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The competitive advantage of a ‘customer moat’

The competitive advantage of a ‘customer moat’

One type of competitive advantage that we find particularly compelling is the customer moat. Businesses with a strong customer moat – like Amazon and REA Group – create value for their customers, making them highly durable investments over the long term.

It’s no secret that the key to outperformance in the stock market stems from the ability to invest in the equity of companies at a price which is at a discount to intrinsic value and benefit from the wealth generated by its assets over time. If this wealth is reinvested wisely, it has the tendency to produce favourable long-term results.

At Montgomery, we take this a step further by investing for the long term in high quality companies. The logic of focusing on quality here is due to the following:

  1. High quality implies the ability for the firm to grow earnings by reinvesting capital (without too much debt) for a high rate of return.
  2. The long timeframe allows the company ample opportunity to deploy multiple rounds of capital and grow earnings considerably.

We also look for competitive advantages. Competitive advantages are required to protect current profitability and future growth. Clearly if a business in which we’ve bought 100% of the equity for $1 million is earning $1 million in profits (100% yield p.a.), then such a lucrative opportunity will attract competitors which would put downward pressure on said profits.

Bruce Greenwald & Judd Kahn take note of the strongest key competitive advantages in their book Competition Demystified. In summary, they are:

  1. Switching costs.
  2. Protected demand (e.g. network effects etc).
  3. Supply advantages (e.g. government licences for special access to resources etc)
  4. Economies of scale.

But one that is not mentioned was discussed recently by John Huber of Saber Capital on his blog – the customer moat. The idea being that the above noted competitive advantages are compelling for owners in terms of warding off competition but whether they create value for customers is another question.

John uses Amazon Inc (Nasdaq: AMZN) as an example in that whilst it has many structural competitive advantages, it also has a strong customer moat – it’s customer-centre culture and business model which drives its decisions and results in customers receiving more in value for the goods bought over Amazon than they have paid for (i.e. creating value for customers).

This idea is interesting because if a firm can position itself such that it is high quality (i.e. earns high returns on capital), has structural competitive advantages and can deliver customer value over the long term, we can begin to see how this would be highly durable and create an immense amount of value for equity holders over the long term.

One good example is REA Group (ASX: REA). We’ve noted previously that REA’s competitive advantages are its network effect combined with economies of scale. It also provides a real estate listing service which is highly economic relative to alternatives such as newspaper listings and other items in the marketing budget for a property. In addition, each ad generates a high number of leads per listing, meaning that whilst a property owner might pay $1k-$3k for a premiere listing, it generates a lot of buyer interest for this sum of money.

Such thinking also leads one to consider how competitive advantages eventually degrade, leading to falling profits for the company and hence a lower stock price. For example, if a competitor can come up with a better value proposition for the customer, advantages such as economies of scale and network effects can become impaired. The benefit of switching may eventually exceed the cost of switching and supply advantages can be useless if demand for a product/service evaporates in favour of another. This takes time of course but is inevitable once the company’s customer value position becomes questionable.

By being able to understand these drivers, we’re one step closer to identifying companies which should outperform over the long term.

The Montgomery Global Fund owns Amazon and REA Group.

The Montgomery Funds own REA Group.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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