Demystifying Competitive Advantages

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This is a chapter summary of The Five Rules For Successful Stock Investing by Pat Dorsey that I found was extremely insightful when thinking about businesses that’s too good not to share. Highly recommended.

Does a company have a competitive advantage? If it does, what is it?

Firstly, what is a competitive advantage?

It’s essentially the X-factor in a company that allows it to maintain strong and stable profits not only now, but 10 or 20 years into the future.

Here are the 4 steps you can use to uncover the clues into a company’s competitive advantage.

  1. Evaluate the firm’s historical profitability.
  2. What are the sources of the firm’s consistently strong profits?
  3. How long (this is just an estimate of course!) do you expect the firm to hold off competitors? This is also known as the competitive advantage period.
  4. What is the industry’s competitive structure?

This can be broken down further into sub elements.

Evaluate the firm’s historical profitability

This step encourages you to look for hard evidence that indicates that a company is worth looking into. Here are some questions to ask when looking at a firm’s financial results.

A) Does the firm generate Free Cash Flow? How much?

– Free Cash Flows are Cash Flows from Operations minus Capital Expenditures.
– It indicates the amount of money that can be extracted from the business without damaging its core business.
– It’s also a measure of amount of cash flows that is available to equity and debt owners
– A firm that can convert 5% of its revenue into FCF is considered a cash machine.

B) What are the firm’s net margins?

– The Net Margin reveals how much profit it earns for every $1 of sales
– This metric should be compared with similar firms in similar industries

C) What are Returns on Equity?

– ROE reveals the amount of profit investors can expect to generate for every $1 dollar invested in the company
– ROE is an important metric in evaluating management effectiveness

D) What are Returns on Assets?

– ROA reveals how much a company generates in profits relative to the book value of assets
– Its purpose to the show how effective a company is utilizing its assets

Note:  When looking at these metrics to assess a firm’s profitability, you want to look the ratio over a period of at least 5 – 10 years to make sure that they are generating SOLID, CONSISTENT results.

What are the sources of a firm’s profitability?

How effective is the firm at stealing customers away from the competition? Why can’t a competitor charge a lower price for a similar product/service? Why do customers accept annual price increases? What value does the product/service bring to customers?

Some of the most common ways a company can build a sustainable competitive advantage are:

Real Product Differentiation

This type of economic moat relies on innovation and is usually not sustainable. Why?

Having better technology/features may guarantee the short-term ability to keep competitors out…until someone comes in and builds a better product. Building a premium product usually involves charging a premium price, which reduces the number of customers who are willing and able to pay for it. In fact, many customers are willing to settle for a slightly inferior product at a significantly lower price.

It’s extremely difficult staying one step ahead of the game while constantly having to devise new ways to beat the competitor. Some examples of this would include companies like Dell EMC and Apple.

Perceived Product Differentiation

Tiffany & Co, and Michael Kors comes to mind when talking about perceive product differentiation through a branding. This type of economic moat is ideal and sustainable. Why?

It is of little relevance whether a firm is actually better/different from other firms, but as long as customers perceive your brand as more superior, they’re willing to pay a premium for it.

Note: Take note that a strong brand is usually associated with expensive advertising. So make sure that it really does translate into higher profits through consistently positive returns on capital because not all strong brands can create a price differentiation.

Driving costs down

This is a very powerful source of competitive advantage, especially in commodity industries such as airline or PC industry, where products are difficult to differentiate.

Comparing a firm’s profit margins with that of similar sized peers would give you a good indication if it’s able to charge a higher price. Also, when identifying the source of the cost savings, it is able to achieve economies of scale (the ability to spread your fixed costs over many more units of goods, lowering your per-unit fixed costs). The company also develops a process-based advantage;  Dell’s uses this strategy for a build-to-order system, which allows them to take advantage of the quick price erosion of PC parts and squeeze costs from its supply chain instead of letting the parts sit in inventory losing value while waiting for incoming orders.

Locking In Customers

Does the firm’s product/service create high switching costs (in terms of money or time) for customers? Is the product an industry standard? Are you required to sign long-term contracts just for using an product? If yes, the firm is able to charge more for it.

To understand this, think about the reason most places of business preferring to use Microsoft Windows OS, despite the fact that a large portion of the public use Macs for personal computing. Microsoft Office is far superior on a PC than on a Mac in terms of functionality, productivity, software integration and efficiency. The cost of accommodating both Mac and PC users in the workplace is very high, and rarely ever happens in most firms.

Locking Out Competitors

This last strategy is also a strong way to keep high profits rolling in for years.

  • Acquire regulatory exclusivity:  Patents/licenses as seen in the pharmaceutical industry. It should be noted that patents may invite litigation, which could erode some profits.
  • Network Effect: Sellers want to be where buyers are, and vice versa. The more buyers and sellers there are, the more valuable eBay becomes to the auction market participants.
How Long Should It Last?

A competitive advantage works in two ways: Depth and Width.

Depth being how much money can the firm make. Width being how long the firm can sustain above-average profits. You want to at least be able to classify the competitive advantage period into 3 buckets: a few years, several years, and many years.

For competitive advantage that relies on real product differentiation such as tech superiority/innovation, it’s typically short for reasons mentioned above.

Other Factors When Evaluating an Industry

Here are some key questions to ask:

  • Are sales for firms in the industry generally increasing or decreasing?
  • Is it a cyclical or stable industry? (Look at the sales and earnings growth trends)
  • Is the industry dominated by a few players or full of similar-sized firms?
  • How profitable is the average firm?

Answering these questions are important to get a feel of the industry, including its competitive structure, profit structure, and the nature of the businesses.

I hope this post gives you a little more clarity on how to approach the research process and helps you get the ball rolling when looking at companies.

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