Whole food market sustained competitive advantage

Sustainable competitive advantage? The 6 essential criteriaapprox. 13 Min.

Warren Buffett prefers to invest in companies with a sustainable competitive advantage. Or a wide moat, as he calls it (Wide Moat in English). What Buffett means by this is a component of the business model that makes the market position of a company very, very difficult to attack and therefore provides him as an investor with attractive returns over a very long period of time.

The question now is how do we recognize such companies or business models?

Of course, every business model has its very own and specific success factors. Nevertheless, I think we can make a very rough division of the business models into certain "drawers" ... and at least we would have a starting point if we are dealing with a new company with a previously unknown business model.


Table of Contents

What you will learn in this article

  • Which is a sustainable competitive advantage
  • What types of competitive advantages are there
  • How we can recognize a company with a sustainable competitive advantage

When is a competitive advantage sustainable?

A sustainable or structural competitive advantage is generally something that shields a company from the competition. Companies with a structural competitive advantage often have above-average margins and returns over long periods of time and are therefore very interesting for long-term value investors.


Market entry barrier vs. sustainable competitive advantage

Analogous to Michael Porter's 5 Forces model, we could also speak of very high market entry barriers in the case of a competitive advantage. In my opinion, however, that would not be thought far enough.

For example, I would say that there are quite high barriers to market entry in the mining industry or the steel industry. After all, every new plant or mine costs a few billion dollars. And the production is also technically demanding. Nevertheless, it is precisely these industries that are regularly plagued by overcapacities and price wars.

So in the end the barriers to market entry are not that high and a structural competitive advantage is something else?

I think the difference is made by the little word “sustainable” or “structural”. In fact, companies in the steel industry have no structural advantage. There are a few companies that operate in a very attractive niche and therefore have higher margins over a certain period of time.

But only until the first competitors have developed the same skills.


Non-structural competitive advantages disappear over time

If a competitive advantage is not structural, it will usually disappear after a few years because new competitors enter the market with new quantities and prices and margins come under pressure as a result.

The iPhone is a good example of this. In terms of technology, other smartphones are probably almost as good by now or the iPhone is at most marginally better. The competition has clearly caught up. And this is exactly what is also evident in Apple's financial figures (AAPL). The average price for the iPhone fell below USD 600 for the first time in the third quarter of fiscal 2015/16 and sales figures are currently stagnating.

Still, in my opinion, Apple has a sustainable competitive advantage. It is, however, somewhere else, but more on that later.


What types of competitive advantages are there?

In the course of my research, I identified 6 different types of structural competitive advantages (if you know any others, please write to me or comment below), which I would now like to go through individually and explain using an example:

  • Intangible competitive advantages (brands, patents, accreditations, etc.)
  • High switching costs
  • Good cost-benefit ratio
  • Network effect
  • Cost advantage (process costs and economies of scale)
  • Inflation protection

Incidentally, the competitive advantages are not mutually exclusive. In fact, there are some companies that have several of the above-mentioned competitive advantages at the same time (e.g. Transdigm, TDG in the field of aerospace components).


1. Intangible competitive advantage

Intangible competitive advantages are always difficult to grasp, but can certainly be seen as a sustainable advantage. However, in a company valuation, I would not assign any additional value to a brand or patent, for example, because I assume that this is already taken into account via the return (ROC or ROE).

When it comes to intangible competitive advantages, three main factors come to mind:

  • a strong brand name
  • a well-defined set of patents
  • an accreditation

brand

A strong brand can be a sustainable competitive advantage, see for example Coca Cola (KO) or Apple (AAPL). Whether a brand is actually (and will remain) strong enough to establish such a competitive advantage depends on several factors.

First of all, the brand itself has to be so strong or known that it

  • changes consumer behavior
  • the search costs for a product are significantly reduced

A characteristic of a brand with a sustainable competitive advantage is a positive correlation between price and demand, i.e. the demand for a product is higher when the price is higher. We are talking here, so to speak, of an inverse price-demand function.

Furthermore, the company that owns the brand must have sufficient funds to invest in the brand value or the brand capital. E.g. Absolut Vodka had a very good and trendy brand a few years ago. Unfortunately, the company didn't have enough resources to continue building the brand.

