Competitive advantages
In hockey, there are many phrases that are long outdated and have become rather meaningless. Perhaps the best known of these, in my opinion, are the importance of staying out of the penalty box and of power-play and good goalkeeping. Of course, the above-mentioned mantras are necessary for a team's success and form a kind of foundation, but they are not sustainable qualities that lead to medal games, let alone structural ones. In other words, a team that takes few penalties and finishes efficiently on the power-play should have relative competitiveness over its opponents. Based on these characteristics, however, it’s still too early to talk about actual competitive advantages.
Translated into the context of investing, one could understand this comparison to mean that while factors such as a good product, competent management and a healthy organizational culture undoubtedly contribute positively to long-term success, despite their importance, they are only the things that earn a place in the competition. Thus, in order to identify, locate and assess the right, genuine and preferably sustainable competitive advantages, I believe that a company must always be looked at from a deeper level than the outer shell.
What is a competitive advantage?
To make the above train of thought on the nature of competitive advantage more concrete, a more detailed discussion of the whole concept should start with a technical definition. In my view, the definition of competitive advantage, in all its simplicity, is that the company's business has structural elements that allow the capital invested in the business to consistently and sustainably outperform the cost of capital over the long term - i.e., ROIC / RONIC > WACC and the company has very strong protection against new entrants to the industry. Simple on paper, but not easy in practice.
Since there can be several companies operating with different earnings models in the same industry and value creation is never independent of capital needs, I don’t think that there should be a straightforward equivalence between high margins and competitive advantage. A more comprehensive measure of profitability is needed to benchmark business qualities and operating models. A return on investment that combines both operational profitability and efficiency in the use of capital—and at the same time necessity—is the most viable choice for this work. Moreover, the return on investment is a pure measure of the earnings capacity of the business and the ability to allocate capital. Unlike return on equity, it is not subordinate to the financing decisions taken or to be taken. In this context, it’s the return on operational capital that I believe is also the factor that determines the attractiveness of an industry in the eyes of outsiders.
As discussed above, ROIC consists of two components: operational efficiency, i.e., the ability of the business to generate profits, and capital efficiency, i.e., the ability to get the most out of the available assets. Based on these two components, ROIC is best understood as the operating profitability multiplied by the rate of return on invested capital From this, I think that two conclusions can be drawn that are essential for understanding competitive advantages: 1) although a high margin level doesn’t directly indicate the existence of a competitive advantage, it often indicates that a company has a price or cost-side characteristic that is different from the so-called gray mass of ordinary consumers, and 2) a competitive advantage can also be acquired through the balance sheet.
However, against this background, and especially against the definition of competitive advantage, finding one does not, in my view, automatically mean that a company is the sovereign number one in its target group or market. In some industries, such as pharmaceuticals or health technology, ROICs can be very high, and a company with a 20% ROIC, for example, shouldn’t be categorized as uncompetitive, even if it falls outside the top two in the industry ROIC comparisons. Of course, the same logic operates on a two-way street. For example, in the steel industry with its raw material end products, substantial capital requirements and thus difficult economies throughout, the ROIC of even the best companies are very close to required returns on capital.
Based on the literature I have read, the companies I have studied and the observations I have made, competitive advantages can be approached through five categories. These are: 1) intangible assets, 2) cost benefits, 3) economies of scale, 4) switching costs and 5) the network effect.
Intangible assets
Intangible assets that bring competitive advantages include brands and patents, but in some cases also favorable legislation. Brands provide a competitive advantage only if they increase customer willingness to pay or product loyalty (e.g., by keeping search costs very low). Thus, a genuine brand-based competitive advantage should give the company pricing power, be reflected in a relatively high gross margin in the income statement and create the conditions for better operational profitability than other players in the industry and, while maintaining the efficiency of balance sheet use, also a better ROIC.
