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 ShareCompanies 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 ManagementHaving 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 EffectThe 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 PatentsTrademarks 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 StructureBeing 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 CostsAnother 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.