How can a business gain a competitive advantage?

How can a business gain a competitive advantage?

As value investors, we are always on the lookout for businesses with a competitive advantage. Having a competitive advantage can give a business an edge over rivals and an ability to generate greater value for shareholders. But what do we really mean by competitive advantage, and how does it come about?

There are several types of competitive advantages and numerous ways of categorising them. One way to categorise competitive advantages is in three broad groups[1]: economies of scale, supply based, and demand driven. Let’s take a look at what these terms mean and when they might arise.

Economies of scale

This occurs when a business is the largest market player and can better spread its fixed costs. This can be particularly effective in companies with large fixed costs and commoditised products. Let’s take an example: You’re in the business of making gloves. To make gloves you need a machine that costs you $50m and can produce 100m gloves a year. If the machine is amortised over 5 years and you sell 100m gloves (working the machine to its full capacity), it costs you 10c a glove. However if you only sell 50m gloves it costs you 20c a glove. Producing more gloves per machine spreads the fixed cost across more gloves – effectively making each one cheaper to produce.

A company with such a scale advantage can match the cost of competition, but pocket a larger margin. Alternatively it can under-cut competition in the hopes of taking market share. As its cost base is lower it can do this longer than its competitors and thereby remain in a relatively better position.

Economies of scale can also be used as a negotiating tool for suppliers – being able to purchase in bulk and manage your inventory effectively can lead to lower prices per unit than your competitors. This leads us to the second type of competitive advantage…

Supply based advantage

This is when a company is better able to supply a product than other firms. Some examples of this include:

• A company with a patented superior technology which reduces its cost base
• A pharmaceutical company with a newly approved drug that has been granted a period of exclusivity
• An importer which owns an import terminal closest to its key market.

This advantage means either a company has a period of time where competitors cannot enter the market (e.g. the pharmaceutical company) and it can enjoy superior returns over this period, or whilst other players may enter the market they will be disadvantaged by having a higher cost base. This allows the incumbent to price them out of the market.

Demand driven advantage

This is when customers are very loyal to a brand and reluctant to switch to competitors. For such an incumbent to be disrupted, new entrants need to offer significant discounts or incentives to entice customers to switch. Businesses with high switching costs can be a beneficiary of this kind of advantage.

Incumbents with competitive advantages like these are harder to compete against for new entrants. Whilst competition can hurt margins for a period of time, companies with these characteristics are better positioned to protect their market positions over the long term. Such firms create large barriers to entry and deserve to trade at a premium to those without such advantages.

[1] Bruce Greenwald and Judd Kahn define these categories in detail in their book Competition demystified.