Reflecting the first two manifestations of brands, I think it’s essential to understand that mere awareness isn’t synonymous with strong pricing power or brand value. In my view, the most relevant questions for identifying brand-based competitive advantages, and especially for assessing their sustainability, relate to whether higher selling prices are sufficient to compensate for the higher total costs of brand investment, and in which direction the brand's vitality and pricing power will evolve in the long run. From a global perspective, companies with a valuable brand and at the same time a recognizable competitive advantage include among others the luxury handbag maker Hermès, as well as PepsiCo and the Coca-Cola Company in the soft drinks industry.
Patents, on the other hand, give their owners a competitive advantage where a single patent or a larger family of patents provides protection against direct competition for a product that is essential to their business and usually differentiated in some way. Conversely, and in the best case, the patent or patents should, during their term, give the company an exclusive market position, pricing power and thus a basis for generating a higher ROIC than non-patented operators.
Although understanding competitive advantages that are based on patents is fairly straightforward, I think that identifying them, and particularly assessing their sustainability, is a challenging exercise. This is because patents are not eternal and can be quite detailed in their content. From the point of view of competitive advantage, the main issues to be considered in relation to patents are, in my view, the size of the patent portfolio, the timing of the expiry of the main patents and the possible substitutes for the product covered by the patent, and hence the competitive dynamics. Competitive advantages built through patents are typically found in pharmaceutical and (health) technology companies.
Among the sources of competitive advantage provided by intangible assets, there is still favorable legislation. For the company and the underlying business, legislation (including various regulatory approvals) naturally provides protection when it substantially impedes or even completely prevents new competitors from entering the same operations. A particularly strong competitive advantage is guaranteed by favorable legislation in a situation where a company is able to operate in a quasi-monopolistic or oligopolistic position, but without any regulation on the price side (i.e., significant pricing power).
However, my observations suggest that such arrangements are the prerogative of only a few industries, and, for example, price regulation or state ownership can substantially reduce the strength of competitive advantages gained through public authorities. In addition to the various countermeasures and their effects, a particularly important, if often unpredictable, issue for assessing the strength of a competitive advantage based on legislation relates to possible changes in legislation. I believe that rating agencies such as Moody's, Fitch and Standard & Poor's are good examples of companies that enjoy sustainable competitive advantages through legislation and related authorization processes.
Cost benefits
Let’s move from intangible assets to sources of competitive advantage that are perhaps a little easier to identify, but in turn a little easier to copy. As the name implies, cost benefits mean that a company's cost level is clearly and preferably sustainably lower than that of its competitors. This, in turn, with similar sales prices and capital efficiencies, naturally means both higher margins than competitors and a higher ROIC.
In particular, the assessment of sustainability is of paramount importance with cost-based competitive advantages, as a competitive advantage that appears strong and excellent can quickly disappear if it is based on elements that can be easily and reasonably quickly replicated (e.g., sourcing from low-cost areas). Since cost-based competitive advantages, like intangible assets, do not provide traditional pricing power, but rather a certain degree of pricing flexibility, it is logical to seek to build these features, especially in price-sensitive and substitution-rich industries.
The most common factors explaining cost-based competitive advantage are: 1) more efficient business processes, 2) a more favorable geographical location or 3) a unique asset. In other words, to achieve competitive advantages on the cost side, a company must be smarter, closer, or more unique than others.
Of the three main factors, I consider the more efficient business processes to be the most susceptible to copying, especially if it is a manufacturing or distribution process. However, susceptibility to copying does not imply immediate copying capacity and hence loss of a competitive advantage, although in the long run the process benefits will typically be passed on to other actors in the industry. Of course, at this stage it is no longer a matter of competitive advantage, but rather a new normal within the industry. In my view, the new normal analogy applies remarkably well to a case where the dissipation of a process-based competitive advantage has been the result of a permanently changed industry structure, such as lower entry barriers that have come down in line with technological progress. Equally, at a practical level, efficient business processes can be the result of a different business model (e.g., building a stock vs. JIT deliveries), strategic choices made or simply better knowledge of the same core processes.
To be honest, the last point would be largely due to incompetent competitors, and I don't think it should be considered a very strong source of competitive advantage, just by the laws of market economics alone. In summary, the sustainability of a process-based competitive advantage depends both on competitors' own capabilities and the timeline of competitors’ ability to replicate the process journey and, to some extent, on competitive forces affecting the structure of the industry (e.g., the threat of new entrants and the current competitive situation).