A brand therefore requires constant maintenance and further development, e.g. via its own stores or control over the customer experience.

For this reason, companies with well-known brands in the premium segment often establish an additional sales channel in the form of their own stores (e.g. Apple, Hilfiger, Boss) and at the same time avoid sales via supermarket chains or similar.

So when analyzing stocks with a strong brand name, we should look at consumer behavior, search costs, and also marketing spend and strategy.


Patents

Patents can also represent a structural competitive advantage.

It is important, however, that a company has a whole set of patents, ideally covering a fairly specific field or technology. Individual patents in different areas are often no real protection against competitors.

From my point of view, it is quite difficult for a DIY investor to really evaluate a competitive advantage from patents, simply because there are far too many patents and there is no real transparency with regard to the content. Even with a professional tool like the Thomson Reuters patent database (cost point> 100,000 EUR per year) it will be difficult to derive a competitive advantage directly.

I would therefore consider the existence of patents and technologies as a positive side effect, so to speak, but not base my investment thesis solely on such an advantage.


Accreditation

In some industries, e.g. in aircraft construction, accreditation can be a sustainable competitive advantage. An accreditation essentially means that a product (or even a production plant) meets the required quality requirements of the OEM (Original Equipment Manufacturer, e.g. Boeing or Airbus).

As in the car, many parts in the aircraft are safety-relevant and therefore usually have to go through a lengthy series of tests before they can or may actually be installed and used.

Due to the high effort and the associated costs, the OEMs often initially have no incentive to accredit another alternative provider for a certain part. And since aircraft are in service for an average of over 30 years, such accreditation can guarantee a relatively secure turnover from the spare parts and maintenance business for a very long period of time.


2. High switching costs

Somewhat related to the accreditation are high switching costs as a competitive advantage. Because many parts are safety-relevant in the aerospace sector and therefore have to go through a longer accreditation process, the OEMs do not tend to switch to a new provider without further ado. This means that as soon as a company has placed a part on an airplane, it has a quasi-monopoly position for a long period of time.

Another good example of high switching costs is software. With the introduction of an ERP system, e.g. from SAP (SAP.DE), all important processes and procedures of a company are precisely aligned with this system, which makes a later changeover extremely costly.

Or an example from my private environment: I use Evernote for my notes and to-do's, a tool in which I can create various notebooks and which I can access from any device. The tool is free and I have now stored over 2,000 notes (book tips, tools, interesting articles, etc.) there. If Evernote were to abolish the free version of the tool (which I don't assume and which I don't hope), then I would have to ask myself whether I really want to either categorize all my categorized knowledge again or build everything from scratch (if in doubt, no) .

An important success factor in such a business model is to get your foot in the door first, i.e. to install the part or software at the customer's premises. This is often done at cost (in the aerospace sector), via a free basic version, etc.

Incidentally, companies with such competitive advantages often have high development costs, which then appear on the balance sheet as intangible assets. The margins are therefore often high, but the return on investment is not inevitable. We should also pay attention to this in our stock analysis.


3. Good cost-benefit ratio

A high margin depends, among other things, on how well a company is able to increase its prices over time. It has been shown that this is achieved particularly well by companies that offer products with a high benefit-cost ratio for the customer.

This means that it is about important components for the final product, which are, however, rather negligible in the customer's cost structure. The customer usually does not even notice a price increase (or does not care because the product does not cause high costs in relative terms).

We can find good examples of business models with this competitive advantage in the aviation industry, but also, for example, in the food and cosmetics sectors.

In the aviation industry, a company like Transdigm supplies a large number of low-cost components that are of little importance for Airbus or Boeing compared to the costs for other parts such as the structure, wings, engine, etc. That is why Transdigm was able to increase prices by 5-10% annually over a long period of time (which, by the way, is also reflected in the EBIT margin and the ROC).

In the food sector (and also in cosmetics), companies such as Symrise (SY1.DE) or DSM (DSM2.DE) produce ingredients such as flavors and fragrances that are essential for the manufacturers of food or cosmetics, but at the same time are not a major cost factor.


4. Network effect

Network effects are probably the most discussed competitive advantages at the moment, because the success of many new tech companies such as Facebook or LinkedIn is based on a structural network effect. The question that we as investors have to ask ourselves here is to what extent these network advantages are actually sustainable and structural in nature.

