Competitive advantages and their limits

In simple terms

In most industries, high profits attract competitors who copy the product, cut prices and win away customers, until profits fall back to ordinary levels. A competitive advantage is something that stops this from happening, at least for a long time. Investors often call it an economic moat, after the water-filled ditch that protected a castle.

A company with a real moat can earn returns well above its cost of capital for many years. That is one of the most valuable things a business can have, and also one of the most overestimated.

The main sources of advantage

Pricing power. The ability to raise prices without losing many customers. It usually comes from a brand customers trust, a product they cannot easily replace, or a small cost in the customer's total budget. Pricing power is the clearest sign of a moat.

Switching costs. When changing supplier is expensive, risky or time-consuming, customers stay. Examples include business software built into a company's processes, a bank account with years of linked payments, or industrial components that must be re-certified if the supplier changes.

Network effects. When a product becomes more valuable as more people use it, the largest network attracts still more users. Payment systems, marketplaces and messaging platforms can work this way. Network effects can be very strong, but they also make competition winner-takes-most, so a second-place network may be worth little.

Cost advantages. A company that can produce more cheaply than rivals can either earn higher margins at the same price or win share at a lower price. Sources include scale, access to cheaper raw materials, a better location, or a more efficient process.

Licences, regulation and intangible assets. Government licences, patents and long-term concessions can limit competition directly, though they can also be changed or withdrawn.

Testing whether an advantage is real

Stories about moats are easy to tell. The test is whether the numbers show one.

Look for these signs over many years, including at least one difficult period:

1. Margins persistently above peers'.
2. Returns on capital persistently above the cost of capital, as the ROCE lesson explains.
3. Stable or rising market share without buying it through price cuts.
4. Price increases that stick.

If a supposed advantage does not show up in any of these, be sceptical.

Why advantages fade

Moats are not permanent.

• Technology can make an advantage irrelevant: a strong distribution network matters less when customers buy online.
• Regulation can remove a licence-based advantage or cap prices.
• New competitors with deep pockets may accept losses for years to win share.
• Changing tastes can weaken a brand.
• Complacency: companies that rely on past advantages can underinvest and lose them.

An analyst's question is not only "is there a moat?" but "is it getting wider or narrower?" Falling margins, slipping share or rising spending just to stand still are early warnings.

Why it matters

The value of a company depends heavily on how long it can earn high returns. A business with a durable advantage can reinvest profits at attractive rates for years; one without will see its returns competed down. Understanding the source and durability of an advantage is therefore central to every valuation, and paying a high price for a moat that turns out to be imaginary is one of the most common and costly mistakes in investing.

Limitations

Judging competitive advantage is qualitative and uncertain. Past margins can reflect a favourable period rather than a lasting edge, and the evidence can only confirm an advantage after it has existed for a while. A real advantage also does not make a share a good investment at any price: the market may already value it fully.

Common mistakes

• Equating a famous brand with a moat. A brand matters only if it brings pricing power or volume.
• Confusing a good product with a good business. Excellent products can be copied.
• Looking only at the good years. Advantages are proved in downturns.
• Assuming a moat is permanent. Ask what could erode it and watch for early signs.

Try it yourself

Pick two listed companies in the same industry.

1. From their annual reports, note operating margin and return on capital employed for as many years as you can, including a weak year for the economy.
2. Note whether each company raised prices and whether its sales held up afterwards, using the MD&A.
3. Decide which, if either, shows signs of a competitive advantage, and name its likely source.
4. Write down one thing that could weaken that advantage.