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The Importance of Competitive Advantage
Nicholas van der Meer
1 September 2010

Competitive advantage is evident all around us – in everyday life and in business. In running the 100m sprints, the fastest runner has a competitive advantage over his peers. In running the Comrades Marathon, the runner with the best combination of speed, stamina and determination possesses the competitive advantage.

A competitive advantage is any characteristic that enables a competitor to beat its peers in achieving a goal. In business, this goal is to increase shareholder and stakeholder value. As long-term investors, we want to invest in the companies that possess a competitive advantage, because chances are they will outperform their peers.

Three important checkpoints
When evaluating the competitive advantages of companies, make sure that they adhere to three checkpoints:

1.    The competitive advantage must be unique

If the company cannot produce something unique, or produce a homogenous product in a unique way, then it’s unlikely that it has a competitive advantage. For example, if three identical companies all produce identical cars that sell at identical prices, no company has an advantage over the others.

However, if one company can produce the identical cars at half the price because it owns some special technology, then it has a competitive advantage. Similarly, if it can produce a more powerful and beautiful car for the same price it will also have a competitive advantage. Simply put, the company must be able to do something that sets it apart from its competitors.

2.    The competitive advantage must be sustainable

As long-term investors, the last thing we want is to buy a company that loses its competitive advantage, thereby diminishing its profit-making ability and causing the share price to plummet. Instead, we want to ensure that it is sustainable and is going to remain intact indefinitely.

The best example of a company with a sustainable competitive advantage is The Coca-Cola Company. The Coca-Cola Company was incorporated in 1892 to produce the sweet fizzy drink – first developed by a pharmacist – that has become the world’s most recognised brand.

Today, almost 120 years later, The Coca-Cola Company is still going strong and is one of the most sought-after stocks on the New York Stock Exchange. Coca-Cola’s competitive advantage has proven its sustainability over the last 100 years.

This can be ascribed to:

 

  • The secret recipe for Coca-Cola, which arguably tastes better than other cola drinks.
  • Their ability to continue developing new products and re-inventing old ones – Coca-Cola currently offers over 400 brands in 200 markets worldwide.
  • The world’s most comprehensive distribution system has made Coca-Cola accessible to billions of people worldwide. Coca-Cola is often available in ample supply to people in areas where other consumer goods companies would never consider delivering their products. The African continent is an excellent example – it’s fairly common to see a small shop selling cold Coke in the middle of nowhere.
  • Coca-Cola’s production techniques are so well developed that it costs a fraction of the selling price to manufacture their product, resulting in high profit margins.

The Coca-Cola Company is the kind of company we’re looking for – a company that will hopefully keep going forever. Such companies have a low risk of going bust or getting taken out by a competitor, and the chances that profits will dry up are slim.

3.    The competitive advantage must be relevant

The relevance of competitive advantage is often overlooked by investors, but is probably the most important of all the characteristics. Simply put, a relevant competitive advantage is one that aids in achieving the goal. For investors, this goal is a high return on capital and profit growth.

Beware of buying shares in a company simply because it has a competitive advantage. If the company cannot convert their advantage into consistent exceptional returns on capital, then rather find some other shares to buy. There are countless examples of companies that possess a special technology or access to a scarce resource, yet the other parts of the business function so poorly that they cannot convert it into something meaningful for the investor – profit. In conclusion, don’t look at competitive advantage in isolation – make sure it is converted into financial return.

Examples of competitive advantage:

  • Brand equity – Having a strong brand means customers think favourably when coming into contact with that brand. Coca-Cola is once again the best example of brand equity in that it is the most recognised brand in the world. When evaluating a company’s brand equity, be sure to make a comparison with the brand equity of competitors. In South Africa, Five Roses Tea may have a good brand, but Joko and Lipton are also strong brands. So Five Roses’ brand may not be as much of a competitive advantage as one might think.
  • Barriers to entry – High barriers to entry make for an excellent competitive advantage. In Coca-Cola’s case, the cost of setting up manufacturing, bottling equipment and distribution is very high and that capital outlay deters many potential competitors from entering the market. In South Africa the cell phone industry has high barriers to entry. This is due to the large capital outlay required to set up a cellular network, as well as the cost and difficulty in acquiring a cellular license.
  • Cost advantages – If one company possesses a machine, a process or technology that allows it to produce a similar product at a lower cost, it may have a significant competitive advantage. Be sure, however, to critically ask whether competitors will be able to acquire the same machine, process or technology – if competitors can do so, there wouldn’t seem to be any sustainable benefit to the company.
  • Distribution – As previously discussed, being able to deliver products to all potential customers on demand is a massive competitive advantage. In South Africa, South African Breweries (SAB) relies heavily on its distribution system to townships and rural areas, where it sells over 70% of all its beer. Until now competitors have not been able to compete with SAB in these areas because they simply don’t have the distribution network.
  • Innovation – Apple Inc., the developer of the IPod, is an excellent example of a company that has outperformed its competitors with superior technology and design. They are continually innovating new products and re-designing the outdated, which keeps them ahead of the pack. But beware of companies like these because they’re on a fast-moving treadmill – as soon as they run out of ideas or their technology becomes obsolete, they need to innovate something new. The technological landscape changes so fast and innovations become obsolete so quickly that these companies have to continually reinvent themselves to maintain their competitive advantage.

Conclusion

Before buying shares in a company, ask yourself what sets this company apart from its competitors. If there is nothing, move on to another company that possesses a competitive advantage. Always evaluate the sustainability of the advantage. And most importantly, assess the competitive advantage in relation to achieving a relevant goal – does the company make money?

 

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