Competitive Advantages
Date Added: March 26th,
2006
By Chris Stallman
| E-mail
Investors
often fall into the trap of only researching quantitative factors
in evaluating potential investments. However, it's important
to remember that a share of stock also represents a share of a business,
so you should be interested in how the company as a whole performs.
Successful companies come in all shapes and sizes but
they tend to have one thing in common: they all have some significant
competitive advantage. This advantage allows them to ward
off competitors and stick around for a long period of time.
Why are
competitive advantages so important? Well, mostly because
they can ensure that a company earns excess returns for a longer
period of time. By increasing the life of a company, the value
of the stock is enhanced.
Competitive advantages don't just come in one form.
Also, companies can have multiple competitive advantages; in fact,
the more the merrier. For the purpose of this article, we'll
outline five areas where companies can stand out and ensure their
long-term success: establishing market share, strong brand management,
enjoying the network effect, having certain trademarks and patents,
being cost effective, and creating high switching costs.
Market Share
Companies with significant market share create a problem
for competitors because these competitors will have to rely on "stealing"
market share away from the competition; they can't just create business
out of thin air. After all, would you want to create a cola
product if you knew you'd be going head-to-head with such goliaths
as Pepsi and Coke? It's also great for the company because
it means its products are well-known and well-received in the marketplace.
Market share can be imposing but if the industry has significant
profit potential for new entrants, market share can be eroded.
Strong Brand Management
Having a strong
brand can ensure a company's long-term success and it also allows
companies to earn healthy profits because their brand allows them
to charge a price premium. For example, analysts never thought
Starbucks would be successful in charging premium prices for a commodity
product like coffee. However, the company has been wildly
successful thanks in large part to its strong brand management.
Strong brands tend to create the longest-lasting competitive advantage.
Network Effect
The network effect occurs when a product creates demand
from users, which then enhance the product. For example, eBay
is a company that benefits from the network effect; by attracting
more sellers, it has in turn attracted more buyers, establishing
a dominant market share. The network effect is fairly uncommon
but it can be extremely lucrative when it occurs.
Trademarks and Patents
Trademarks and patents can be sources of competitive
advantage for some companies, although it's not too common.
One example is ShuffleMaster--the company creates auto-shufflers
that are used in many casinos. The company stays on top of
technology and keeps close reigns on its patents to ensure competitors
don't easily enter the market. But the company is growing
another area of its business: it creates new casino games and then
licenses them to casinos, allowing it to collect a huge royalty
check each month. These patents and trademarks have given
ShuffleMaster a great outlook.
Cost-effective Structure
Being a low-cost producer has some advantages, although
they're often short-lived. By shaving all possible costs,
a company can "undercut" its competitors and offer compelling prices
on its products, thus attracting many customers. The obvious
example of this is Wal-Mart, who has taken its cost cutting to the
furthest limits, which is responsible for the company's status as
the world's largest retailer.
High Switching Costs
Another
way to earn excess returns and lengthen a company's life is to install
switching costs into the business model. For example, wireless
telephone companies require you to enter into contracts that restrict
your ability to change service providers. Some software companies
also have high switching costs because the learning curve to learn
a new software program is often steep.
These advantages are important to keep in mind when
seeking out your next investment opportunity. By investing
in companies with significant competitive advantages, you're safeguarding
yourself against some threats.
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