Warren Buffett, the chairman and CEO of Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), has long said that a "durable competitive advantage" is the single most important trait of companies that generate market-beating returns. But what exactly does he mean by this?

Motley Fool podcast hosts John Maxfield and Gaby Lapera discuss competitive advantage in this week's episode of Industry Focus: Financials. Using the analysis laid out in Michael Porter's book Competitive Advantage, John and Gaby dig into the tell-tale signs of Buffett's favorite metric for identifying outstanding stocks.

A full transcript follows the video.

 

Gaby Lapera: Hello, everyone. Welcome to The Motley Fool's Industry Focus, financials edition. My name is Gaby Lapera and joining us on the phone is John Maxfield.

This week, we're going to be talking about competitive advantage. Specifically, we'll discuss Michael Porter's work. He's a pretty fantastic economist with a book titled Competitive Advantage -- very appropriately -- but we're in D.C. right now; we're not creative people when it comes to titles. I really appreciate a title that is just what it's about.

Let's talk a bit about what competitive advantage is. Porter defines it as: "A function of either providing comparable buyer value more efficiently than competitors, which is low cost, or performing activities at comparable costs, but in unique ways that create more buyer value than competitors; and hence, command a premium price, which is differentiation."

Either of those things help companies maintain an advantage over their competitors and thus provide them with a wider profit margin.

John Maxfield: If you think about it, if you're an investor, one of the people that you read about, that you think about, and in some ways try to learn from and mimic... that's Warren Buffett. He's the chairman and CEO of Berkshire Hathaway. One of the things that Buffett says in his letters, which are quite amazing things for investors to read, is when identifying a good investment that's going to outperform both its industry and the broader market in general over the long term, the single, most important thing to know is: identifying companies with a durable competitive advantage.

So the question is: Is this just Warren Buffett spitting out another awesome quote? He has millions of them in his letters. Is there more substance to this? This concept of competitive advantage... is there a model that investors can find and follow to identify companies that have this? There is. The godfather of competitive advantage writing and literature is this guy Porter. His book Competitive Advantage is really where he spells it out.

Lapera: One of the things I want to point out about that Buffett quote is, Warren Buffett talks a lot about -- he frames it in terms of an economic moat. That means companies have a sustainable advantage. Michael Porter helps identify short-term things that might help the company succeed over other companies, but Buffett is really looking for -- and you can use Michael Porter's forces to do this as well -- companies that can succeed over the long term and can maintain those things that differentiate them.

Maxfield: Here's the thing: I would not put those as mutually exclusive things. I would say what Porter does is add substance. They're talking about the exact same thing, but he's taking it to an analytical level. He's breaking it down and saying, "This is how you identify competitive advantage." Let me reiterate: The reason competitive advantage and durable competitive advantage matter so much is because a company that has an advantage over its competitors is able to earn more money than them.

This sounds so obvious that there's almost no point in saying it, but the reason they're able to earn more money is because that competitive advantage is one of two things. It either allows them to earn more revenue than their competitors relative to the expenses that it costs to generate revenue.

You have a wider margin and if you have that wider margin, you can then price your products for less than your competitors. If you can price your products for less than your competitors, you're going to sell more of those products. That's one component. The other component is on the cost.

If you can generate the same revenue with a lower cost base, the same exact principle comes through. You have a wider profit margin, which then allows you to price your products or services at a more competitive level, relative to your competitors. If you follow that wide profit margin all the way through the financial statements, you'll see that you're given the opportunity to generate a higher return on equity.

If you can generate a higher return on equity, over a sustainable period, your shareholder returns are going to be higher than both the industry and the broader market. That's why identifying competitive advantage is such a critical thing for investors to be able to do.

Lapera: If we want to round back up to Michael Porter's book, he describes five different forces -- referred to as "Porter's Five Forces" -- for assessing and industry's dynamics when it comes to competitiveness. I'll just list them out and then we'll circle back and talk about them.

The level of competition among participants who are within the industry, the power of a "buyer to price to product," the power of suppliers to affect the product entry barriers and the threat of substitutes. Where do you want to start?

Maxfield: Let's start with this: Porter breaks the analysis down into two different component pieces. You have the competitive dynamics of an industry. There are some industries that have characteristics that make them more prone to allowing companies therein to have durable competitive advantages. Those five components that you talked about are what an investor would use to assess an industry.

Let's talk about two different industries in particular to flush these things out. First, you have restaurants. You have McDonald's going along, really struggling a lot recently. A lot of their franchise owners are complaining about the overemphasis on the value menu because you're selling things for $1.50 or $1 that they used to be able to sell for twice that. There isn't a lot of margin in that. The reason McDonald's is struggling in the margin category is because the restaurant business as an industry doesn't have large entry barriers. Anybody can start a restaurant. As long as you know how to cook and you can get a little capital together to rent a place and put a stove in, you can start a restaurant.