Another source of cost benefits is a more favorable geographical location than other operators. In my view, competitive advantages based on such a characteristic can be identified in industries where the final products are rather bulky, heavy, low in value-to-weight ratios and, as a consequence, produced close to the customer's own operations. In other words, generally businesses with at least complex business structures. However, depending on the nature of the business, replicating a geographical location can be extremely difficult or, under the right conditions, impossible. Reflecting this, a competitive advantage based on such a characteristic is generally more sustainable than its process-based counterpart.
A cost-based competitive advantage based on a unique asset, as the name implies, gives the company access to an asset that is sometimes completely inaccessible to competitors. As I understand it, this usually means the cost-effective exploitation of a raw material resource of exceptional size or other characteristics, such as a rock salt deposit or a eucalyptus forest.
Like geographical location, a unique asset is difficult to replicate, making it a relatively durable source of competitive advantage. However, industries where it is possible to find such and other cost-based competitive advantages are quite challenging in other structural characteristics (e.g. high capital requirements and limited pricing power). These characteristics, and in particular their effects on the dynamics of the industry, can be significant and at the same time dilute the actual source of competitive advantage in a substantial way.
Economies of scale
To the sources of cost benefits listed above, a fourth area could justifiably have been added: economies of scale. I think this would have been justified because operating on a larger scale has typically meant direct cost benefits. However, economies of scale, with their subcategories and matters affecting them, are a more complex package than size alone. Reflecting this, and in order to ensure a broader understanding of competitive advantages, I believe that an independent examination of economies of scale is a sensible choice.
As far as economies of scale are concerned, I think it is important to highlight two fundamental laws before jumping to more comprehensive considerations. The first of these is that magnitude must always be seen as a relative rather than an absolute property. In other words, a large absolute size is not a guarantee of competitive advantage and noteworthy benefits if competitors also operate in the same caliber. Perhaps the best practical example of this is the battle between the leading aircraft manufacturers Airbus and Boeing. As both companies are massive and dominant, I don't think it is very likely that they will succeed in building relative economies of scale.
The second of the fundamental laws of economies of scale relates to cost structures. In simple and somewhat straightforward terms, the higher the share of fixed costs in total costs, the better the chances of building economies of scale for an industry and the companies within it. The reason for this dynamic is logical, since in principle a higher relative share of fixed costs means greater scalable mass and hence a clearer tangibility of the benefits of larger size. The same idea also has a strong link to the structure of the industry, yet again in simplified terms, the relative shares of fixed costs are much higher in areas with concentrations of actors than in the opposite structure (i.e. the economy of scale shaped/shapes the industry).
Then to the actual point.
In my view, the sources of economies of scale can be divided into three categories. These are: 1) economies of scale in manufacturing, 2) economies of scale in distribution / access to distribution channels and 3) dominance in a niche market. The most classic example of economies of scale in manufacturing is found in the production line industry, which is dictated by utilization rates. In general, the higher the utilization rate of a production facility, the more profitable the company and the easier it is to scale fixed costs. Of course, realizing economies of scale in manufacturing, the importance of scale of sourcing is also relevant, reflecting the typically increased purchase volumes, increased bargaining power and exploitable quantity discounts through a larger size.
However, I believe that the economies of scale in manufacturing are not only achievable by companies operating in the manufacturing industry, but that the underlying logic of decreasing unit costs with increasing size is also applicable to other industries and parts of the business model. For example, product development-driven players, such as global gaming and pharmaceutical companies, can leverage their huge revenue streams and large size to both scale product development costs and manage the risk levels of individual product development projects.
An extensive and dedicated distribution network can at best be the source of an admirably strong competitive advantage and, by studying the economics of logistics, this is something that is easy to understand. The transport fleet (including drivers' basic salaries and a large proportion of fuel) is in practice a fixed cost item and, to simplify, the only truly variable costs of distribution operations are the possible overtime hours (i.e., destinations deviating from the normal routing in terms of location and schedule) and extra fuel used during these hours.
