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What really drives competitive advantage?

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May 31, 2013 – Comments (16)

Whenever I read about companies with great financial performance there is always the term "competitive advantage". Usually its something like lowest cost, or strength of a brand name. The brand name one kind of bugs me. While I know for certain that a stron brand name is definitely a competitive advantage, I hate how so many fundamental analysis articles go on rants about how wishy washy technical analysis or momentum investing or etc is, but "strong brand name" is as wishy washy as it gets. 

 

Basic economic theory (which I usually find to be wrong, but it was my major so it was unfortunate burned into my skull) says that a competitive advantage shouldn't last in the long run. People will figure out how to get the costs as low as the lost cost producer, etc


I guess it's more of a philosophical level, but what creates/drives a long term competitive advantage? Why is KO never gonna be the average beverage company? Why can't somebody else just replicate them?why can't another big company finance a smaller company into a "high cost of capital to entry " field? If a field has such high barriers how did the current top dogs make it?


All I can think of is government  for some industries (patents, land rights, bail outs, regulations, etc) and first discovery to a huge natural reserve field but there must be more 
I don't know exactly what I'm looking for here...but something deeper than porters 5 forces 

16 Comments – Post Your Own

#1) On May 31, 2013 at 3:19 AM, somrh (86.56) wrote:

Well, I'll whore out a blog I wrote on this:

Competetive Advantage Types

At the very least that should direct your inquiry because it will partly depend on what type of advantage it is. 

Regarding the "perfect competition" that (neoclassical) economists have blind faith in, see slide 6 from here:

Thinking about ROIC and growth

While there is some "mean reversion" (indicating competition does put pressure on how ROIC), those high ROICs persist over time indicating that competitive advantages can persist to some extent. 

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#2) On May 31, 2013 at 8:57 AM, lemoneater (79.19) wrote:

Great thought provoking question.

Some American companies like Coke and Apple manage to capture the imagination in ways that other companies do not. They even become a part of our linguistic heritage. How does one company become such an integral part of human culture while another does not? I think answering that is as hard as defining "goodwill" in a business context.

somrh has an excellent point. One needs to know what kind of competitive advantage (if any) a company has. How strong is a strong brand? Look at a company in context with its competition. If I were buying Coke, I would look at Pepsi at the very least. Both brands are strong so what does it really mean?

I think it might be better to think of brands in terms of permanence. Some brands are written with water soluble markers, some are branded in flesh, and some are engraved in stone. The real question: Does your company own a real brand or is it a temporary tattoo?

Or is it in a highly regulated industry like railroads. When was the last time you heard about a railroad startup? A competitive moat can be a force field keeping out new companies.

Have a good weekend!

 

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#3) On May 31, 2013 at 9:58 AM, Valyooo (99.53) wrote:

But how do you measure the strength of the name coke versus the name pepsi?  I don't think theres a quantitative way or even a reasonable way other than "it just is, it feels right" (which may be 100% true, and I would agree with it, it just sounds like a sloppy investment thesis especially)

How many brands from the 1700s are still branded in flesh today?  None that I can think of....so why can't KO go by the wayside too?

 

Also, railroads of course.....that is what I was talking about with government....government kills competition which helps some companies.

 

Thanks for response!

 

somrh, thanks for the links, I will read them in a few minutes then reply 

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#4) On May 31, 2013 at 1:25 PM, somrh (86.56) wrote:

lemoneater wrote:

"Does your company own a real brand or is it a temporary tattoo?"

This reminds me of remark by Warren Buffett about Harley Davidson motorcycles; those tattoos they get aren't temporary. 

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#5) On May 31, 2013 at 1:36 PM, somrh (86.56) wrote:

As the author's suggest in the article I discuss in the link above, there's a perceptual link between brand and quality (and for that matter, price and quality).

So a new brand comes on the market and produces what is essentially the same product but offers it at a lower price. Do I buy the cheaper one? Of course not! It's interesting to note that the word "cheap" has two connnotations: lower price and lower quality. 

While in some cases of competetive advantage, I think there's a "rational", "economic" explanation for its persistence, in many cases it's just psychological. 

Consider Tylenol and Advil. Apart from (unlikely) possibility that one is allergic to the inactive ingredients in the product (and it seems to me that it would be just about likely to be allergic to the name brand than generic), these products are able to consistently sell at a higher price. There's not good reason for it but yet it persists. 

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#6) On May 31, 2013 at 1:42 PM, Valyooo (99.53) wrote:

Yeah I know, but what is your qualifier for better?  I guess just better ROIC?

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#7) On May 31, 2013 at 1:55 PM, somrh (86.56) wrote:

Valyooo,

I think you're right that's that Coke could lose it's place in the future. There's a lot of barriers though. For example, go to any restaurant or any convenient store/gas station with a fountain machine and you'll find either Coke or Pepsi (or both in some cases). It's not straight forward how you can break into that. 

I think there's definitely a qualitative (wishy washy?) aspect to competitive advantage.

But it's one way to acheive excess returns. If you have a company that has a formula for producing 20% return on capital and their cost of capital is 10%, the company can compound its formula to earn an excess return. 

The only other way to earn excess returns is to find a mediocre 8-10% return on capital company and buy it at a huge discount.

But there's no growth potential there (or rather growth adds no value). If you have a company with a 10% cost of capital and they get a 10% return on capital, then it makes no difference if the company reinvests or not as it adds no value.  

