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  • Writer's pictureAnkur Kapur

How to evaluate competitive advantage

The competitive advantages will eventually be copied away or the tastes and preferences of consumers will change and companies will become irrelevant. But a few generate enormous wealth during their lifetime.


How to evaluate competitive advantage
The key to investing is determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. – Warren Buffet

 

To understand competitive advantage you need to follow a few steps.

 

1.     Evaluate a company's historical profitability.

This can be done using profitability ratios i.e. RoE and RoA.

 

RoE of more than 15% p.a. over 10 years and RoA of more than 6% p.a. over 10 years will indicate that the company has some competitive advantage.

 

If you understand financial analysis deeply, return on investment capital is a very good matrix.

 

2.     Understand what is the source of its profitability.

 

Why is the company able to earn well and why competition is not taking away its profitability?

 

3.     How long the company can continue to be profitable?

 

Understand how sustainable is the competitive advantage.

 

4.     Analyse the industry’s competitive landscape.

 

If there are Only 2 or 3 players in the industry usually those industries are better in terms of growth.

 

In case the company is in an industry which is crowded with many competing with each other, usually the industry will suffer from low return on investment.

 

Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over forty years and you hold it for that forty years, you're not going to make much different than 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with one hell of a result. – Charlie Munger

 

Sources of competitive advantage

 

1.     Creating real product differentiation through superior technology or features.

In the case of Apple, the iPhone and the iOS system is far superior to their closest competitor. Asian paint has more than 60% of India’s paint market share and has similar paint in comparison with the competitor, but their supply chain is the best in the world.

 

2.     Creating perceived product differentiation through a brand or reputation.

Coca-Cola and Pepsi enjoy a certain reputation that even when you are travelling outside India there is trust in the brand and you do not doubt the quality of its constituents. You may order a local beer but you would be reluctant to order a local aerated beverage.

 

3.     Driving costs down and offering a similar product or service at a lower price.

The cost advantages can be driven through better processes. A better process will ensure costs are managed at a lower level and they are sustained at a low level and these structures may be difficult for the competitors to copy.

 

The other more sustainable cost advantage comes through the scale. If an industry requires heavy investment not everyone can be part of that industry. Usually, the largest player in the market takes a massive market share and the fixed cost gets spread out over large volumes.

 

4.     Customer lock-in

Areas where the company may have customer lock-in advantage.

  • The company has an advantage if the company has to provide a significant amount of client training.

  • If the product is mission-critical, switching can be disastrous to the main product.

  • If the product is an industry standard and consumers expect the company to use the industry standards products only.  

  • If the benefit of switching is too small and the pain is more.

  • A company locks in customers when the company tends to sign long-term contracts.

 

5.     Keeping the competition on bay

An easy one is to get regulatory protection. The other option is patenting, although patents can be challenged and may not always provide a competitive advantage due to being copied away.

 

The next strategy is the network effect. Throughout the world people use Microsoft Excel for work. One of the reasons for this is both sides of users use the same product so that there is a common way of doing work.

 


These competitive advantages will eventually be copied away or the tastes and preferences of consumers will change and companies will become irrelevant.

 

Management that is always on the lookout to understand how they can improve their product or services and take necessary course correction, will be at an advantage to sustain these competitive advantages.

 

A smart analyst will be able to have some sense of figuring out when the competitive advantages are fading away. Watch out for a fall in operating margins over the last few quarters. 

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