Identifying Competitive Advantage
By Matt Argersinger
December 11, 2009
What's the single most important attribute that Warren Buffett looks for when evaluating a company? While there have been dozens of books, hundreds of interviews, and countless articles over the years attempting to “uncover” the key to Buffett's unrivaled investment success, it's not much of a secret at all. In fact, Buffett shared it with the world in a Fortune article in 1999. It's sustainable competitive advantage.
As Tom alluded to in the video section, a sustainable competitive advantage puts a company in the position to earn outsized profits, fend off competitors, and grow its business at high rates for extended periods of time. It's what led Buffett to long-term winners like American Express (NYSE: AXP), Coca-Cola (NYSE: KO), and Gillette, now part of Procter & Gamble (NYSE: PG).
Now that Tom has shared his three-step formula for finding quality businesses with sustainable competitive advantages, I'll show you how to dig in and assess a company's ability to create and maintain those advantages over time.
What Is a Sustainable Competitive Advantage?
As Colonel Sanders could attest, all great recipes have just the right herbs and spices. To identify businesses with strong competitive advantages, Tom looks for at least one of these three attributes:
- A comparable product or service that's cheaper
- A higher-quality product
- A product or service that's more convenient
Any one of these can help a company to maintain an edge over the competition, while protecting present and future cash flows. If you're a conscious consumer, these first two are fairly simple advantages to recognize—once you know that you're supposed to look for them. On rare occasions, as Tom points out in the video, you'll find companies that offer both the best quality product and the lowest price -- a beautiful convergence that's nearly impossible to compete against.
Types of Competitive Advantage
So how does a company position itself in that sweet spot … and stay there? After all, shifts in consumer tastes, a savvy marketing campaign, technology, a good management team, or even dumb luck, can temporarily put a company in a position of competitive strength. We want to focus instead on the qualities that keep them there for the long term.
In a speech several years ago at Harvard, hedge fund manager Mark Sellers shared what he believes are the four sustainable sources of competitive advantage:
- Economies of scale and scope. Big companies are better able to purchase goods at a lower cost from their suppliers than smaller players, and they can spread operational costs over a larger store base. This ultimately enables them to offer cheaper prices to their customers. McDonald's (NYSE: MCD) enjoys some serious economies of scale, as does Wal-Mart (NYSE: WMT).
- Network effect. Sometimes, the value of a company's services increases in direct proportion to the size of its user base. The appeal of online retailers Amazon (Nasdaq: AMZN) and eBay (Nasdaq: EBAY) increases as their pool of buyers and sellers -- and therefore the number of products and services offered -- grows.
- Intellectual property rights. Government-protected patents, copyrights and trademarks enable certain companies to be the sole suppliers of premium products and services. Companies as diverse as Disney (NYSE: DIS) and drug giant Pfizer (NYSE: PFE) can charge premium prices for their unique -- and, in the case of Pfizer, critical -- products.
- High switching costs. Finally, some companies benefit because it's just too dang hard or expensive for customers to switch. Microsoft (Nasdaq: MSFT) is a good example here, but so is fellow software firm Adobe (Nasdaq: ADBE). Developers and web designers spend years learning Adobe's suite of design and publishing products. Because it would be difficult for most of them to switch, Adobe can continue to charge premium prices every time it upgrades its software packages.
You'll notice that Sellers did not mention brand power as a factor in competitive advantage. Obviously, companies like Apple (Nasdaq: AAPL), Coca-Cola, and Nike (NYSE: NKE) benefit from familiar, respected brands. But brand power is usually the end result of actions taken over time that differentiate each company's product or services from competitors' offerings -- Tom's second competitive advantage attribute. In most instances, brand power can be limited unless it's continuously reinforced through innovation or marketing.
The preceding discussion should serve as a framework for understanding why a particular company has a competitive advantage and how it can be sustained. Take a moment to consider the stocks in your portfolio. Are there any that exhibit these characteristics? Are there any that completely miss the boat?
