Lesson 3 – Sustainable competitive advantage

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Lesson 3 – Sustainable Competitive Advantage

In the last lesson you read about understanding a business and why it is important in stock investing.

Lesson 2 – Homework

If you have studied the six IT companies (MPhasis, Persistent, Infosys, Infotech Enteprises, KPIT Cummins and Geometric) that I mentioned in the Homework for Lesson 2,  you will appreciate that different companies have different business models. Different IT companies have different revenue exposures to various lines of business and geographies. You have already started your practical work in this E-Course. Congrats!

If you have not had the time, it is OK. I urge you to revisit Lesson 2 and then start Lesson 3.

 

What affects a business

No company operates independent of market forces. I am careful in making absolute statements but I make this statement confidently.

Like you read in the last lesson, a business will face pressures from multiple entities. Customers, suppliers, competition, technological developments, economic downturns and labour problems. The list goes on.

The one question you should ask to know if it’s a solid long-term business is,

What is that special thing about this company that helps it perform better against competition and gives the business longevity and health?

 

What do I mean by the statement above?

If I were to list the major points,

  • Having a competitive pricing advantage where customers are ready to pay a premium for the company’s products or services as compared to competitors’ products or services
  • Having cheaper costs of operations as compared to competitors enabling the company to earn more profits from every product or service sold
  • Unique products and services backed by technology or business processes that others cannot provide at all or as well.
  • A business that is relatively resilient to downturns in the economy.

If the company that you are studying can achieve one or more of these they have a competitive advantage.

 

Warren Buffet and moats

 

Warren Buffett

Source: Mark Hirschey, Wikipedia

 

Warren Buffett of Berkshire Hathaway also considered as one of the investing greats, popularized the term moat. In ancient times, a moat was dug around a castle. Then you had crocodile-infested waters that an enemy had to cross to get in. Once the drawbridge was pulled up the castle was secured.

Sustainable competitive advantages act like moats that protect a business.

Warren Buffett wrote this in the 2007 Berkshire Hathaway letter,

A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

What can create competitive advantages?

Brands

There is no doubt that brands give a company pricing power. Take a look at a pack of Maggi noodles and compare them to Top Ramen noodles. Tell me the difference in price for the same weight of noodles.

Or consider why many like wearing a pair of Levi’s jeans which are considerably more expensive than an Indian brand like Spykar? Is the denim in a pair of Levi’s jeans that much better as the difference in cost? What do you think?

A business which has good brands is a good business.

But brand-building is not cheap. It requires money and effort to build a strong brand. Think of the amount of money fast moving consumer goods companies (FMCG) spend. Hoardings, TV, and newspaper ads cost a lot. A company needs to invest significantly in a brand to reap the benefits.

Business Processes / Business models

Take the case of Southwest Airlines in the US. It is a case study of how to do things right in the world of aviation. They concentrated on airports which were smaller and away from major cities. Their fleet of planes consisted of a single model thus ensuring lower costs of maintenance and servicing as compared to other carriers whose fleets had a mix of planes, sometimes from different manufacturers. Their customer service is legendary.

At the end of the lesson I have shared a nice read on Southwest Airlines. Don’t miss it.

Business models need conscious thought on the part of top management. They also need superb execution to convert them to reality.

Switching costs

Think of telecom in India. Mobile Number Portability (MNP) arrived recently in India. Till MNP arrived most frustrated customers continued with the same mobile service provider. You could change your provider. But it meant that you had to change your mobile number. Too much time and effort could be wasted in sharing your new number with acquaintances and friends. So most did not switch numbers.

Customers paid a “switching cost” till MNP was kicked off. This cost was not only in terms of money to buy a new mobile connection. It included the headache.

One can safely say that pre-MNP there were switching costs. Now with MNP switching costs have reduced. Earlier companies had competitive advantage to an extent. Now it has disappeared.

Switching costs are inherent to the business model and / or the sector respectively.

Size advantages

A large scale of operations brings many benefits to a business.

  • Better bargaining power with buyers as the company buys comparatively large volumes.
  • Ability to spread fixed costs over comparatively higher revenue.
  • Potential competitors are deterred by the large amounts of capital they will need to enter the market dominated by a large player.

Think of a 1 million tonne per annum (TPA) plant and the amount of staff it needs for administration, HR and marketing. If manufacturing capacity is doubled by setting up another plant, would the company need to double the size of the administration, HR, and marketing teams?

Usually this would not be the case. They will surely need to double the number of workers. That is unavoidable. But most fixed costs of operations do not increase as the scale of operations increase. This is an advantage that large companies have over small companies.

Patents, Intellectual Property

If a business has technology that is protected by patents, competitors cannot copy it easily. Or they may be able to start using the technology after the end of an exclusivity period. In the exclusivity period, only the patent-owner can sell products or services based on the patented technology.

Consider the recent Apple-Samsung case where the judge ruled that Samsung had copied Apple’s patents on smartphones. Samsung was asked to pay upwards of a $1bn fine.

Network effect

A network effect is when there are benefits to all existing customers as the number of customers using a product or service increase.

Think of a social networking site like Facebook. If all your friends are on Facebook, do you have any need to seek another social network? If a few friends go to a new social network, you will not log on to the new social network as much because the bulk of your friends are on Facebook.

I am reminded of Nokia phones. When Nokia was the leader in mobile phones in India, I heard many friends saying that it is better to buy Nokia phones. Why? Because everyone around used Nokia and that you could get a charger very easily if you were not carrying yours. I tend to think that it was probably a network effect.

 

Is the competitive advantage sustainable?

This is a very important question that you should ask yourself. Sometimes competitive advantages can be temporary. Certain business practices might give the impression that they are competitive advantages.

  • A company might be spending heavily on advertisements and brand building. But if the core product is bad, it will not help the company. No competitive advantage exists.
  • A company might be nearing the end of a patent exclusivity period for a product which is a big contributor to revenue. They have rested easy until now and not invested in further research and development (R&D). Competitive advantage is not sustainable.
  • Orkut, the social network that many Indians used before Facebook arrived, seemed to be going strong. A couple of years is all it took for Facebook to be the dominant social network in India. Orkut’s competitive advantage was not sustainable as proved already. I don’t think Facebook is radically different. Who knows? We might have another social network rise up in the next few years.

 

Homework

Study Nestle and Bosch from a business perspective and try to understand their moats. How have the companies built the moat? Is it sustainable? What are your views?

Next lesson

You will study the impact of good and bad management on business and stock performance.

 

Recommended Reading

Southwest Airlines – Deloitte study

Berkshire Hathaway – Letter for year 2007 (page 5-6)

Samsung – Apple lawsuit verdict