This blog post is an excerpt from my new book, The Defensive Value Investor, outlining how I analyse companies to see whether they have any durable competitive advantages or not.
Competitive advantages can make a company more profitable than its peers. This is good because profitability is effectively the rate of return you get on any earnings which are not paid out as a dividend.
Competitive advantages can also help a company survive the inevitable tough times that come around every now and then. This is especially important for value investors because we often end up investing in companies that are attractively valued precisely because they’re going through tough times.
However, competitive advantages are hard to build and can be even harder to maintain. Most companies simply don’t have any and that’s why so few companies generate high rates of return over prolonged periods of time.
Another reason to look for competitive advantages is to learn about why a company has been successful in the past. Doing this research should complement the previous research carried out when answering the value trap questions.
The rest of this [extract] covers how I look for competitive advantages using another series of questions, this time based on Pat Dorsey’s book, The Little Book that Builds Wealth. It’s an excellent book which sums up the topic of competitive advantages nicely.
Dorsey’s framework is used extensively by Morningstar and consists of four main types of competitive advantage. When I’m researching a company I always like to think about whether or not the company has any of these traits, and to what degree.
I’ll cover competitive advantages in some detail here, but if you want even more detail then Pat Dorsey’s book is a good place to go.
My rules of thumb for durable competitive advantages are simple:
- Prefer companies that have durable competitive advantages to those that have short-term advantages or no advantages
- Prefer companies that have low-cost competitive advantages to those with advantages that are expensive to maintain
I have four questions which are designed to uncover whether or not a company has a durable and defendable competitive advantage. Few companies are likely to get more than one yes answer from the four questions and most will get none.
However, not having a competitive advantage is not necessarily a reason to ignore a company.
For Warren Buffett it might be, because his preferred holding period is forever. In other words, he would rather not sell a company once he’s bought it, in which case competitive advantages are critical if the company is to perform well over decades.
I, on the other hand, am not a buy-and-hold investor. I expect to be invested in a company for somewhere between one and ten years, and over that timescale a durable competitive advantage is less important (although still preferable).
So for me a competitive advantage is a nice-to-have rather than a must-have feature, and regardless of whether or not a company has any advantages, asking the following questions will increase your understanding of its business.
1. Does the company have any intangible asset advantages?
There are three kinds of intangible asset that really matter:
- Brand names
- Regulatory licences
In different ways they each help a company to be the go-to destination for a particular product or service.
[The book covers intangible asset advantages with another thousand words or so but in the name of brevity I’ve left that out of this excerpt]
2. Does the company gain an advantage from switching costs?
Switching cost is a term that refers to how easy it is for customers to switch or substitute one product or service for another. The cost here is not necessarily in financial terms, although it can be, but could also include costs such as time, effort and so on.
For example, our local supermarket is a Tesco, so that’s where we get our groceries. If we moved house and Sainsbury’s became our local supermarket then that’s where we’d shop. We can switch from Tesco’s to Sainsbury’s with only the tinniest amount of hassle (such as working out where the baked beans are).
The problem of low switching costs hampers most companies, but not all. One example of a company with very high switching costs is Microsoft.
Millions of people use Microsoft’s products because that’s what they’ve always used and it’s what most other people use. Microsoft users have built up skill and familiarity with Microsoft’s products, not to mention a huge archive of files which work best with Microsoft software.
The bother of switching to a competitor’s word processor or operating system, even if it were significantly better, just isn’t worth it for most people. The effort required to learn the new software is usually just too big a barrier to climb, and in some cases files and software won’t work on anything but Microsoft’s products.
So, for the most part, existing Microsoft users stick with Microsoft even though it may or may not offer the best products.
3. Do the company’s products or services have a network effect?
Some products and services get better as more people use them. eBay, Facebook and Microsoft are all good examples of how the network effect works.
eBay, for example, is an online marketplace for pretty much anything. As more people go to eBay to buy things it becomes a more attractive place for sellers as they will be able to sell a wider variety of goods more quickly than if there were fewer buyers. In turn more sellers will draw in more buyers as there will be a wider variety of goods on sale and competition among sellers will keep prices down.
This positive feedback loop between the number of buyers and sellers is why eBay has been so successful. Once a critical mass of buyers and sellers was reached, eBay’s competitors found it impossible to compete without an equally large pool of buyers and sellers.
4. Does the company have any durable cost advantages?
Being able to sell products or services for less than your competitors, while maintaining decent levels of profitability, is of course a great advantage. But as with most competitive advantages it’s a difficult trick to maintain over time.
It’s no good simply cutting costs to boost profits in the short term as that will likely undermine the company’s long-term prospects.
It’s also no good simply investing in newer, more efficient technology that enables the production of widgets more cheaply than competing widget manufacturers. If one company can do it then others can do it, and it wouldn’t be long before every widget manufacturer had invested in the same technology to gain the same advantage.
At that point they’d be back to competing on price, producing very little in the way of profit and a terrible return on their new technological investment (although of course the consumer would benefit from cheaper widgets).
Durability is what really matters and durable cost advantages come in four flavours:
- Cheaper processes
- Better (and cheaper) locations
- Unique low-cost physical assets
- Greater scale
[As with intangible asset advantages, the book also covers cost advantages with another thousand words or so, and again I’ve left that out in the name of brevity]
Answering these competitive advantage questions is the final step in my company analysis process, after which I’ll make a decision as to whether I’ll invest or not, and at what price.
Finally, if you’re really interested in competitive advantages then the chapter which covers them in my book is a good starting point, but to get a much deeper understanding I would urge you to read Pat Dorsey’s book as well.