Competitive advantages are characteristics that differentiate a company from its competitors and enable it to provide higher returns to its investors.
Identifying competitive advantages can significantly improve your investment decisions. And to do so, ask yourself:
1. Is the company effectively managing costs and profitably reinvesting earnings?
2. Does the company have a strong brand identity?
3. Does the company enjoy cost advantages through attributes like operational efficiency or size?
4. Does the company enjoy a commanding position within the industry?
Management and brand
Having great management is important to any company's success in earning excess returns. I recently discussed how to identify strong management, so I won't go into much detail here.
The hard work that goes into establishing brand recognition, however, deserves a closer look. After all, a company can charge a premium if it convinces us that its product is superior to its competitors'. In some cases, the branding is so successful that the brand itself becomes synonymous with the type of product (Kleenex) or enters everyday language (Google). Brand is often based on customer sentiment, of course, so it tends to be a fickle and fragile thing. But a well-managed brand can be a useful ally in a long-term investment strategy.
Luxury-goods manufacturers illustrate the power of branding. Does a Rolex watch, for example, perform any better than a Casio? It's debatable, and in fact, the Casio watch probably has more features than the Rolex. However, Rolex has positioned its brand as a status symbol, and people are willing to pay thousands of dollars more for the product as a result.
Krispy Kreme Doughnuts presents a slightly different lesson. The Krispy Kreme brand once stood for light, fluffy, melt-in-your-mouth pastries, and people would wait for hours at Krispy Kreme store grand openings to try the tasty treats. From its IPO in April 2000 to its high in August 2003, Krispy Kreme's stock rose by more than 400%. But overexpansion, investigations by the Securities and Exchange Commission, and (according to the company) an increasingly health-conscious public all caused the company to lose its mojo. The stock price plummeted and now trades below its IPO price. Fizzling in its fryers, Krispy Kreme is now hoping that its brand still has enough pull to drag in some more dough.
Efficient business models
Some companies establish competitive advantages by introducing more efficient business models. Dell (NASDAQ:DELL), for example, introduced direct-to-consumer computer sales. By removing the middleman and avoiding expensive retail showrooms, Dell was able to post high margins while selling products 40% cheaper than its established competitors, like IBM.
Like Dell, Amazon.com (NASDAQ:AMZN) operates a centralized distribution model that allows it to manage inventory much more efficiently than traditional retailers can. Storing inventory is costly, after all, and the inventory itself can quickly become outdated, especially in technology markets. So the faster a company can ship its inventory, the better. Amazon.com sells its entire inventory every 25 days! By contrast, Best Buy (NYSE:BBY) takes 60 days, and Barnes & Noble takes 146.
Barrier to entry
Some industries present significant barriers to entry and operate in quasi-monopolistic environments. For example, there are only two main commercial airline manufacturers: Boeing and Airbus. The expense involved in manufacturing passenger airplanes and the relatively limited size of the market make it uneconomical for additional competitors to enter the industry.
In another industry, Freddie Mac and Fannie Mae (NYSE:FNM), once governmental agencies, control a significant majority of the American secondary mortgage market. These companies still enjoy certain advantages from their close association with the government -- specifically, most investors believe that the government would not allow them to default on their obligations, even though the government, in reality, does not officially guarantee the debt. As a result of the perception of a guarantee, Fannie Mae and Freddie Mac are able to borrow money at reduced interest rates. That and other advantages kept Fannie Mae in the Berkshire Hathaway portfolio for many years.
The early-mover advantage
Although first movers can get valuable traction in markets, they also tend to make costly mistakes, in terms of both money and time. Companies that follow closely behind the trailblazers, though, can gain many of the benefits of being early to market while avoiding some of the pitfalls.
A classic example is Microsoft (NASDAQ:MSFT). Although Apple introduced the first personal computers, it limited itself by trying to do everything -- building the computers, creating operating systems, and developing software. Microsoft, meanwhile, focused exclusively on the operating system, and MS-DOS soon emerged as the default standard for personal computing. Microsoft used this toehold to launch itself into productivity software, and who better to write software for an operating system than the company that built it? Microsoft was not the first mover, but its popular Office suite soon left competitors in the dust. The company's conquest of Netscape in the Web browser market followed a similar story. In short, Microsoft doesn't invent; it innovates -- and it's done that very well.
Size
In many cases, bigger is better. Large warehouse stores like Costco (NASDAQ:COST), Home Depot (NYSE:HD), and Wal-Mart now dominate the retail industry that used to be made of small, local stores. They never had a chance against the bigger and more efficient big-box outlets.
But the size advantage does not stop there. Because Wal-Mart is such a large customer, it has significant sway over its suppliers. In addition, Wal-Mart has deep pockets that allow it to underprice its competitors. It even sells some items at a loss to squeeze out the competition. So the size advantage tends to feed on itself -- more stores and better operations mean better prices for more customers because of increased bargaining power over suppliers.
Conclusion
Competitive advantages are like a seatbelt for your investments. They allow a company to remain in more control of its destiny when facing the uncertainties of the future. And although competitive advantages don't guarantee that a company will perform without failures, they do make it easier for a company to recover from its missteps. Identifying meaningful competitive advantages in your investments will therefore help you protect your investment dollars.
Related Fool content:
- Identifying Effective Management
- Strategy Creates Sustainable Advantages
- Be Like Buffett
- Digging Into Buffett's Numbers
Dell, Fannie Mae, Microsoft, and Home Depot are all Motley Fool Inside Value recommendations. Dell is also a Motley Fool Stock Advisor pick, along with Costco. Our newsletter services will give you a great advantage -- try any of them out free for 30 days.
Jim Schoettler is still in search of his personal competitive advantages, which may explain why he's single (not including his faithful dog). Check out Jim's other Fool articles. He does not own any of the stocks mentioned in this article. The Motley Fool has a disclosure policy.
