Contrary to popular management belief, there are only a few types of competitive advantage. Examples of sustained competitive advantage are rare to say the least. The simplest form of advantage is created by government when it grants a license to one or more companies to engage in some kind of business with potential entrants deterred by law. Other forms of competitive advantage stem from the basic profit equation: revenue less costs equals profit. This equation highlights two key elements to profits, namely costs and revenue. Some companies have a cost or supply advantage and some a revenue or demand advantage.
Cost or supply advantages are only sustainable if the company possesses production techniques or products that other companies or new entrants cannot match. These could include patents, or specialized know-how (known as a downward sloping learning curve), or access to cheap resources like labour or capital. Note that technology could create a cost disadvantage, i.e. where a newcomer sets up with the latest technology, and erode any incumbent advantage.
Customer demand advantages happen when a company has access to customers that a potential entrant or existing competitor cannot match. For the competitive advantage to persist, customers must in some way be captive to these companies, and there is a limited number of ways this can happen. Habit is the most powerful of these. High search costs, i.e. the costs in searching for an alternative supplier, is another advantage and generally apply in local situations with local companies or companies with comprehensive product ranges and great customer satisfaction ratings. The final demand advantage is companies that have products with high switching costs like the case with banks and complex systems, e.g. computer systems. This advantage relies on the time, money and effort required to switch from one supplier to another.
The final, and generally most durable competitive advantage, is a combination of economies of scale (on the supply side, with high fixed costs relative to variable costs and stable unit variable costs) with some form of demand advantage. In order for economies of scale to constitute an advantage the demand advantage must provide the company with a dominant share of the market. The demand advantage can be small and still matter. Even with only a minor demand advantage, economies of scale will translate a slightly superior market share into lower costs, higher margins, and higher profitability, while attracting a larger share of newcomers into the market. A company with economies of scale, but without a demand advantage, should fiercely protect its markets share. Once its market share starts to erode, the underlying cost advantage shrinks with it. Economies of scale are often linked to companies with a disproportionately large regional market dominance or product-line dominance. When these companies spread across other regions or other products the economies of scale advantages often shrink or disappear eroding its competitive advantage.
Another marker to look for in identifying companies with a competitive advantage is price increases. Companies with a competitive advantage have the ability to raise prices aggressively and often. Whether a supply, demand, or patent advantage, the strategy is to reinforce the advantage while making full use of pricing opportunities.
Reproducibility is another factor that differentiates economies of scale as a competitive advantage. This is based on superior production systems, but lasts only as long as the underlying technology does (which is at most a couple of years). The same thing happens with captive customers, they eventually disappear over time. Consumer franchises that are sustainable over decades must have a competitive advantage in recruiting new customers as well as retaining existing ones (i.e. very high demand preferences like Coca-Cola) combined with economics of scale.
An identifiable and structural durable competitive advantage only exists where a company benefits from barriers to entry that keep out potential competitors or insure that if they choose to enter, they will operate at a competitive disadvantage relative to the company. Successful value investors remain within their circle of competence, where their knowledge of markets, industry, and companies, allows them to identify with certainty competitive advantage. If not these investors are just more punters, taking fliers rather than making investments.
Be extraordinary!
Myles Rennie
Cost or supply advantages are only sustainable if the company possesses production techniques or products that other companies or new entrants cannot match. These could include patents, or specialized know-how (known as a downward sloping learning curve), or access to cheap resources like labour or capital. Note that technology could create a cost disadvantage, i.e. where a newcomer sets up with the latest technology, and erode any incumbent advantage.
Customer demand advantages happen when a company has access to customers that a potential entrant or existing competitor cannot match. For the competitive advantage to persist, customers must in some way be captive to these companies, and there is a limited number of ways this can happen. Habit is the most powerful of these. High search costs, i.e. the costs in searching for an alternative supplier, is another advantage and generally apply in local situations with local companies or companies with comprehensive product ranges and great customer satisfaction ratings. The final demand advantage is companies that have products with high switching costs like the case with banks and complex systems, e.g. computer systems. This advantage relies on the time, money and effort required to switch from one supplier to another.
The final, and generally most durable competitive advantage, is a combination of economies of scale (on the supply side, with high fixed costs relative to variable costs and stable unit variable costs) with some form of demand advantage. In order for economies of scale to constitute an advantage the demand advantage must provide the company with a dominant share of the market. The demand advantage can be small and still matter. Even with only a minor demand advantage, economies of scale will translate a slightly superior market share into lower costs, higher margins, and higher profitability, while attracting a larger share of newcomers into the market. A company with economies of scale, but without a demand advantage, should fiercely protect its markets share. Once its market share starts to erode, the underlying cost advantage shrinks with it. Economies of scale are often linked to companies with a disproportionately large regional market dominance or product-line dominance. When these companies spread across other regions or other products the economies of scale advantages often shrink or disappear eroding its competitive advantage.
Another marker to look for in identifying companies with a competitive advantage is price increases. Companies with a competitive advantage have the ability to raise prices aggressively and often. Whether a supply, demand, or patent advantage, the strategy is to reinforce the advantage while making full use of pricing opportunities.
Reproducibility is another factor that differentiates economies of scale as a competitive advantage. This is based on superior production systems, but lasts only as long as the underlying technology does (which is at most a couple of years). The same thing happens with captive customers, they eventually disappear over time. Consumer franchises that are sustainable over decades must have a competitive advantage in recruiting new customers as well as retaining existing ones (i.e. very high demand preferences like Coca-Cola) combined with economics of scale.
An identifiable and structural durable competitive advantage only exists where a company benefits from barriers to entry that keep out potential competitors or insure that if they choose to enter, they will operate at a competitive disadvantage relative to the company. Successful value investors remain within their circle of competence, where their knowledge of markets, industry, and companies, allows them to identify with certainty competitive advantage. If not these investors are just more punters, taking fliers rather than making investments.
Be extraordinary!
Myles Rennie
RSS Feed