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Guide: Finding Sources of Competitive Advantage in the Stock Market

“If you build a better mousetrap, the world will beat a path to your door.” 

Ralph Waldo Emerson

As investors, our search for companies with a competitive advantage is a never-ending goal. We all desire to find a company that can last forever and retain its long-term advantage and grows our wealth.

I never tire of hearing Warren Buffett talk about finding companies with a durable competitive advantage or economic moat. Buffett has taken the ideas of his mentors, Ben Graham and Phil Fisher, and merged them into a style that attempts to find companies with a long-term competitive advantage.

The trick has always been, how do we find companies with a durable competitive advantage? Or better said, what are the sources of competitive advantage?

In this post, we will discover:

  • What is a Competitive Advantage?
  • Michael Porter and Sustainable Competitive Advantage
  • Sources of Competitive Advantage
  • How to Find Companies with a Competitive Advantage

Ok, let’s get to it.

What is a Competitive Advantage?

Simply said, a competitive advantage is anything that makes a company’s products or services superior to any of the customer’s other choices.

A competitive advantage usually is associated with business, but it can apply to other situations as well, such as sports or countries.

Think of Michael Jordan during his hey-day, his drive, skill, and ambition would be a classic case of competitive advantage. Undoubtedly the Chicago Bulls were a fantastic team with many talented individuals, but the separating factor was Michael Jordan.

Another competitive advantage from history would be Roman’s use of the shield wall they employed. The Romans weren’t better fighters than the Gauls, or braver. Rather they employed tactics and technologies that were superior to their opponents, couple with their resolve and discipline. All of which led to their eventually ruling most of the known world during their time.

In business, the classic case of competitive advantage in more recent times would be Apple’s development of the iPhone. With the creation of the iPhone, Apple put a computer in everyone’s hands, which was a game-changer for not only Apple, but it was a death knell for Blackberry who wasn’t able to adapt.

There are three main components to creating a competitive advantage.

  1. Benefits – What is the benefit your product or service provides? It must be something a customer truly needs, such as a cell phone. The value it offers must be real and without compare.
  2. Target Market – Defining who your customers are and what their needs are. If you don’t define this, then no matter the technical skill you create with your product, it will fall flat if you don’t know why you are making it. If you can define who needs the product and why they need it, you can create demand which will drive growth.
  3. Competition – Defining who your competitors are; they aren’t always your direct competitors. They could also be anything your customer could do to meet the need. A great example is newspapers until the creation of the internet; newspapers thought their main competitors were other newspapers. Too late, they realized the internet was the bigger competitor because it allowed people to read the news without any newspapers.

The most important take away for identifying your competitive advantage is understanding your benefits and being able to articulate them to your target market better than your competitors.

That, in a nutshell, is your competitive advantage. It is not enough to create the greatest product or service; you need to be able to communicate the benefits to the people that can most benefit.

Michael Porter and Sustainable Competitive Advantage

In 1985, Michael Porter, a Harvard Business School professor, wrote what is considered the definitive book on competitive advantage. Aptly named “Competitive Advantage,” the book was designed to help businesses to create a competitive advantage.

Think of it this way, just because Amazon is a market leader today, doesn’t mean it will be forever. If you go back to the year 2000, the top companies by market cap were General Electric, Exxon Mobil, Pfizer, Citigroup, and Cisco.

Wrap your brain around that, flash forward 20 years, and not a single one of those companies is still in the top five, and only Exxon is still in the top ten.

Companies must develop clear goals, strategies, and operations to build sustainable competitive advantages. Also, include the company’s culture and employee’s values, and you have something incredibly difficult to do, let alone year in and year out.

According to Michael Porter, there are three factors that any company can use to create a sustainable competitive advantage. Porter discovered these ideas by studying thousands of successful and not successful companies.

The three primary ways are:

Cost Leadership – cost leadership can be described as offering products and services at a lower price. Companies do this by constantly improving their operational efficiency. Unfortunately, that sometimes coincides with paying their employees less. Some companies try to offset this by offering additional perks such as stock options, benefits, or promotional opportunities. Other companies take advantage of unskilled labor surpluses.

As these companies grow in size, they can benefit from economies of scale, such as the ability to buy in bulk. Walmart, Amazon, and Costco are leading examples of cost leadership. The main knock against all of these companies is they pay lower wages, and with the introduction of higher minimum wage laws, these factors threaten their advantages.

Differentiation – differentiation means that you deliver better benefits than any other competitor. A company can achieve this by delivering a unique or higher-quality product. Other methods would include delivering the product faster or targeting your marketing to reach your audience better.

Companies with differentiation can charge premium prices, which coincides with a higher profit margin.

In other words, companies can achieve differentiation with innovation, customer service, or quality.