The fact that so many people can come into it is driving those margins down and making it difficult so even an established industry player like McDonald's to get along in that regard. Let's talk about another dynamic that impacts this: chip making. You have Intel -- I live in Portland, Oregon.

This is not where Intel is based, but Intel has a large chunk of their manufacturing facilities based here. When you drive by these things -- in fact, my brother-in-law works for them -- these are enormous. Then when you see the commercials online and you see the sophistication of the technology that's in one of these, that makes it clear that -- say, you and I wanted to start a business. God forbid you'd have to start a business with me. That would be miserable for you.

Let's say we wanted to start a business. Let's say we got a couple hundred thousand dollars in capital together to start this business. It would take billions of dollars in capital to get into the chip-making business that Intel is in. You have that huge entry barrier to the industry itself that has allowed Intel, over decades, to generate such a wide profit margin. That's the first piece of the analysis, of looking at the industry. 

Lapera: That's true. For our listeners out there who are more well versed in technology, I will say that I just got schooled by our technology editor 10 minutes ago about Intel. Apparently, out of China there's a lot more chip makers now. So Intel is actually starting to struggle to maintain its hold on its market share.

Maxfield: That's exactly right. This is a relatively new thing, and China is kind of a new entrant to the market, so the dynamics are certainly changing for Intel. Where Intel really makes its money on that cutting-edge stuff, it's still got the advantage, but is it durable? Not necessarily, but it is certainly a competitive advantage.

Lapera: I interrupted you. You were about to go into the second component that you want to talk about.

Maxfield: The second piece of Porter's analysis, you look at the industry overall -- and another industry to think about in this regard and they provide positive competitive dynamics -- that's utilities. Your water companies, electric companies, even your waste management companies. Waste Management picks up our garbage, but it's not like Waste Management can compete with the Portland Garbage Service to pick up more garbage.

The City of Portland actually gives Waste Management an exclusive license to operate in certain areas. I don't know if it's the whole city or if it's certain areas or how that works; but you're giving a monopoly for a specific industry segment to a company in the utilities sector. That monopoly allows them to earn higher profits, as long as they're able to operate efficiently. That's another observation point to throw into your analysis when you're thinking about competitive dynamics on an industry level.

Now, the second piece of Porter's analysis looks at the companies themselves. Once you've assessed and industry for its competitive dynamics, then you want to get in there and assess whether or not the specific companies in that industry have a durable competitive advantage. He talks about two different ways that a company can acquire that. The first is through cost -- low cost.

Think about Geico. They say: "Spend 15 minutes to save 15% on your car insurance." Well, the reason Geico Insurance is so much cheaper -- for the record, Geico is a subsidiary of Berkshire Hathaway and there's not a coincidence there that it has a strong competitive advantage, and that Berkshire Hathaway bought is.

The reason Geico is able to operate and sell their insurance products for less than their competitors is because they don't have offices all around the country like State Farm. They operate much less expensively and can therefore sell their products less expensively. That's a competitive advantage on the cost side.

Wells Fargo is the same, exact thing in the banking sector. This company has earned outstanding returns for decades now, and it's been able to make it through a lot of these crises that have otherwise hobbled its competitors. Why has it been able to do all these things? It's my analysis of Wells Fargo that the reason it's been able to outperform its competitors is because it has a pricing advantage. Keeping costs low is in Wells Fargo's DNA.

That comes through loud and clear in their shareholder returns over time. You have that cost piece of the competitive advantage on the company level; that's the first element. The second element in the company's specific level is differentiating your product. Making your product uniquely appealing in some way, shape, or form that differentiates it from the competitors and allows you to generate wider margins from it.

Lapera: I think this is a lot more intuitive for people to grasp because pricing structures can be hidden and people don't think about them as much. For example: if you're in a CVS, will you reach for Band-Aid, or CVS Adhesive Wound Stopper? You're going to reach for the Johnson & Johnson product, which is Band-Aid. Everyone knows about Band-Aid, or Coca-Cola. Are you going to buy Coca-Cola, or are you going to buy supermarket soda?

It's fine; supermarket soda is pretty much the same thing as Coca-Cola, but brands have managed to create this trust among consumers where they are able to charge consumers more because without thinking about it, people will reach for their products before other people's.

Maxfield: Yeah. When I think about differentiating a product, when you say "Coke," that's the textbook example. My wife is ridiculously frugal. We do not use a full roll of paper towels for a year and a half. Possibly longer. I could go through a number of examples to give you. She's all about buying generics and all that, but we had a gathering at our house a couple weeks ago and her whole family came over.

She sent me out to do the shopping, which is always an enormous mistake, but I go out and I'm looking on the soda aisle and I'm thinking, "What would I do if I was Jamilla?" I'd think, "I definitely have to go with the generic."