But take another step back. There are basically two types of networks that can create a competitive advantage:

  • Radial networks
  • Individual knots

Radial networks

Radial networks are networks that consist of individual hubs, but which do not represent any added value for one another.

Companies with a network of locations or branches fall into this category. These can be banks, but also other service or service companies.

Such networks represent a competitive advantage, but could theoretically be replicated quite easily by a potential competitor. Depending on the size of the network, this would of course be time-consuming and costly.

Another important point is that a global network does not actually offer much added value for the customer. The local density of branches is more important here (see smaller savings banks).


Individual knots

The second type of network benefit only arises as the number of customers using the network grows.

A good example of a company with such a network advantage is e.g. Mastercard. It is precisely because Mastercard credit cards are actually accepted everywhere that they are of such great value to customers and the market is so difficult for competitors to attack.

Interestingly, many of the new, alternative payment methods (Paypal, Stripe, and many others) also work indirectly through the major credit card companies. Apparently, it has also become clear to the startups that they should bring Mastercard or Visa on board instead of attacking them directly.

A company like Facebook also falls into the category of companies with a structural competitive advantage from network effects. The advantage of Facebook (and also the associated messenger service Whatsapp) arises simply from the sheer mass of people who use the platform.

Once a company has built up such a competitive advantage, it is far more difficult to copy than, for example, the branch network of a bank.

The likelihood that customers will switch to a newly emerging competitor is therefore much lower. For example, to switch from WhatsApp to an alternative provider, we would have to convince all the people in our network to do the same.

From my point of view, the most important point here: If we analyze a company with a structural network effect, then we should form an opinion about how likely we are to consider the entry of a new competitor or the change of users to such a competitor.


5. Cost advantage

Cost advantages can also represent a (more or less) sustainable competitive advantage. Here, however, we should differentiate between process cost advantages (easier to copy) and economies of scale.


Process cost advantage

Process cost advantages are competitive advantages that arise, for example, from more efficient production or from leaner processes. This can mean a competitive advantage for a while, but will eventually be replicated by competitors too.

The computer manufacturer Dell, for example, had a very low cost position compared to all major competitors in the late 1990s (due to the standardized manufacture of the computers and the direct sales channel via the Internet), but was ultimately caught up again by the competition.


Economies of scale

Economies of scale arise with the increasing size of production facilities, mainly through the degression of fixed costs. To operate a production plant based on a certain technology, for example, in many cases roughly the same number of staff is required, regardless of whether it is a small or a large plant. Such economies of scale tend to be more permanent than process cost advantages.

However, economies of scale are more important at the plant level. A company like GM has of course no (or only minor) direct economies of scale from the size of the company, because it operates a large number of independent and decentralized production facilities.

In my opinion, when investing in a company with a cost advantage, the investment time horizon plays a role. We should therefore possibly form an opinion about how long the company can maintain the competitive advantage (or on what the existence of the competitive advantage depends).


6. Inflation protection

Built-in inflation protection can also be a competitive advantage.

Mastercard is another good example of this: The company's business model works through commissions that the company receives for every credit card payment. Since this commission is calculated using a fixed percentage of the purchase price, sales (and also profit) increase proportionally with the general price increase.

Mastercard does not have to enter into negotiations with its customers first, e.g. to successfully pass on increased costs to them.


Important factors: management and corporate culture

So far we have mainly talked about structural competitive advantages and what are the main reasons for the sustainability of such advantages.

When it comes to the persistence of competitive advantage, there are two other factors that we shouldn't completely neglect:

  • The quality of the management
  • The corporate culture

Both factors can individually have a strong influence on how sustainable a competitive advantage is or sometimes even whether a competitive advantage arises in the first place.

Very capable managers are able to build up a structural competitive advantage over time. Caution is advised here, however, as the competitive advantage is or can be very closely linked to the people involved.


Conclusion

There are a number of competitive advantages that can be viewed as sustainable or structural.

In principle, however, almost all competitive advantages can be replicated by competitors and it is our task as investors to find out how likely such a scenario is from our point of view. For me, this is one of the most elementary considerations we should make before investing.