Competitive advantages

There are different ways of investing successfully in the market to obtain good returns. The method I am going to describe in this post consists on investing in extraordinary companies at reasonable prices, and allowing these companies to reinvest the profits they generate with high returns, thus making the value of the business grow over time. The greatest exponents of this investment philosophy are Warren Buffett and Charlie Munger, considered two of the best investors of all time.

The first step in this type of investment is to identify businesses that are able to generate above-average returns on capital in a sustainable way over time; in other words, businesses with a competitive advantage.

Next, we need to wait patiently until the price of these companies’ shares falls below the value we estimated for them and produces what we consider to be a wide enough margin of safety, and then we invest.

Finally, we need to hold on to these companies until the business deteriorates (the competitive advantages erode), the price exceeds our estimated value, or we find more attractive investments.

But why is it important to invest in businesses that generate high returns on capital? If it is a good business, the return on capital employed (ROCE) will be higher than the cost of this capital (WACC), so the capital will have increased in the process, thereby generating wealth for investors. If the business is mediocre or poor, the ROCE generated will be the same or less than the cost of capital, so no wealth will have been generated in the process, or it will even have been destroyed.

To understand these concepts, let’s look at the following example: imagine we want to invest in a clothes shop that is going to cost us 100,000 euros. In the course of the first year it generates profits of 20,000 euros. So the return on capital (ROCE) is 20%. Let’s also imagine that we didn’t have the 100,000 euros saved, but that we had to borrow it and that we need to pay 10% interest on that loan. That is, we have to pay 10,000 euros to whoever lent us the money. This cost is our cost of capital, or WACC. In this case the 20% return generated by the shop is higher than our 10% cost of capital, and has generated a difference of 10% or 10,000 euros. This second figure is the new capital that has been created with the business and has generated wealth for us as owners of the shop.

Now let’s imagine an investment in a fruit shop, also with an initial investment of 100,000 euros, but whose profits in the first year are only 2,000 euros. So the ROCE is 2%. If we’ve also taken out a 100,000 euro start-up loan for the shop at an interest rate of 10% (10,000 euros), the conclusion is that the ROCE is less than the WACC. So capital or wealth has been destroyed for the shop’s owner.

When we detect that a company has a high ROCE, that’s when the concept of competitive advantage or barrier to entry comes into play. The market generally works and attacks businesses that have high returns. The competition notices these good returns and tries to copy the businesses that obtain these profitabilities, ultimately causing a drop in the high returns on capital.

However, if the company has competitive advantages, they can act as barriers to prevent the competition from entering the business and allow the company’s ROCE to remain high over time. These are the famous economic moats described by Buffett, which surround the castle (the company) and protect it from the enemy (the competition).

There are two main groups of competitive advantages:

-Those that make it possible to extract greater value from our customers or charge them more for the products and services offered. These are what Bruce Greenwald classifies as “demand advantages”.

-Those that make it possible to have sustainably lower costs than the competition. These are what Bruce Greenwald terms “supply advantages”.

There are basically three demand advantages: intangible assets, switching costs and the network effect.

Intangible assets are elements like brands, patents or regulatory licences. A company with some of these advantages has a small monopoly that allows it to extract substantial value from its customers.

Brands only create an entry barrier if they affect the consumer’s behaviour in two ways: they either increase the customer’s willingness to pay more for the product (for example, a Tiffany diamond) or they generate captive customers (the case of Apple).

The danger is that a brand may lose its appeal, and this is difficult to estimate in the future. A common error is to think that very well-known brands offer a competitive advantage. Sony and Panasonic DVD players are known around the world, but the only thing that differentiates them in the customer’s eyes is the price, and they don’t confer any advantage.

Patents are a legal protection awarded to a company by the regulator which eliminate competition for a limited period of time. An example would be the patents owned by pharmaceutical companies when they bring out a new drug that they can sell on the market for some years without anybody being able to compete with them. Caution must be exercised with patents because they have a limited lifespan.