Outside Forces That Can Affect Competitive Advantage
So far, we've focused on the internal attributes that lead to competitive advantage. There are also numerous external factors -- often far outside the company's control -- that can also influence whether or not a competitive advantage is sustainable.
In his seminal work, “How Competitive Forces Shape Strategy,” published in the Harvard Business Review in 1979, Michael Porter laid out the five forces that dictate competition and sustainable profitability within an industry:
- The threat of substitute products
- The threat of the entry of new competitors
- The intensity of competitive rivalry
- The bargaining power of customers
- The bargaining power of suppliers
Each of these forces can have a measurable impact on the ability of a company to earn outsized profits over long periods of time. For example, what kind of startup costs do new entrants face? Take Boeing (NYSE: BA), for example. The threat of new competition is low thanks to the enormous cost of starting up a competing airplane manufacturer. However, that's probably not the case for a clothing retailer like Abercrombie & Finch (NYSE: ANF) or a small restaurant chain like Famous Dave's (Nasdaq: DAVE).
And what about bargaining power among customers and suppliers? We already know that big retailers like Target (NYSE: TGT) and Wal-Mart can put the squeeze on their suppliers, but what about vice versa? Take Hasbro (NYSE: HAS), the maker of iconic toy brands like G.I. Joe, Monopoly, and Transformers. Toys ‘R' Us accounts for a meaningful chunk of Hasbro's sales every year, but that doesn't necessarily put the toy retailer in a position of power. Hasbro's products have a loyal customer following and are usually big sellers, putting pressure on Toys ‘R' Us -- the customer in this case -- to set aside valuable shelf space and pay premium prices for its products.
Porter's five forces framework deserves more consideration than we can give it here, but this brief introduction should at least get you thinking about companies within an industry context. Because no matter how many positive attributes a company exhibits on the inside, outside forces can often play a major role on how sustainable those attributes really are.
Measuring Competitive Advantage
Unfortunately, there isn't an exact formula for measuring whether or not a company is enjoying a competitive advantage. However, there are a few ratios we can observe that can at least tell us whether or not we're on the right track.
- Consistently high operating margins. Operating margins, or operating profits as a percentage of revenues, will vary widely from industry to industry, but a company that generates above average margins compared to its direct competitors over extended periods of time is probably enjoying a competitive advantage. We'll stick with operating margins instead of net margins, or net profits as a percentage of revenue, because the latter is often skewed by debt costs, taxes, and other factors that lie outside the company's core operating business.
- Consistently high returns on equity (ROE). One of Buffett's supposedly preferred metrics, ROE measures profitability for the equity holders of a company. It's one way of measuring the return a company has generated from the capital that has been invested in the business. To calculate it, take this year's profits as a percentage of the prior year's shareholders' equity. Returns on equity are more comparable across industries, so if you're seeing high-teens ROE over long periods of time, especially for a company with little debt (high debt companies have a smaller equity base, which artificially increases ROE), you've probably got a well-positioned business.
- High returns on invested capital (ROIC) versus weighted average cost of capital (WACC). This measure takes the most work, but it may be the most useful way to confirm or disprove a competitive advantage thesis. It measures the return a company is getting on the capital (both debt and equity) invested in the business versus the cost of that capital. For example, a company may be earning a 9% return, but if it's paying an 11% interest rate on its debt, it's destroying capital. Conversely, a company earning 15% returns from a capital base that is only costing 8% is creating value and probably enjoying some measure of competitive advantage. In most industries, competition will drive down ROIC to the company's WACC, removing any excess returns. Our job is to find companies that are able to maintain a positive spread between their ROIC and WACC over long periods of time.
For a more thorough primer on how to calculate ROE, ROIC, and WACC, check out this 6-part series on Fool.com.
The Foolish Bottom Line
This supplement introduced you to the concept of sustainable competitive advantage -- Warren Buffett's not-so-secret recipe for finding great investments. Tom shared his own framework, and we explored ways to measure and assess the sustainability of a particular company's competitive advantage. In the next article, we'll show you how you can apply these concepts to companies that you're considering for your portfolio.