As a result, the fixed costs of a large distribution network are typically quite high, but the corresponding margin profiles for transport beyond the critical mass are excellent. Translated into competitive (advantage) dynamics, this means that directly challenging an operator with a large distribution network and high margins, or copying the benefits that come through distribution channels, is a remarkably demanding challenge, both economically and in terms of time.
The third source of economies of scale is dominance in a niche market. As mentioned earlier, economies of scale are never based on absolute size, but on relative size. Thus, to have this kind of competitive advantage, a company need not be anywhere near large, as long as it is larger than other companies in the industry. Against this background, a company operating in a dominant position in its niche market, such as the manufacture of industrial pumps or valves, is therefore able to create a kind of mini-monopoly and thus erect high entry barriers. Thus, positioning in the right niches and succeeding in creating relative economies of scale within them can, in my view, give a company a sustainable competitive advantage over time.
Switching costs
Switching costs are, as the name implies, the costs related to switching a service or solution provider. However, these are not only direct monetary items, but can and often are related to lost time, the extra hassle and uncertainty of switching, or, e.g., the increased level of risk that switching may entail.
Switching costs can be particularly high when the solution provided by the company is critical to the customer's business and the number of alternative suppliers is limited. In a practical context, this should give the company pricing power and thus again the conditions for generating a ROIC that is sustainably higher than the required return. In my view, high switching costs can be found both in areas where the price tag of a potential failure or operation is steep, and in situations where the solution-to-be-delivered represents a moderate proportion of the customer's total operational costs (i.e., decision making is not price-driven).
Given the above industrial logic of switching costs and the dynamic nature of the operating environments of consumer product companies or comparable companies, it is not surprising that competitive advantages based on switching costs are typically found in B2B businesses. Of course, there are cases that deviate from this framework, and the best example I can think of is Apple.
I myself am a user of Apple's extensive product portfolio and the infrastructure built around it. Personally, I find the value created by the effortless interplay between different devices and the micro-services marketplace so great that I cannot imagine a situation that would justify switching. While it is always dangerous to translate personal feelings into a general cumulative truth, and Apple undoubtedly has other competitive advantages besides the switching costs, the excellence of the company's operational history and its long track-record of high returns on capital suggest to me that I am not entirely alone in my sense of ease and perceived value.
Network effect
The fifth and final source of competitive advantage is the network effect. The network effect is at its most dynamic and powerful in a business where the value of the service or solution provided increases for both new and existing customers as the total number of customers grows.
With this in mind, I believe that network effects can be summarized in two basic principles: 1) The first mover advantage is extremely strong. In terms of competition and value creation dynamics, this often leads to the growth of the first big players and the corresponding shrinking of the smaller ones. 2) Companies with network effects typically operate in businesses based on sharing information or combining the needs of different parties (i.e., acting as a two-sided marketplace).
In practice, the benefits of the first mover advantage boil down to critical mass, i.e., a sufficiently large flow of operations and success in maintaining it. I think that a prime example of this, and of how the whole network effect works, is the business of Facebook or, more appropriately, Meta. Facebook, with which almost everyone is familiar, is based on building networks of people and interacting within them. Thus, for the individual user, the wider the group of acquaintances it enables, the more valuable Facebook or other Meta media should be.
In turn, the absolute size of the number of users is synonymous with the absolute size of the marketplace itself. This, according to the network effect thesis, is an essential variable for the decision making of various marketing functions. In other words, existing Facebook users have been attracted to the platform by the marketing efforts of companies, which in turn have and will continue to attract new users to Facebook. In turn, this should lead to increased marketing efforts within the network (including new companies) and, through a certain exponentiality (high margin of additional sales from a business perspective), an increase in both the value experienced by the user base and the value created by the marketplace.
Another good example of the competitive advantage of network effects is Copart, which auctions cars wrecked in road accidents off the balance sheets of insurance companies and on their behalf. Throughout its history, the company has invested heavily both in the land needed to preserve the cars and in the technological transformation of the auction process. Simply put, these investments made Copart the global market leader and its network effect very strong: insurance companies prefer Copart as a sales channel because it has the largest customer and distribution network in the market, and customers prefer Copart because it has the largest range of cars in the market. This cycle is further accelerated and hence the network effect is reinforced (i.e., high RONIC) by the fact that, as I understand it, the company continues to allocate a significant part of its free cash flow to the acquisition of new land. In other words, an already large-scale player is growing at the expense of smaller players.
