The Three Paths to Competitive Advantage

As Managing Director and Head of Global Financial Strategies at Credit Suisse, Michael Mauboussin advises clients on valuation and portfolio positioning, capital markets theory, and competitive strategy analysis. He has also authored three books -- Think Twice, The Success Equation, and More Than You Know -- and is an adjunct professor of finance at the Columbia Business School, and chairman of the Board of Trustees at the Santa Fe Institute.

For a long time the three paths to competitive advantage were low cost production, differentiation, or enjoying some kind of legal or regulatory protection. In today's market, technology is allowing some companies to hit two of these targets at once.

A transcript follows the video.

Koppenheffer: As long as we're on Buffett ... moats. Can't talk about Buffet without moats!

You had a great piece recently on evaluating moats. One of the things you did was break it down into three component parts. This was for competitive advantage. There was the process advantage, the consumer advantage, and then -- I forget what you called it -- but it was the government advantage, basically, if there's a government protection there.

Can you explain the basics of these, and how they give one business an advantage over its competitors?

Mauboussin: Sure. There might even be an easier way to say this. It would be, work done by Michael Porter -- and I think most of these people sort of align to the same thing -- Michael Porter says there are two generic ways to get a competitive advantage.

One would be low cost producer, and we call that a process advantage. Low cost producer means, "We can produce this good or service cheaper than everybody else, and it's of reasonable quality" -- so it's not like it's totally horrible -- and we can go into the market that way. When you think about low cost producers, you typically think about things like Wal-Mart (WMT -1.75%) in retail. You might think about Southwest Airlines (LUV -0.91%) in airlines -- people coming in that way.

By the way, just to be a little sophisticated for a second, often the way they do that is by having very rapid capital velocity, so they're not making a lot on margins, but they're able to use their capital very efficiently.

The second generic way to get to competitive advantage is so-called "differentiation." That means you have typically higher than average prices, and you're OK on cost, but your key is that you're differentiating yourself. You might think about luxury goods, for example.

Koppenheffer: Tiffany (TIF). That's the first thing that popped into my head.

Mauboussin: Tiffany should pop into your mind. You think about luxury automobiles, or what have you. They're charging a higher price, you're willing to pay it for whatever reason. Again, their costs have to be competitive, and that can allow them to satisfy this interesting niche.

Those are the two generic ways to get competitive advantage.

One of the things I'll say as an interesting side note is, technology seems to be coming along and busting a lot of this stuff. It used to be the case that you'd want to be one or the other, but now companies are coming along and they're actually quite effective on a number of fronts.

Technology is allowing companies to deliver goods or services in a very customized way, which would be consistent with the differentiation strategy, and do that on a very low cost basis. You may think about a retailer like Amazon.com (AMZN 1.30%). We were talking about books before we came on the air, but these guys know pretty well what you like to read, and what you're likely to read next.

Koppenheffer: They know better than I do, I think!

Mauboussin: They often know better than you do, and they can deliver it to you very cost effectively, either electronically or even in a physical version. That's also a very interesting set of developments, is how is technology even affecting these two typical categories that we talk about for competitive advantage?

Koppenheffer: Then the third bucket; the government bucket, if it's an industry or company that's protected by regulation or something else like that. Just from your perspective as an investor, is that an advantage that you'd want to rely on, versus the other two? It seems maybe less durable.

Mauboussin: Yes, I would feel less comfortable with it. Now there are some categories -- things like patents -- where patents were explicitly set up as a way to compensate people for taking risks ...

Koppenheffer: That would fall into the government bucket.

Mauboussin: That would be sort of in the government bucket, and licenses, and those kinds of things.

But to your point, whenever you have things that are related to government actions -- on taxes, or what have you -- you have to be very careful because, obviously, you're subject to the vagaries of government policies and the whims of government policies, to some degree.

So, yes, patents are obviously fine, but I'd rather see less of that aspect as a main driver of your investment thesis, and more one of those two generic strategies we talked about.