How To Find A Company’s Competitive Advantage?
What made companies like Coco-Cola, Disney, Walmart, Apple, Facebook, Twitter, Intel household names? Apart from the products and services they offer, ever wondered why customers “stick” with these kinds of companies? How these companies protect themselves from their competitors as they continue expanding their business?
In this article, I will discuss how companies continue to achieve sustainable higher returns through something called a moat. I will also describe the signs you should look for to identify moats, what is not a moat and how to identify moats empirically.
Let’s get started.
What is a Moat?
A moat is a durable competitive advantage that protects a business from its competitors. Investing Legend Warren Buffett popularized this abstract idea when he said:
“A truly great business must have an enduring “moat” that protects excellent returns on invested capital” — Warren Buffett
Essentially, moat can be thought of as something that makes a company more durable by keeping competitors out. Hence, companies with durable moats can enjoy higher returns over longer periods of time, thus making them more valuable.
Signs of Moat in a Business
In his book 100 baggers: Stocks that return 100–to-1 and how to find them [1], author Christopher Mayer describes signs or characteristics that can help you as an investor in identifying companies with moats:
Companies with a strong brand
Ever since you were a kid, you have enjoyed movies and cartoons from Disney. People would happily pay upwards for the blue box that Tiffany provides with every purchase although they might get the contents of the box somewhere else at a cheaper price. Coca-Cola is a popular beverage with a global presence and its customers won’t settle for any other drink. All these brands have a moat.
High switching costs
Pat Dorsey, author of The Little Book That Builds Wealth drives this point home when he describes banks. There is not much of a competitive advantage that one bank has over the other. Due to hassles, people have to go through switching banks, people tend to stay at their banks for years. Thus, high switching costs create a moat.
Companies that are built on network effects
Best examples of network effects are YouTube, Facebook, and Twitter platforms. This is one of the best moats a company can have. Because as more people use these products, the more these kinds of companies enjoy the power of network effects. Network moats can be very difficult to break and create a barrier of entry for other players.
Companies that do something cheaper, better and more efficiently than anybody else
Think Walmart, Costco, Dollar Tree, Gap. Low cost creates a moat for these kinds of companies.
Companies that are the biggest
At times, the relative size of a company can itself create a moat. Imagine how difficult it is to replicate a business model like Walmart, Amazon or Intel. Competitors would rather not invest their time and energy in a niche market dominated by these mega companies.
“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 Buffett
What is *NOT* a Moat?
A popular product alone is not a moat. Pat Dorsey, the author of The Little Book That Builds Wealth [2], described this in his book with an example. Krispy Kreme makes great doughnut, but as a company, it has no moat. It is easier for people to switch to other alternatives.
Dorsey also points out that great management by itself is not a moat. As Warren Buffett put it:
“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” — Warren Buffett
Empirical Evidence For Identifying Moats
As an investor, identifying a moat can be tricky. Matthew Berry, a Columbia Business School alumnus and former analyst at Lane Five Capital, in his unpublished paper “Mean Reversion in Corporate Returns” found that moats can be identified empirically and essentially are a way for companies to fight mean reversion.
Mean reversion is an abstract phenomenon in the market where everything trends towards average. If a company’s earning shows an outsized return, mean reversion says over time, the company will revert towards average return. Similarly, if a company is earning low returns, mean reversion says over time, the company is likely to rise towards average returns.
Berry wrote that companies that are high perform continue to earn high return on invested capital (ROIC). He identified that high gross profit margins are the most important factor for companies to earn sustainable high returns. If a company started off with a high gross profit margin, it tended to keep it. If a company started off with a low gross profit margin, it tended to stay there as well. As an investor, you can continue to look for trends in the above metrics as you are analyzing a company.
Summary
True moats are rare and very difficult to identify. As a result, as an investor, you can use the signs I described above as a guideline when analyzing a company. If it’s not clear, then you might probably end up talking yourself into it. Hence, you need to do your due diligence by finding empirical evidence of moats, the ones I described above, in the company’s financial statements.
References
- Christopher Mayer, 100 baggers: Stocks that return 100–to-1 and how to find them, https://www.amazon.com/100-Baggers-Stocks-100-1/dp/1621291650
- Pat Dorsey, The Little Book That Builds Wealth, https://www.amazon.com/Little-Book-That-Builds-Wealth/dp/047022651X
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Further Reading
- Investing in Initial Public Offerings (IPOs): https://medium.com/@amrut.patil88/investing-in-initial-public-offerings-ipos-be9ffd9c86ed
- Momentum Investing: Be Like The Secretariat: https://medium.com/swlh/momentum-investing-be-like-the-secretariat-5d27521ba10
- The Snowball Effect: How To Compound Your Wealth Using Dividends?:https://medium.com/swlh/the-snowball-effect-how-to-compound-your-wealth-using-dividends-d92b719ffe79
- Fundamental Analysis Using Company’s Income Statement:https://medium.com/@amrut.patil88/stock-investing-fundamental-analysis-using-companys-income-statement-37b0d80531f1
- Fundamental Analysis Using Company’s Balance Sheet:https://medium.com/@amrut.patil88/stock-investing-fundamental-analysis-using-companys-balance-sheet-153531d98f8b
- Fundamental Analysis Using Free Cash Flow Statement:https://medium.com/@amrut.patil88/stock-investing-fundamental-analysis-using-free-cash-flow-statement-454beaa7f00
Disclosure
The content in the above article is for information and educational purposes only. I am not a licensed securities dealer or financial adviser. The views here are solely my own and should not be considered or used for investment advice. Also, I have no business relationship with the books referenced or any company whose stocks or ETFs that are mentioned in this article. Please consider the risk involved and your personal financial situation before investing or seek a duly licensed finance professional for investment advice.
About me
Amrut is a Full Stack Software Engineer who is passionate about designing and developing web and mobile applications. He likes to write about technology, coding, investing, trading, finance, and economics. In his free time, Amrut likes to understand business models of publicly traded companies and analyze their financial statements. He strongly believes in adding value to people’s lives through quality work and empower people to take control of their personal finances.