When thinking about innovation, think Apple’s iPod. The device that allowed us to play our music whenever we wanted, in whatever order we wanted.

Quality allows companies to charge more because they are thought of as having the best products. Tiffany’s can charge whatever they like because their customers believe their jewelry is the best.

And customer service means going out of your way to delight your customers. Nordstrom was one of the first to allow customer returns with no questions asked. Enterprise Rentals goes out of its way to help customers by picking them up. Apple stores allow their customers to get help with their problems with a wide range of Apple products from trained technicians.

Focus – Focus means that the company understands its customer’s needs and service its target market better than the competition. Companies can either utilize cost leadership or differentiation to accomplish those goals; sometimes, they will utilize both strategies. The key to success is a focus strategy is to choose a very specific target market and concentrate on that market. A popular phrase is the “riches are in the niches.”

A great example of this strategy is community banks. They focus on local small business or high-wealth individuals. The customers enjoy the personal touch that many big banks aren’t able to provide. The community bank’s customers are willing to pay a little more for this service, and this is how the small banks can use a focused strategy to compete with the Wells Fargos of the world.

Sources of Competitive Advantage

Now that we understand what a competitive advantage is and how companies can use different strategies to achieve that advantage, let’s explore some sources of these advantages.

Brand Power and Premium Pricing

Brand power is regarded as the ultimate in currency craved by all businesses. A brand often creates great business by being the main influencer on a customer’s buying decisions.

“Every person in California has something in mind about See’s Candies, and overwhelmingly it was favorable. They had taken a box on Valentine’s Day to some girl, and she had kissed him… See’s Candies means getting kissed. If we can get that in the minds of people, we can raise prices.”

Warren Buffett

Another prime example would be Apple. According to Forbes magazine, Apple is the world’s most valuable brand. Check this out, the average sale price of an Apple phone is $500 more than it’s chief competitor, Samsung. That pricing power enables Apple to earn over 90% profits in the smartphone category and continue their build-up of its cash on the balance sheet.

There are countless examples of brand power, such as Coke, Netflix, Tiffany’s, Nike, and many more.

Think of it this way, in the short-run, a company’s brand power is almost impossible to overcome by its rivals. Better than that, brand power is underrecognized on a company’s balance sheet. Typically a company will list any brand power in its intangible assets, which is extremely difficult to categorize. Coke, for example, doesn’t list any assets for its trademark, which is arguably one of the most valuable assets it owns.

Network Effect and User Stickiness

If the pandemic has taught us nothing, it is the power of the network effects and their stickiness. You have to look no further than a company like Facebook. During the stay-at-home orders, many of us have spent far more time on Facebook than we would like to admit, but their network is extremely sticky and encourages us to be super active.

Network effects are known as a phenomenon where the additional user of a network improves the value of a network. The stickiness of Twitter, Facebook, Snapchat, and the new kid on the block Tik Tok all are fantastic examples of this effect.

The network effect can help build a strong barrier to entry for other social media players and is extremely competitive, thus why Facebook purchased Instagram. If you examine the profitability and revenue growth of Facebook, it is all enabled by the network effect and the stickiness of their network.

Likewise, in China, Tencent’s WeChat, which is the mobile-first social network app of China, dominates the mobile internet space. Approximately 95% of all large cities users are on WeChat, and 70% of smaller cities, numbers that Facebook can only dream of. The users of WeChat are so “sticky” that they check the app over 15 times a day on average, and connect with friends, family, conduct business to the tune of over 300 hours a year. That my friends is sticky.

Tencent is taking the next step by developing an ecosystem within the app that will allow subscriptions to other services such as transportation, dining, shopping, and personal finance.

Economies of Scale and Low-cost Producer

As a company grows in size, it acquires bargaining power against suppliers and can spread the fixed costs over a large number of goods or services that the company produces or sells.

Often referred to as economies of scale, these scales allow companies to deliver their goods and services at a low cost. The scale gives the companies a moat that is distinct because they can choose to undercut competitors on price. Or they can choose to offer the same prices and earn a bigger profit than its competitors because of the lower costs of goods.

Costco, who makes the majority of its profits from its subscription model, not its margins on goods for the products it sells, is an example of economies of scale at work. Costco’s business model allows it to sell its products at an amazingly low price, which provides it with its distinct competitive advantage.

Another fantastic example of economies of scale is GEICO, Warren Buffett’s favorite acquisition. The little green gecko is famous all over the world. By continuously refining the low-cost model, it has achieved economies of scale, which allows it to use its profits to outspend its competitors in marketing to expand its brand further. GEICO is now the second-largest auto-insurer and has continuously stolen market share from its competitors.

Proprietary Technology and its Protection

Companies owning a proprietary technology and the patents, along with it, enjoy a tremendous competitive advantage over its competitors. Think of pharmaceutical companies as the best examples of this advantage.