Reflecting the background and examples discussed above, building genuine network effects is undoubtedly time-consuming. However, once a critical mass has been reached, undermining the benefits and value creation potential of network effects is, at best, close to impossible. It is therefore obvious that a competitive advantage based on network effects is strong in nature and powerfully time-resistant. This is particularly true when a company can reallocate the cash flow generated by its operations to reinforce an existing competitive advantage, be it a network effect or one of the other sources discussed, and to deepen the structural moat surrounding its operations. We will now look at this idea, and particularly at its relevance.
Legacy or reinvestment moat?
Sustainable competitive advantages are rare privileges that belong only to the highest quality companies. The companies operating under the protection of competitive advantages can be further divided into two rather fundamentally different groups, separating the wheat from the chaff: 1) companies with a legacy moat; and 2) to companies with a capital reinvestment moat.
From my own observations, the vast majority of sustainable competitive advantage businesses fall into the first category, which is not at all surprising given the laws of the market economy. In plain language, the returns on existing assets of these companies and hence businesses are high, but the scope for reallocating capital at similar levels of return is limited. Thus, the companies that fall under the reinvestment moat are a special breed of top companies and arguably worth seeking out, as they combine both the fundamental benefits and operational protections provided by legacy moats and the valuable long-term capital allocation capabilities.
In addition to high returns on invested capital (i.e., good investment decisions made in the past), strong market positions and often decades-long histories are characteristics of legacy moat companies. In line with the above, the range of value-creating growth opportunities for these companies is limited, but on the other hand, seizing them does not usually require a huge amount of additional investment. Reflecting the lack of options for capital reallocation, the lion's share of the free cash flows generated by companies is directed to profit distribution.
Since fair value growth over time must be based on the margin return and the investment rate (RONIC x investment rate), the dynamics of legacy moat companies should inevitably be reflected in the overall returns to the owners of such businesses. In my view, a valid example of a company protected by a legacy moat that is also of high quality in every respect is the Finnish machinery manufacturer KONE. The scale of the company's capital-light and high-margin services business, combined with the thickness of its global market share and the large base of installed machinery it brings, have made the company’s ROIC ratios wild. However, to my understanding, it is not possible for KONE to allocate free cash flow generated by the business to grow these operations at the level of historical ROIC. Reflecting this, KONE's payout ratios in recent years have been close to 100%.
Finally, we come to what I think is the most interesting but most challenging category in the whole corporate and investment space in terms of sustainability assessment. The reinvestment moat companies can be even touchingly beautiful: The performance capabilities of these players are, on my subjective scale, at least backed by the average power of a legacy moat company. However, at the same time these companies are typically able to leverage the source(s) of competitive advantage provided by the same legacy moat to push the cash flow generated by their operations back into the business at, in the best scenario, higher ROIC than historical levels. Accordingly, the reinvestment moat and the business it protects is understandably more valuable, the more sustainable—or deeper to build on the moat analogy—the actual competitive advantage is (i.e., the period of reallocation/length of a kind of growth runway).
For the model of value creation, and in particular for the ever-marching role of the compound interest phenomenon, it seems clear to me that the most important and arguably most difficult issue for assessing reinvestment moats is precisely the perception of the duration of the competitive advantage. The difficulty is that successfully assessing a reinvestment moat requires both a solid grasp of the underlying business model, strategy, and industry dynamics, locating the source of the legacy moat, and predicting the future that is completely uncontrollable and involves multiple variables.
However, being right about the quality of the business for the right reasons is the optimus maximus of successful investment in the long run and, like the table above shows, more important than the purchase price. This is why I see both the disciplined and patient implementation of the decision-making process that culminates in this idea and the building of the right mindset—i.e., owning a business rather than a ticker—as key sources of competitive advantage at the individual level.
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