Licences are permits given by the regulator (city council, governments…) to a company so it can run its business, making it difficult or impossible for new competitors to enter the market. New competitors can only enter the business if the regulator gives them a licence, and generally very few are allocated. Examples are credit rating companies (Moody’s, Fitch…), slot machine manufacturers, casinos…

Switching costs occur when the benefit to be gained from changing from Company A’s product to Company B’s is LESS than the cost of doing so. When was the last time you switched banks? If a consumer/customer has fewer probabilities of switching to the competition, I can charge him more and obtain higher returns on capital.

The clearest example is Microsoft: almost all the employees in the world have learnt to use Excel and PowerPoint, so any company who wants to use another program will have to teach its employees all over again, which implies time and money. Additionally, even should the company be willing to assume this cost, it will then have problems when its employees send documents to other companies, as they will not be compatible with the system everyone else uses. In practice it is very difficult to stop using Microsoft.

The network effect means that the value of the product or service increases with the number of users. This advantage is very powerful and tends to create monopolies or oligopolies. The most famous example is Facebook: I register with Facebook because my friends are there, but when I register with them, other people register because it has more and more members, which means that the competition (Tuenti) loses users who see that Facebook offers better value, and the whole process starts all over again. Currently almost a third of the world’s population uses Facebook.

Location, one of the most durable barriers

There are essentially four supply advantages: better processes, location, unique assets and economies of scale. These advantages tend to be less solid than those that allow us to extract more value from the customer and can be very quickly eroded. Cost advantages are more important in industries/sectors where price constitutes a very important part of the customer’s purchasing criterion, such as in commodity industries (that is, where price is the only factor that differentiates your product from the competition’s).

A better process than the competition is an advantage which in principle can be replicated, but it may take time. An example is the first low-cost airlines such as Southwest Airlines in the USA and Ryanair in Europe. Other airlines ended up copying them, but for some years they made a lot of money.

Location is a more durable entry barrier than an advantage based on better processes, as it is more difficult to replicate. It is most often found in commodity-type industries, with cheap and heavy products that are consumed near where they are produced. This is the case of the Korean steel mill Posco, which has a privileged location very close to its customers in the shipyard and motor industry. Any other competitor would find it very hard to replicate Posco as it would have to transport the steel from farther afield.

Access to a single asset worldwide is another entry barrier that tends to occur in commodity-type businesses. The main examples can be found in businesses involving natural resources such as petroleum and mining. If you have access to a site whose natural qualities allow the material to be extracted at an average cost that is significantly below the competition, this creates an important barrier. For example, Saudi Arabian oil can be extracted at a total cost of 10–15 dollars a barrel, which is an advantage that cannot be replicated.

Economies of scale consist of being considerably larger than your competitors. The important thing is not to be large in absolute terms, but relative to your direct competitors. For example, Airbus is an enormous company, but it shares 50% of the market with Boeing, which is practically the same size. In contrast, Corticeira Amorim is a small company in absolute terms, but it is four times larger than its direct competitor and therefore has economies of scale in comparison. Economies of scale offer a greater advantage when the fixed costs of the business are high. For example, if my fixed advertising costs are similar to those of the competition – let’s say one million euros – but I divide these costs between 1,000 products sold because I’m much larger than my competitors, while they divide the same costs between 100 products, their advertising costs are much higher. My costs will be 1,000 euros/product and those of my competitors will be 10,000 euros/product. In this case the company can do several things:

• As it has lower costs it can sell at the same price as its competitors and obtain more profits, because it will have better margins. So the company will have a better return on capital which it can then return to its shareholders or invest in growth.
• It can invest more in advertising, displacing the competition with more advertising, until it raises its average advertising cost for each product sold to the same level as the competition.
• It can lower its prices. As its costs are lower it can cut its prices and thus maintain the same profits, dislodging competitors who cannot compete with lower prices.

In the end the company will generally increase its market share and size compared to the competition, squeezing out smaller competitors and preventing any new competitors from entering its business.

A combination of economies of scale and a demand advantage that enables more value to be extracted from your customers is the most powerful advantage a business can have.