One of the well-tested assumptions of modern capitalist economics is
that competition will eventually erode most business advantages.
Consider the history of consumer electronics. One company will introduce
a new product to make a lot of money with initial success, only to lose
the market to many smaller competitors who develop cheaper, faster,
simpler, or more available clones.
This commoditization
(where a unique product available from only one vendor becomes an
interchangeable product available from many vendors) spurs businesses to
continue to invent new products to sell (until they're copied). If
you're a customer, this is a good thing. Prices decrease as value
increases.
If you're a business owner—or a shareholder of a public
company—commoditization makes you work harder for the same
revenue, whether inventing new products or finding ways to reduce
expenses to retain your profits. You can't rest; someone else will come
along and make it cheaper, faster, better, or different.
What is a Competitive Advantage?
A competitive advantage is something a company does which
makes its business model difficult for competitors to disrupt. For
example, an Apple phone may do the same
thing (roughly) as a Samsung phone, but
Apple has a competitive advantage in its very strong brand.
People will wait in lines outside stores to buy a new phone when it's
released.
A competitive advantage may be the execution of an idea. For example,
Amazon is very, very good at shipping
things quickly. Even though you could drive to your local store and get
an item right now, sometimes it's easier to order online and wait two or
three days for free shipping.
Amazon has a second competitive advantage, shared with Walmart: size. Both companies are large enough to
dictate payment terms to suppliers and sell enough product that they're
effectively getting short
term loans from their suppliers in the form of inventory that's immediately
sold with the profits invested in very short terms. Even a tiny amount of
interest on a lot of money makes a lot of money.
A restaurant or food or beverage with a secret recipe—say that
of Coca-Cola is another competitive
advantage. To some people any fried chicken or cola will do, but to
others, only the real thing is acceptable. Brand helps there too.
What is a Durable Competitive Advantage?
When you analyze a business, knowing about any competitive advantage
and ranking it against other businesses will give you more information
about the value and growth prospects of the company.
A durable competitive advantage is a business edge which
keeps commoditization at bay entirely; it's something that can only be
disrupted at great time or expense. A competitive advantage will
eventually fall, but a durable competitive advantage is immensely
stronger.
Think about the formula to Coca-Cola. A
trade secret is an important competitive advantage, but it's also
risky. If that secret were ever revealed, competitors could duplicate
the flavor of a Coke and produce an exact competitor. Coca-Cola would
still have the competitive advantages of its strong brand, its network
of suppliers and bottlers and shippers, and all of those soda machines
across the world. Its profits would probably go down though.
If the secret Coke recipe included a rare ingredient only grown on a
single farm owned by the corporation, its competitors couldn't
make an exact duplicate. Coca-Cola's advantage would persist.
This durability of competitive advantage has degrees. A patent (17
years of monopoly control over a device or invention) is less durable
than a copyright (70+ years of monopoly control over a creative work). A
trade secret is only as durable as it remains a secret.
What is an Economic Moat?
An economic moat is a durable competitive advantage which
allows a business to maintain its profit over the long term against any
competitors. Good and great competitors may exist, but this advantage in
quality of product, brand, production, productivity, or execution which
allows the company to out-compete everyone else. Warren Buffett coined
the term "economic moat".
An economic moat is good for investors. It may be neutral or negative
for customers; moats can produce monopolies and monopsonies, but they
can also provide important information, such as brand quality. Coca-Cola
doesn't have to spend a lot of time coming up with new flavors of soda
which will be immediately copied. Everyone knows what they're getting
with a Coke.
On the other hand, Amazon and Walmart do continue to invest
in their logistics and inventory systems, because those moats
do degrade over time.
A good moat can do many things. It can prevent competitors from
appearing at all. While it's too expensive to start a business to go
head to head against Amazon in general, you may have a store which
successfully sells niche products and competes on selection, quality of
service, or another non-logistical angle. It can also reduce the profit
available to potential competitors, such as Standard Oil dropping prices
in certain markets to make it not worth anyone's time to try to sell oil
or gasoline.
A moat can even be a specific business process, such as Intel's tick-tock
model of building a new fabrication plant for a new type of semiconductor
and making it cheaper to get better yields out of it. Where a competitor may
replicate the technology, it's unlikely to repeat the process of improvement at
the same scale and quick timeframe, and will soon find itself selling obsolete
products.
How Important is a Stock Moat?
Not every good company has a strong moat, but many companies with
strong moats are owning. When you research good stocks, a durable
competitive advantage is a major positive.
Paying the right
price for a stock is still the most important factor in the profit
you're going to make. Obviously companies with economic moats and
undervalued stocks are worth considering. Knowing the long term business
potential of a business—especially how a company can address
competition and commoditization of its products or services—will
help you find and buy great stocks.
