What Is Competitive Advantage?
In its simplest form, competitive advantage refers to any attribute that gives a business a leg up on its competition. This advantage can manifest itself in a company's numbers in several ways, including greater sales, higher margins, and a stronger ability to retain or attract customers.
Legendary investor Warren Buffett coined his own term for this characteristic; he calls it an "economic moat." Just as a physical moat protects a castle from assault, an economic moat protects a business from competitors eager to encroach on its profitable turf. So how does a moat protect a business? Let's dig into how businesses earn excess profit to help answer that question.
Fending Off the Competition
Basic economic theory teaches us that any company earning excess profit will soon find itself swarmed by rivals itching for a share of those excellent returns. This is where competitive advantage comes in – an economic moat is what allows that rare, outstanding business to sustain excess profit over time, warding off competitors in the process. Competitive advantages come in just a few main categories.
1. Cost advantages
These come in a few varieties. For example, companies such as Anheuser-Busch InBev benefit from economies of scale: As the world's largest brewer, Anheuser-Busch InBev sells such a huge quantity of beer that it can produce, market, and distribute those libations much cheaper (with lower per-unit fixed costs) than other beer producers. Low cost of production from advantaged assets is a similar competitive advantage, allowing companies to price their products at the same level as their competitors' but earn higher profit thanks to lower input costs (see former Options company Exelon and its low-cost nuclear power plants.
2. Network effects
Perhaps the most powerful of the competitive advantages, a "network effect" is when the value of a company's product or service increases (for both new and existing users) as more customers join in. Generally, there's a point of critical mass when adoption and network strength really take off. Great examples on our scorecard are American Express, with its network of cardholders and merchants, and Shutterstock, with its growing network of stock photography images, photo contributors, and site users.
3. Switching costs
If you've ever changed banks, you know what a hassle it is to readjust your automatic drafts and direct deposits to flow through your new accounts. A lot of people stick with the same (subpar) bank for years for that very reason. That's switching costs in a nutshell – one-time expenses customers incur when moving from one product or service to another. The desire to avoid the fees and hassle of switching effectively locks in customers, creating a powerful incentive to stay or renew with one company Interactive Brokers even if a competitor offers a better or cheaper solution.
This category can include intellectual property (brands, patents, trademarks, etc.), favorable government regulations, or company culture. As its name suggests, this type of competitive advantage is not as quantifiable as the other categories and can be difficult to assess.
For example, Disney's brand strength is the reason it can command a premium price for its cable networks, hotels, and theme parks. Another good example of a strong brand is Alphabet's Google, evidenced by the fact that the company's brand name has become an officially recognized verb.
In searching for outstanding businesses, one of the first things an investor should look for is evidence of a competitive advantage. A competitive advantage acts as an economic moat, protecting a company from the onslaught of profit-eroding competition. The four main sources of competitive advantage – cost advantages, network effects, switching costs, and intangibles.