structural competitive advantage over time. However, caution is advised here, as the competitive advantage is or can be very closely linked to the people acting.

Conclusion

There are a number of competitive advantages that can be considered sustainable or structural.

In principle, however, virtually all competitive advantages can be replicated by competitors and it is our task as investors to find out how likely such a scenario is from our point of view. In my opinion, this is one of the most elementary considerations that we should make in the run-up to an investment.

About Alexander Kelm

Alexander Kelm is a passionate value investor and runs the website Wall St. Nerd. Here, the passionate value investor writes in-depth articles on the topic of Value Investing. Value Investing involves analyzing a company's fundamentals and can be characterized by an intense focus on a stock's price, its intrinsic value and the relationship between the two.

Alexander Kelm offers online courses on stock investing.

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