An Introduction to Competitive Advantage

Warren Buffett, the chairman and CEO of Berkshire Hathaway (BRK.A 1.18%) (BRK.B 1.30%) has long said that a "durable competitive advantage" is the single most important trait of companies that generate market-beating returns.

Using the analysis laid out in Michael Porter's book Competitive Advantage, Motley Fool contributor John Maxfield and analyst Gaby Lapera dig into the tell-tale signs of Warren Buffett's favorite metric for identifying outstanding stocks.

When purchasing a well-known brand product, you're paying for the name and we have competitive advantage to thank for that. When looking to invest, this is an area that should be closely analyzed to ensure the name you're investing in holds up in the market against its competitors. As we dive into Porter's book, we'll learn the key components to review in helping with any decision to invest based on the stability and reliability of a company, or even a sector.

Listen to the entire podcast by clicking here. A full transcript follows the video.

Gaby Lapera: 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.