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#8) On May 31, 2013 at 1:57 PM, portefeuille (99.60) wrote:

how do you measure the strength of the name coke versus the name pepsi?

For publically traded companies it is usually done quite simply by guessing the BV/EV ratio, where BV = brand value and EV = enterprise value. That is why you usually see huge jumps in BV yoy in those yearly listings of world's most valuable brands. They would really hate showing BV exceeding EV when list is published ;)

That is just my opinion, though, based on having glanced at some of those lists ;)

see for example

http://www.millwardbrown.com/brandz/2013/Top100/Docs/2013_BrandZ_Top100_Chart.pdf.

 

An average 10y old, given a list of enterprise values and short company descriptions, would need around 10 minutes to produce a top100 list that would be "indistinguishable" from the "real one" ... ;)

Those brand value top lists are utter nonsense, but I still look at them every now and then. A little like the "caps" game top lists ... :)

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#9) On May 31, 2013 at 2:02 PM, portefeuille (99.60) wrote:

The equally useless full report. Well, at least I think it is, have not really looked at it yet :)

http://www.millwardbrown.com/brandz/2013/Top100/Docs/2013_BrandZ_Top100_Report.pdf.

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#10) On May 31, 2013 at 3:42 PM, Valyooo (99.53) wrote:

port, I would imagine a physicist such as yourself would take an exceptional dislike towards "you just have to kind of feel it out".

 

 Sometimes I understand it, but you can't say it that way to investors, you know what I mean somrh?  A guy want to invest 100mm with you and asks your investment strategy and you say "buy good companies", he walks right out.

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#11) On May 31, 2013 at 5:04 PM, lemoneater (79.19) wrote:

You are right, Valyooo, brand strength is hard to pin down. One must have a context to judge by. Once a company is a certain size how meaningful is brand strength? 

Thanks for the list, portefeuille. However, I probably will not buy shares of the featured companies. If a company has attained global competitive "moatness" how much growth does it have ahead? 

If I understand BV/EV correctly we could restate it as mood / math. The human element is what makes investing a soft science and what makes it so interesting to me :).

Rather than simply considering top internationally, known brands let's also hear it for the local brands. The size of the pond determines the size of the moat needed. I bought IMTKA Ingles Grocery because I enjoy shopping there every week.

 

 

 

 

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#12) On May 31, 2013 at 5:38 PM, somrh (86.56) wrote:

@portefeuille - Those look like interesting reads.

@Valyooo - Well, I think there are at least two things here.

The first is that I think you're referring to "durable competitive advantages" or "economic moats" which are a subset of competive advantage. For example, a company with a patent (say a drug company) has a competitive advantage for the duration of the patent but that aspect of the advantage falls off once the patent expires. 

So can we sort through which competitive advantages are "durable" and which ones aren't? Do we even need to?

The second thing is you can point to evidence that companies that have high return on capital measures (which I'll use as an operational defintion for companies with a competitive advantage) do well as investments.

For example, this study looks at "gross profitability" (defined as gross profits / assets) and finds that these companies outperform and that it has low correlation with "value stocks" (book to market). Then there's Joel Greenblatt's famous "magic formula" which includes a return on capital metric. 

So it might even be the case that you don't have to get it right, that you can simply invest in companies that have competitive advantages (some of which will turn out to have durable ones).

Thankfully (or perhaps unfortunately?) I don't have anyone who wants to invest a bunch of money with me so I don't have any explaining to do :) 

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#13) On May 31, 2013 at 6:52 PM, Valyooo (99.53) wrote:

Haha, that's a good point. What were your last 2 investments, and why?

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#14) On June 01, 2013 at 2:25 PM, somrh (86.56) wrote:

I think my two most recent purchases were AAPL and MSFT.

Jae Jun posted an interesting case for AAPL here.  I basically concur that the "bear case" is, more or less, priced into the stock already. So if they turn out correct, I'll end up with OK returns. If they're wrong, AAPL will do quite well. And since announcing significant dividends and buybacks, I'm guessing the next two years should be good. I think it's still trading right around my buy-in price. 

MSFT still has a strong product line. While they've had limited success in entering new territory, the stock is/was selling at a reasonable price. Given I didn't expect huge upside, I entered it as a covered call strategy, writing long term out of the money calls while collecting the dividends. They're in the money now. Maybe they had more upside than I suspected. *shrug*

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#15) On June 01, 2013 at 3:24 PM, Valyooo (99.53) wrote:

Eh, thats a high quality problem..but msft will probably drop....its way too expensive now IMO

 

how did u select which calls to sell?

 

Yeah, I recently bought AAPL too...I think my buy price was $455...just too cheap 

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#16) On June 01, 2013 at 3:58 PM, somrh (86.56) wrote:

I guess I see MSFT as about fair value. EBIT-taxes / EV is around 7-7.5%. Assuming no growth, that's not horrible in this interest rate environment. But it still might drop *shrug*

Buying the calls I figured part of the MSFT return would come from share buy-backs. I also wanted to factor in some revenue/profit growth. So I ended up picking a price around 15-20% over my buy.  My goal was to buy them just out of the money enough so they wouldn't get called away. They expire in Jan so it's still possible. But no mechanical method to the madness.

I think my call premium came in around 1.5-2%. Add into that dividend and shareholder yield and it wasn't too shabby. 

I think my buy price on AAPL was about the same as yours. I thought about buying more at $400 but I frankly have never liked Apple products (admittedly, I haven't touched one for a few years so I'm probably not giving them a fair shake.) We'll see how it goes. 

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