This article first appeared on Advisor Perspectives.
As we have discussed previously, sustainable competitive advantages (SCAs) are a key characteristic of high-quality businesses. While SCAs are good indicators of business quality, not all competitive advantages are created equal. The strength of the competitive advantage and the risks that the business needs to protect itself against are largely dictated by the type of competitive advantage that the business possesses.
Further, to understand the sustainability and strength of a business’s competitive advantage, the analyst will need to understand the source(s) that give rise to the firm’s competitive advantage. The sources of competitive advantage dictate, to a large extent, the competitive strategies that the business needs to follow. Consequently, understanding the source(s) of a firm’s competitive advantage allows the analyst to develop an effective decision-making framework to evaluate management actions – whether they enhance or shrink the competitive advantage of the business.
Types of competitive advantage
Competitive advantages allow the firm general superior profitability and returns on investment. This superior profitability is a result of better revenue-generation capability or is driven by lower cost per unit or a combination of both. Competitive advantages that affect the revenues do so either because they endow the business with a captive source of demand or because they provide superior pricing ability. Cost-based competitive advantages are either a result of operational scale or driven by supply advantages, which can be a result of access to low-cost sources of supply.
Over several years of scouring for high-quality businesses globally, we have identified six sources of competitive advantages as discussed below:
- Economies of scale. Economies of scale are the most widely discussed of the competitive advantages. The basic tenet of economies of scale is that the cost per unit declines as output increases. The lower cost per unit is largely driven by the presence of fixed costs within the business’s cost curve. If the economies of scale advantages are easily replicable, such advantages will not lead to SCA.
- Consumer preference. In some industries, customers strongly prefer certain brands, e.g., of soft drinks, cigarettes, etc. Brand preference can emerge for various reasons including indicators of uniqueness or consistency of the product, of status symbol or of product quality. However, all brand preferences do not lead to SCA. Unless the brand preference endows its owner with pricing power, the competitive advantage of the brand is limited or non-existent.
- Switching costs. Switching costs serve as another source of SCA as they lead to customer captivity. Switching costs may emerge for a variety of reasons. For example, customers may need to spend substantially to switch from one supplier to another, or there may be substantial business implications related to the possible loss of business or significant inconvenience to the customer’s clients. In each of these cases, the customer is less willing to switch.
- Network effect. Much like economies of scale, network effect has been widely discussed and frequently invoked to justify higher valuations for a variety of businesses. However, we assert that network effect refers to a specific type of competitive advantage that requires specific conditions, including a natural tendency on part of consumers/customers to gravitate towards the largest company and that every time a new user/customer joins the network, all users are better off as their access increases and/or the cost per user declines.
- Mission criticality. A much less discussed form of competitive advantage is what we refer to as mission-critical suppliers or service providers. In general, these are niche businesses that have built a strong reputation as reliable product/service providers of mission-critical requirements of the customers.
- Low-cost supply. Lastly, certain businesses have greater access to low-cost supply sources than their competitors. Such advantages are different from economies of scale because they are driven not by the scale of operations but by favorable sources of supply. Such competitive advantages are especially relevant in cases where the supply of the underlying product or commodity is limited.
These sources of competitive advantages are not mutually exclusive. On the contrary, the existence of a dominant source of competitive advantage frequently gives rise to another ancillary competitive advantage. For example, the dominant competitive advantage that Coca-Cola enjoys is related to consumer preference, which manifests itself in the revenues side of the company’s economics by providing it a captive source of consumer demand and provides it with a strong pricing power. However, the wide acceptance of product gives rise to an ancillary competitive advantage – economies of scale in distribution. This cost advantage allows The Coca-Cola Company to outsell several other products where the consumer preference is not as strong.
Hierarchy of competitive advantages
As we stated earlier, not all competitive advantages are created equal. There is a hierarchy within the six types of competitive advantages. The strongest is the network effect, followed by switching costs, consumer preferences and mission criticality. Economies of scale are the second weakest and low-cost supply is the weakest form of competitive advantage.
The job of an analyst does not end at identifying a business that meets the quantitative metrics that are associated with high-quality businesses. Nor does it end at having identified businesses that possess competitive advantages. The analyst needs to dig deeper to understand the sources that give rise to the competitive advantage of the business to understand their strength, the risks that such a business faces, the strategies that the management should follow to protect and enhance the competitive advantage and the sustainability of the competitive advantage.
As we will discuss in our upcoming articles, the analyst’s responsibilities extend well beyond identification of businesses with SCAs. Competitive advantages widen or narrow all the time. It is the analyst’s responsibility to develop an effective decision-making process that allows for monitoring of the health of the moat, whether it is narrowing or widening. Indeed, it is the efficacy in monitoring of companies that were classified as high-quality businesses that differentiates a good analytical process from the rest.