If I sat down and did a blind taste test, I guarantee you and everyone else along with me would not be able to tell the difference between generic cola and Coca-Cola or Pepsi. I get the generic, I bring it home... 

Lapera: I can totally tell the difference between Pepsi and Coke.

Maxfield: I think statistics are against me on that. I bring home the generic and even my wife -- who otherwise would think generics are the way to go -- she was not happy with that because she was thinking, "How is this going to reflect on us with all my family? You bought the generic as opposed to the Coca-Cola." It's basically twice the amount, just for the brand. That is what a competitive advantage gives you. You're making the same thing, but you're selling it for 50% more.

Lapera: Do you want to talk a little bit about how this works out for financial institutions in general?

Maxfield: If you want to talk about financial institution you're going to want to think about J.P. Morgan Chase or Goldman Sachs.

Lapera: Before we start, I just want to put in there that banking, financial stuff in general, insurance companies, REITs... all of these businesses have an extremely high barrier to entry. You have high capital costs, you have high regulatory requirements, you need to have a lot of knowledge, and people aren't going to give you their money if you don't know what you're doing.

In the industry, you're not going to have as much proliferation as you would in other industries such as the restaurant industry.

Maxfield: Yeah. That's a really important point to appreciate about the financial industry. You can't just open a bank if you wanted to just open a bank. Particularly after the Dodd-Frank and financial crisis; it costs so much and it's so complicated to get into banking nowadays. You really have to know what you're doing, and you have to have some money behind you to get in it. The industry dynamics are favorable in terms of entry barriers.

Now, within the industry it's pretty commoditized. Unless you're able to differentiate yourself either on a cost basis like Wells Fargo has, U.S. Bancorp has done the same thing, M&T Bank has done it; the most recent Q1 cap financial was the most efficient bank in the recent quarter. If you can differentiate yourself in cost, that's probably the default way to go. The other way is, you've got to differentiate your product.

If you're talking about product differentiation in the banking field, the best area that you'll be able to identify that is in your wholesale products; your investment banking products, your trading products, and all those types of things. It would lean more toward your Wall Street operations where brand and quality really make a difference. If you go into Goldman Sachs, you know you're going to get a quality product.

There's no question about it. Companies that need a serious thing done, whether it's a merger, an acquisition, advisory work, or something along those lines, then you'll go to Goldman Sachs or J.P. Morgan Chase. That's where that differentiation comes in for the banking sector, in particular. 

Lapera: The other option is to excel in niche type banking things. What I have in mind is New York Community Bancorp. They specialize in multi-family loans in New York City. No one else is as good as them at doing that particular thing in that particular city.

Maxfield: Again, that's a perfect example. If you chase New York Community Bancorp's stock back to 1994 when they IPO'd, it's one of, if not the highest-performing bank stocks over that time period. The reason is, to your point, because they focused on this niche area and you can analogize that to being a local monopoly, almost like a utility even though it doesn't have the same level protection you can analogize it to; that allows it to generate these higher returns on their banks.

Another great example of a niche bank that is able to generate outsized returns is SVB Bank out in Silicon Valley. They focus on helping brand new start-ups technology firms in getting financing and the financial products and services that they need in order to operate and succeed. Nobody really does it as well as SVB Bank.

So just like New York Community Bancorp, you're dealing with a niche market that allows it generate almost monopoly like outsized returns that then translate into higher shareholder returns over an extended period of time.

Lapera: Exactly. Just to wrap up this episode, investors; when you're looking at investing in a company, take a look at what the industry dynamics are for competitiveness. Look at the company that you're thinking of investing in and asking, "Do they have a pricing advantage? Do they have a differentiation advantage? Is it something that can last over a long period of time? Is it something that just gives them an advantage right now?" Do you have anything you want to add?

Maxfield: The only thing I would say is to keep in your head that the single most -- not everyone will have time to go out and read Porter's book tomorrow, and it's a difficult book to read -- but the concept is what matters so much here. That is, when you're picking an investment, look for companies that can in some way, shape, or form be perceived as having a competitive advantage. Whatever that means to you. If you can find those, that's where you're going to have your investment winners.

Lapera: Absolutely. Just a reminder: We on the program may have interests in the stocks that we talk about and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thank you, guys, very much for joining us and we'll see you next week.

Gaby Lapera has no position in any stocks mentioned. John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway, PepsiCo, and Wells Fargo. The Motley Fool has the following options: long January 2016 $37 calls on Coca-Cola, short January 2016 $43 calls on Coca-Cola, short January 2016 $37 puts on Coca-Cola, and short January 2016 $52 puts on Wells Fargo. The Motley Fool recommends Coca-Cola, CVS Health, Intel, and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.