On Competitive Advantage

A competitive advantage is an edge a company has over its competitors, which may be derived from various sources, generally enabling it to capture market share and financial rewards such as higher prices, profit margins, and returns on capital employed.

There are many types of competitive advantages. A great brand or reputation is one of the most powerful. Well-known brands like Coca-Cola and Kleenex are top-of-mind, having become synonymous for pop and tissue paper, respectively. And many businesses have spent decades building strong reputations: Costco (low prices), FedEx (fast delivery), McDonald’s (fast food), Louis Vuitton (luxury). In essence, these companies are selling a consistent promise and through the delivery of this promise have earned the trust and mind share of their customers who remain loyal to each company’s products or services.

High switching costs is another powerful competitive advantage. Customers face high switching costs when a product or service is mission critical, deeply embedded, or part of a larger ecosystem of services. For example, Palo Alto Networks is known for its reliable and critical cybersecurity services. Customers are reluctant to switch to another, less proven cybersecurity offering. Ericsson‘s products are deeply entrenched into telecom networks; ‘ripping and replacing’ them is difficult without materially disrupting services. Millions of customers around the world belong to product ecosystems like Apple‘s or Alphabet‘s (Google, YouTube, Android, Maps, and Gmail) where a web of services makes it difficult to compete against because customers are reluctant to lose accompanying benefits and convenience.

Another competitive advantage arises when a company creates a network effect. Think Facebook and the self-sustaining runaway effects of their social media apps. People use these apps because many others use them. Amazon‘s massive online consumer base attracts the biggest number of merchants, improving selection and pricing, attracting even more consumers and merchants. Google also has a network effect—the more people search, the better the search results.

Fig. 01 — Types of competitive advantage

01

Brand & Reputation

A consistent promise that earns customer trust and mind share over time.

Coca-ColaCostcoFedExLouis Vuitton

02

Switching Costs

When a product is mission-critical, deeply embedded, or hard to rip out and replace.

Palo AltoEricsson

03

Network Effects

Each additional user makes the product more valuable to all the others.

FacebookAmazonGoogle

04

Ecosystem

A web of interconnected services customers are reluctant to leave.

AppleAlphabet

05

Scale

Size that compounds into cost, data, talent, and capital advantages.

AlibabaAmazon

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Investing in businesses with stable or growing competitive advantages has several benefits. Most important, it supports intrinsic value growth over time. Having an edge enables a business to fend off competitors, thereby protecting cash flows and creating opportunities to sustainably grow cash flow.

The presence of a competitive advantage provides a greater degree of predictability when it comes to forecasting cash flows. Greater predictability reduces investment risk since it tilts the probability of an investment thesis playing in our favour. While it is important to buy at the right price, what is purchased has a significant impact on the risk profile of the investment as well.

As buyers seeking value, we always look for a margin of safety because we may err in our appraised value, or an adverse event may occur. In either instance, we’re better off with a more resilient business. If a business is temporarily suffering, having fallen on tougher times, our confidence is bolstered when there are prevailing competitive advantages which normally implies staying power.

Competitive advantages also provide businesses with resiliency to weather periods of macroeconomic uncertainty. A strong brand proposition enables a company to raise prices, thereby protecting gross margins. Loyal customers act like a shock absorber during recessions. High switching costs mean products or services may not be cut even as other expenses are pruned.

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A company’s culture is the wellspring for competitive advantage creation. A good culture creates, sustains, and grows competitive advantages. Fostering this type of culture requires strong leadership that thinks strategically, has a long-term orientation, a clear mission and purpose, and core values that permeate the organization.

Competitive advantages can combine and result in scale, which itself becomes a competitive advantage. This can then lead to cost savings, larger data sets, better talent, and enhanced capital resources which enable businesses to invest in and develop better offerings. Alibaba‘s brands, switching costs, network effects, ecosystem, and scale are formidable for competition to dismantle.

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Competitive advantages can erode over time or even end suddenly. In our ever-changing world new technologies arise and disruption occurs regularly. A competitive advantage may appear robust, but analysis may reveal fragility. A company’s ability to adapt to change can determine whether its advantages erode, or it successfully pivots.

Netflix displacing Blockbuster is a classic example. Netflix foresaw the future of video and pivoted from a mail-order DVD rental model to streaming. Blockbuster remained locked in to its brick-and-mortar DVD rental model and did not pivot.

One must also consider the depth of competitive advantages. The more competitive advantages a business has, the harder it is for competitors to successfully compete. Amazon‘s brand, switching costs, network effects, and scale have made them into a tough foe across e-commerce, cloud computing, and streaming.

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We believe the intensive study of industries, business models, and management teams in the context of competitive advantage is critical in constructing investment portfolios. At Generation, we prefer to invest in high-quality businesses with sustainable and growing competitive advantages run by great managers. We attempt to buy these businesses at discounts to our estimates of fair market value, trying to stay humble so that when the facts about industries, managements, and businesses change adversely, we too can change our minds if value has eroded and/or advantages have waned.

If we can select companies with competitive advantages, in industries with staying power, from the get-go, we believe we’ll fare better. E-commerce, for example, while undergoing some changes to how it is done, is here to stay because consumers prefer greater selection, lower prices, and convenience. While we would like to outperform because we purchase winners, we are just as conscious about avoiding losers. Identifying and understanding competitive advantages and how they are built and eroded is thus a core part of our investment process that helps us generate returns and preserve capital over the long run.