A great example of this is Novo Nordisk, who is the global leader in tracking diabetes cases around the world. As the world gains weight, Novo Nordisk is there to track to increase in diabetes, and the company owns many patents on multiple medicines that help treat diabetes. In fact, the company controls over one-third of the diabetes care market.

A note about patents, like brand power, it is not listed on a company’s balance sheet and is unrecognized in regards to accounting. The power of the patent is typically “hidden” and not recognized easily.

An interesting tidbit about patents, the number one company in the world in regards to patents granted in the US is IBM, with Samsung a close second.

Ok, now that we understand how competitive advantage works and sources of those advantages, let’s look at ways to find companies with competitive advantages to buy.

How to Find Companies with A Competitive Advantage?

There are several great ways to identify companies with great competitive advantages.

First, use your common sense, and locate companies that have great brand power, think about companies like Coke, Apple, Amazon, Netflix, Facebook, Google, Walmart, Nike, and Starbucks.

All of the above companies are easily recognizable businesses that have fantastic brand power, but many of them already have that brand power factored into its prices. A trick is to think outside the box and look at businesses that maybe aren’t so well known but within their fields carry that brand power.

Look inside your circle of competence for ideas of companies that carry a branding power. For me, if I were looking, it would encompass the financial companies that fall into my circle. I would look at Wells Fargo, US Bank, or JP Morgan as examples that have strengths to consider.

If I were looking for a company that is a leader in real estate lending, then Wells would be my pick; if it were business lending, I would look at US Bank. But to find a bank that is a leader in customer service, I would have to expand my circle and look at First Republic, which most of you have never heard of, but they are rated alongside the best customer service companies out there.

Another great way is to use a metric like a free cash flow yield to help you find reasonably priced companies with moats. You can also use owner earnings yield.

To find a free cash flow yield, you calculate the free cash flow for a company and then divide it by the current price of the company. The FCF yield is similar to using earnings per share and dividing it by the price.

To calculate free cash flow, we go to the cash flow statement and locate the item free cash flow from operations and subtract the capital expenditures that are required for current operations, which we would find under the cash flow from the investments section labeled as PP&E.

An example would be Micron Technology (MU):

  • Cash Flow from Operations – $13,189
  • Capex or PPE – 9780

Free Cash Flow = Cash Flow from Operations – Capex
Free Cash Flow = $13,189 – $9,780
Free Cash Flow = $3,409

Next, we divide our free cash flow by the shares outstanding, which is currently 1143.

That calculation would give us a value of $2.98 a share; now, we divide that by the current market price of Micron, which is $44.94.

Free Cash Flow Yield = $44.94 / $2.98
Free Cash Flow Yield = 15.08%

Remember, a higher number, the better.

You can also use owner earnings to find the same result, although that is a story for another time.

Generally, the lower the ratio, the less we want to invest in that company. The lower yield indicates that we are investing in the company, but they are not returning much value to investors. A high free cash flow yield indicates a company has plenty of cash to cover its obligations and be able to return value to us in the form of dividends or share repurchases.

Some companies with great free cash flow yields in the market today are:

  • Micron – 15.08%
  • Chevron – 48.09%
  • Southwest Airlines – 16.90%
  • Fifth Third Bank – 16.26%

You can use this ratio to help you screen for stocks that have a high-yield to free cash flow.

Other metrics that can help you find companies with great competitive advantages are:

All of the above metrics help you find companies that do a great job of utilizing the capital it earns to boose our returns, the strong their overall ratios, the better the company performs over the long-run.

You can use any of these metrics as a means for screening companies that have durable competitive advantages. But they are not a means unto themselves. You will have to use some “soft” skills to determine sources of competitive advantage for any company you are considering.

Final Thoughts

Long-term buy-and-hold investors such as we are should always look for any wonderful businesses at fair prices, but keep in mind that competition usually works against shareholders by eroding “wonderfulness” over the long-term. A high-quality stock should possess a wide moat, demonstrating one or preferably a combination of the characteristics discussed above.

We listed many great examples of companies with competitive advantages. We were using many of the quantitative methods we discussed, such as high grossing, high net margins with consistently low Capex levels, which indicates a minimal investment required to stay competitive.

Understanding the sources of competitive advantage is crucial to identifying wide-moat companies. Once you understand the advantages and the sources, you can identify them in any company you own and the ones you would like to own. The understanding also helps you track your company’s performance over the long-term and help you identify when the advantages might start to wane.

That is going to wrap up our discussion today about sources of competitive advantage. As always, I want to thank you for taking the time to read this post, and I hope you find something of value to use on your investing journey.

If I can be of any further assistance, please don’t hesitate to reach out.

Until next time.

Take care and be safe out there,

Dave