It's no coincidence that Warren Buffett looks for investments with durable competitive advantages, and that his own company, Berkshire Hathaway, owns 10% of Wells Fargo (NYSE:WFC), the nation's fourth biggest bank by assets. I say that because Wells Fargo has multiple competitive advantages that have allowed it over the past three decades to outperform the S&P 500 by a factor of five.
Generally speaking, a company can pursue two strains of competitive advantage. It can seek to be a low-cost provider, which would allow it to sell products and services for the same price as its competitors, even though it costs the company less to supply them. This translates into a wider profit margin, higher profitability, and superior shareholder returns.
Alternatively, a company can seek to differentiate its products and services such that customers will pay a premium for them. Jewelry retailer Tiffany & Co. (NYSE:TIF) serves as a case in point. People don't pay Tiffany & Co.'s exorbitant prices for engagement rings because they're materially better than all-but identical rings at less prestigious, but still reputable, jewelry stores. Instead, and I speak from experience, people buy engagement rings from Tiffany & Co. because we believe its jewelry is superior. Whether that's actually the case is irrelevant, as most of us couldn't discern a difference in diamond quality even if our lives depended on it.
Like a low-cost provider, a company that successfully differentiates its products can generate higher shareholder returns relative to companies that don't. This follows from the fact that a company like Tiffany & Co. can sell its products for a premium to its competitors even though it doesn't cost considerably more to do so. This fattens its profit margins and fuels profitability.
This structure is laid out in Harvard Business School Professor Michael Porter's seminal book on competitive advantage, Competitive Strategies: Techniques for Analyzing Industries and Competitors, and it goes a long way toward explaining why Wells Fargo has outperformed its competitors in the bank industry, as well as the broader market, since at least the mid-1980s.
Unlike Tiffany & Co., Wells Fargo doesn't seek to differentiate its products based on quality -- at least not to the same extent. It has instead become one of the bank industry's lowest-cost providers. You can see this in the California-based bank's efficiency ratio, which measures the percentage of net revenue consumed by operating expenses. In the latest quarter, costs equated to 56.7% of Wells Fargo's net revenue. That compares to Bank of America's (NYSE:BAC) efficiency ratio of 66.1%, implying that Wells Fargo passed nearly 10 percentage points more of its net revenue down to the bottom line compared to the North Carolina-based Bank of America.
Wells Fargo is able to outperform Bank of America as well as most other banks in this regard thanks to four specific competitive advantages, all of which reduce its expenses:
- Credit rating -- Wells Fargo has one of the highest credit ratings in the bank industry, earning an A+ rating from Standard & Poor's compared to Bank of America's A-. This allows the $1.75 trillion bank to borrow money at lower interest rates than Bank of America. In the first nine months of 2015, for instance, the interest rate on Wells Fargo's long-term debt was 1.37%. By contrast, Bank of America paid 2.25%, which amounts to a hefty chunk of change when you consider that it has $241 billion worth of long-term debt.
- Systems -- Technological and operating systems may not seem like an obvious competitive advantage, but they are. They allow a bank to get a more comprehensive view of its customers. This helps a bank like Wells Fargo identify and then sell additional products that a particular customer may be interested in, based on that customer's existing product portfolio as well as trends in usage thereof.
- Data -- No business stands to benefit more from the era of big data than banks, which know more about their customers' financial lives than any other type of company. "We know where you eat on Friday night," JPMorgan Chase (NYSE:JPM) CEO Jamie Dimon said to illustrate this point at a recent industry conference. This helps the nation's biggest banks, including Wells Fargo and JPMorgan Chase, boost revenue through card-linked marketing, which uses data about customers' past purchases to create targeted debit and credit promotions that encourage future purchases, which, in turn, boosts a bank's interchange income.
- Culture -- Finally, Wells Fargo has one of the most prized competitive advantages of all: a culture of prudence and frugality. It's easy for a bank's executives to say they want their company to be a low-cost provider and a disciplined risk manager, as virtually all bank executives do, but it's another thing to execute on these objectives. This is because both translate into less short-term revenue and thus, presumably, lower executive compensation. Through its long-running culture, known as the "Wells way," however, these traits have become ingrained in Wells Fargo's DNA, increasing the likelihood that they'll be transmitted to future generations of the bank's leaders.
It's also worth noting that Wells Fargo's size gives it a cost-based competitive advantage over most of the nearly 7,000 banks in the United States, with the exception of JPMorgan Chase, Bank of America, and Citigroup, the three biggest banks in America. Thanks to economies of scale, the average bank with at least $10 billion in assets on its balance sheet has an efficiency ratio of 57.7%, compared to the 70.1% average efficiency ratio of banks with between $100 million and $1 billion worth of assets, according to FDIC data.
In sum, if you've ever wondered about what led Warren Buffett to Wells Fargo in the early 1990s, it seems safe to assume that this is it. As I noted at the outset, it's no coincidence that the Oracle of Omaha values durable competitive advantages more than anything else, and that Wells Fargo sports an unusually robust assortment of its own.
John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway and Wells Fargo. The Motley Fool has the following options: short January 2016 $52 puts on Wells Fargo. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days.