Competitive advantage

What is a competitive advantage?

When a business earns good profits, competitors crowd in. New shops open, prices are cut, customers are lured away, and slowly everyone’s profit shrinks. A competitive advantage is the lasting edge that holds off this crowd and lets a company keep earning good profits year after year.

Warren Buffett calls it a “moat”, the ditch around a castle. In his words, a truly great business needs an enduring moat that protects its excellent returns, because competitors will repeatedly attack the “castle”.

Why it matters to an investor

• To judge whether profits will last: more important than a good profit this year is whether profits like it will still be there in ten years.
• To estimate intrinsic value: a company’s worth rests on its future earnings, and the stronger the moat, the longer those earnings are likely to last.
• To understand why a high return on equity (ROE) is lasting, or why it may not.
• To see that “popular” and “protected” are not the same thing.

Five common sources of a moat

The research firm Morningstar groups the sources of a moat into five kinds. A company may have more than one, or none at all.

• Network effect: the more people use it, the more valuable it is to each of them. For example, the more customers a payment network has, the more shops accept it, which draws in still more customers.
• Switching costs: moving to a rival costs money, time or hassle. An office that has kept its accounts in one accounting software for years, for instance, finds it hard to change.
• Intangible assets: brands, patents or government licences that keep rivals out or allow higher prices.
• Cost advantage: making something of the same quality more cheaply than others, for example by buying raw materials at scale or having a well-placed factory.
• Efficient scale: a market so small that one or two firms are enough, and a newcomer would make everyone lose money. A small town, for instance, cannot profitably support more than one gas pipeline.

Signs of a moat in the numbers

A moat is not written on the balance sheet, but it leaves marks. According to Morningstar, the real test is how many years a company keeps earning returns above its cost of capital; not a one- or two-year spike, but how long it lasts.

• A good ROE that holds steady over many years and does not collapse in bad years.
• A steady or rising gross margin: being able to raise prices to protect profit when costs go up (pricing power).
• Not losing much market share even when rivals cut prices.
• Remember that these numbers describe the past. Whether the moat will hold in future has to be judged by understanding the business.

How moats break down

No moat lasts for ever. New technology can make an old edge useless, as phone cameras did to the photo-film business. A change in law or licensing rules can strip away a licence’s protection. And a complacent management can let even a strong brand weaken.

Buffett has warned that business history is full of companies whose moats proved illusory, and that a moat which must be constantly rebuilt eventually is no moat at all. His example was the airline industry: it grows fast and needs huge amounts of capital, yet almost no one has kept a lasting advantage.

Common mistakes

• Mistaking a popular product or famous name for a moat. The question is why rivals cannot copy it.
• Assuming a big company is a protected one. Size and a moat are different things.
• Concluding there is a moat from one good year of profit.
• Thinking any share price is fine because the company has a moat. Even a great business can give poor returns if bought too dear.

Read alongside