In the US, there are over 25 million businesses. Most of them are stuck spinning their wheels in notoriously tough industries with a lot of competition and low profits. Many have single digit returns on invested capital and struggle to grow, but a few exceptional companies are able to escape this fate and compound for a long time. The reason is due to business models with a competitive advantage.
Competitive advantage or business moat
Warren Buffett likes to think of competitive advantages as a moat around a business. The economic engine that drives profits for a business is like a castle that needs to be protected. Everything else around the castle is like a moat that is designed to keep competitors away. The wider the moat, the better the company is able to withstand attacks from competitors.
To give you an idea of the power of competitive advantages, Warren Buffett first invested in GEICO for his hedge fund partnership in 1951 when the company had sales of $8 million. Today, GEICO is now part of Berkshire Hathaway and generated $462 million in profits for the company last year. The increase in revenue and profits is staggering.
Investors with the ability to identify companies with wide moats are able to compound their money over a long period of time with many tax advantages. So let’s take a look at some sources of competitive advantages and the business models that go with them.
The low cost provider
Many companies try to become the low cost provider with the goal of capturing a large share of a market. Although popular, the strategy is often subject to disruption and is not as stable as some of the other sources of competitive advantages. The reason is because businesses that only compete on price with a low cost strategy are prone to disruption. New entrants that successfully find more efficient ways to serve the market wreak havoc on incumbents with bulky fixed costs. For example, retailers were disrupted by Sears when it introduced the mail order catalog and more recently, Amazon disrupted retailers by selling everything on the internet.
Although the low cost providers in retail are at risk for disruption, they perform well for the period of time when they have an advantage over their peers. Here’s a look at Walmart starting from 1970 when the company went public at $16.50 a share.
Now some of you might be wondering, why hasn’t GEICO been disrupted yet as a low cost provider of insurance? Well, it turns out, that a single company can have multiple competitive advantages and we’ll come back to this idea later after we take a look at a few other competitive advantages and business models.
Economies of scale
A business with economies of scale has lower costs as more customers use their product or service. This is because of operating leverage and how fixed costs are spread among more customers. In the case of retailers, the economies of scale come in the form of spreading distribution and advertising costs across a larger number of customers. The danger is that when demand falls, the fixed costs remain and what was once an advantage becomes a disadvantage when compared to smaller and more nimble competitors.
Although many low cost providers have economies of scale, there are companies with other business models that benefit from economies of scale as well. For example, companies like Microsoft are highly scalable because they sell software with very low marginal costs. Once the software is developed, it costs very little to create a new copy of the product for new customers. The performance and returns have been impressive for software companies.
One thing to note about software companies is that because the marginal cost of producing a new unit is so low, companies can essentially price their goods for free. As is the case, many software products out there have free or cheaper alternatives. Linux instead of Windows, Open Office instead of Microsoft Office, and Gimp instead of Photoshop are just a few examples. In order for a software company to grow into a large company, they need to combine the benefits of economies of scale with other competitive advantages that can keep competitors away. Otherwise, a race to the bottom with a price war will lead to low profitability for everyone. The countless number of free apps on the Apple or Android app store is an example of what happens to software without a moat.
Companies that are able to lock their customers into their own products or services have a competitive advantage. Sources of customer lock-in include long multi-year contracts, products and services with high switching costs, and products and services with high search costs. A good example of a company that is able to keep customers is Adobe.
Adobe has been around for decades and is still a top choice for creative professionals around the world. Although other companies have entered the market with similar offerings, Adobe is still able to charge a premium. This is because many creative professionals are already used to using Adobe products and would have to learn how to use other products if they switch. The cost to switch is even higher for companies with teams that work together using Adobe products.
With customers locked-in, competitors need to offer something that is much better than what Adobe offers in order to truly compete. Silicon Valley people call this the 10x factor. Something needs to be 10 times better than what is already available in order to successfully break into a market with incumbents.
A special kind of customer lock-in comes from network effects. Businesses that benefit from network effects become more valuable and useful to their customers as more people use their product or service. Network effects can come from social networks like Facebook, two-sided marketplaces like Ebay, or even physical products like Xerox and fax machines. Many of the new unicorn startups such as Airbnb and Uber with private valuations over $1 billion have network effects. These are usually winner take all or winner take most markets.
Companies with unique resources have a competitive advantage over their peers. The unique resource can come from ownership of natural resources or regulatory protections granted by the government.
Natural resources that are located near their end users have a competitive advantage over competitors that require higher transport costs. For example, a rock quarry sells a commodity product, but a quarry in South America is going to have different shipping costs than a quarry in Mongolia. Also, although natural resources are commodity products, each mine has a unique characteristics and the composition of minerals can be different between mines.
Regulatory protections offer companies a competitive advantage that is difficult for competitors to overcome legally. Examples include copyright protection, trademark protection, and patent protection. Although not a natural competitive advantage, regulatory advantages granted by the government can be very profitable. For example, media companies with a lot of content like Disney benefit from copyright protections and drug companies benefit from patents. The table on the right show the return on equity for some of the largest pharmaceutical companies in the world.
Combining moats lead to outstanding results
Although any business with a competitive advantage is already way ahead of their competitors, the strongest businesses in the world combine several competitive advantages at once. These are the companies that end up becoming some of the largest in the world and minting billionaires. Let’s take a look at a company that combines several competitive advantages – Bloomberg.
The Bloomberg Terminal is used by professionals in the financial industry all over the world. Although it costs around $20,000 for each user per year, many people remain loyal to its service despite much lower cost competitors.
Bloomberg is able to charge a premium and keep competitors at bay because of several reasons.
- Accurate information and data is important to investors and Bloomberg provides some of the best available. The information is necessary to make mission critical decisions and quality is more important than price for the customers.
- Bloomberg benefits from high switching costs because most financial professionals are already familiar with the system. Many universities also use the Bloomberg Terminal and students become familiar with it.
- Since most financial professionals are on Bloomberg, the company benefits from a network effect with their messaging system.
- The company has a two-sided market that allows 3rd party developers to create apps for their Bloomberg platform. It is like an Apple appstore for financial professionals where the cost for apps is way more than free.
As a result of Bloomberg’s competitive advantages, the company has grown to become one of the most successful private companies in the world.
When investing in stocks, take a look at the company’s business model and if it has any competitive advantages. If it does, it might be worth holding as a compounder in a forever portfolio.