Successful investors know that finding a business with a high barrier to entry, a moat in Buffett parlance, is the key to creating long-term wealth. Identifying businesses that have a competitive advantage that is sustainable and durable, will deliver the greatest rewards to the owners. Growth, no matter how small, behind a strong moat produces businesses that are what many investors call “compounders” because the cash they generate allows the managers to reinvest in the business or return cash to the owners.
Below is a table that lists some of the sources of sustainable competitive advantage:
Network Effect – A company that is the first to invent a category and as the user base grows so does the moat it builds to keep the competition out. Think of Facebook, they built their own network that users could only join initially if they had a .edu email address. As the network expanded it gained traction and in order to see what your friends were posting other users had to join the service in order to participate. If they didn’t join they were left out. The more users that joined the more others had to join to stay involved, and the larger the network grew. Once Facebook figured out how to monetize all the members, they erected a moat around their business that continues to widen and generates enviable cash flow.
Intellectual Capital/Brand -Warren Buffett recently invested in Apple shares because he saw that his grandchildren couldn’t go anywhere without their iPhones. Apple has used its brand to create a must have product with an ecosystem that makes switching unimaginable. The iPhone has become a symbol of prestige and signals to peers that the owners are a part of the cult of Apple. Meanwhile, Apple has been able to keep their gross margins on the iPhone stable by charging the same price for the phone and wringing scale and efficiencies out of the supply chain. According to some reports, Apple has all the profits in the smartphone market while the other competitors are left to fight over the crumbs.
Cost Leadership – When Costco developed their business model they figured that if they operated at a 14% gross margin they would be able to break even on the sales of merchandise. Since they were breaking even on the sale of merchandise they would attract customers and become known for their low prices. But great businesses don’t break even, they return cash to their owners, and in order to make a profit they decided they would charge a membership fee.
Capital Discipline -Vizio became the U.S. market leader in LCD TVs after realizing that LCD panels were a commodity. The company was able to keep costs low by buying the panels from multiple sources and taking advantage of the declining price as manufacturers gained economies of scale. Vizio became mainly a marketing and customer service company while the panel manufacturers suffered declining margins.
High Switching Costs – SAP, Oracle and Salesforce.com all fall into this category of competitive advantage. It’s very difficult and expensive to implement new enterprise software, especially the ones that run the businesses of large scale organizations. Usually, these software installations have to be implemented over years and the organization adapts its business processes to the software. Changing vendors of software that runs every part of a business comes at a very high organizational cost.
Favorable Regulation/Natural Monopoly – Most cable companies fall into this category of competitive advantage. Through consolidation of the industry in the last couple of decades there usually is only one dominant provider in each region of the country. This allows the regulated monopoly to earn a return on the high cost of building and maintaining their network and erect barriers to keep new entrants out.