Competitive Advantage Part 2

Competitive Advantage Part 2

In the last post about competitive advantage we looked at the first 2 ways which a company can build an economic moat.

Today let’s explore the other 3 ways:

Low Costs or Prices

Offering the same or similar product or service at a lower price can be a powerful economic moat, especially in commodity industries. Airlines and PCs are a couple of commodity industries.

Cost advantages are created by either inventing a better process or achieving a larger scale.

Dell is an example how a better process can reduce costs. Dell PCs are built only after purchase orders are received. This way Dell could avoid stocking up on inventory and letting the inventory value erode while waiting for orders to come in.

At the same time, Dell could take advantage of the rapid price decrease of PC components. This allows Dell to do one of 2 things. Keep the selling price the same, thus increasing margin, or lower the selling price as the price of components fall.

Scale advantages are difficult to beat because they build on themselves. Consider Wal-Mart. Its strength is in the sales volume. Manufacturers are desperate to get their products displayed on the shelves. Hence, this gives Wal-Mart the strength to negotiate lower costs from the manufacturers which is then pass on to consumers through lower pricing or better deals. This in turn attracts even more consumers and more sales resulting in stronger negotiation power for Wal-Mart.


Locking In Customers

Companies can deter customers from switching to competitors’ products by creating high customer switching costs.

If the customer has to undergo significant amount of training and incur lost productivity during the training period, then the customer will be reluctant to switch.

If a company’s product is tightly integrated with the customer’s business, then the customer will be reluctant to switch. Example, a customer manufactures food and buys an ingredient, such as a sauce, from a company. Switching supplier and buying the sauce from another company may result in the finished product having a different taste and texture which may negatively affect consumer preference.

Locking Out Competitors

Companies holding patents of popular and lucrative products have deep and wide economic moats. Patents protect the patent holder from direct competition. A great example is Pfizer and its line of top-selling drugs in the world.

Majority of the cities cannot support more than one large daily newspaper. This means the incumbent holds an advantage. It is difficult for a competitor to enter the market and grab a sizable market share from the incumbent and at the same time still make a decent profit.

 

Conclusion

The first filter in the funnel is to sift out companies with Economic Moat from those that do not have economic moat.

When researching the company, use the 5 Economic as a basis for a checklist and ask if the company has either any of the advantages. Also ask if the advantage can be easily duplicable within years.

If the answer is uncertain, we rather give this company as miss. Being able to identify the Moat of the company takes a bit of practice and conditioning. But after a while, the difference should be obvious.

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Mind Kinesis Research Team
Investment in Stocks Blog
Value Investing Academy – the Warren Buffet Way
http://www.investment-in-stocks.com

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