When searching for the right stock, one of the most important factors to consider is the “edge” a company has over the competition. That is, what makes it special? Does it have a spectacular product, outstanding brand recognition, a favorable cost structure, or is it something else? In addition, it is critical to understand how sustainable that edge is - if a company owns a drug patent that expires in a year, that certainly doesn’t qualify as “durable”. Warren Buffet put it best when he described companies that have a durable competitive advantage as having a “wide economic moat”. That is, think of the business like a castle: the bigger the moat, the better you fare when under siege. We’ll take a look at some of the different types of moats below.
The Benefits of High Switching Costs
When it comes to customers, keeping them from leaving and becoming customers of the competition is the name of the game. This is where “switching costs” come into the picture. That is, the higher the cost of switching to another provider of the same good or service, the bigger advantage a company has.
For example, software company SAP makes complex software that businesses use to manage everything from purchase orders to human resources. Implementing this software across a large enterprise can be quite an investment from both a time and monetary perspective. So, needless to say, the thought of having to uninstall it, purchase another package from the competition, and install it again would have any CEO pulling his hair out. So, the customer would rather stick around than switch providers (even if the incentive is large).
Barriers to Market Entry
Barriers to entry exist when firms who wish to enter a market cannot because entry costs are prohibitive. For example, being able to charge less for the same product is a huge advantage which larger, existing companies have. This is due in part to the effects of “economies of scale”. That is, once a company grows to a certain size it begins to benefit on everything from lower costs of materials (since it buys from suppliers in larger quantities) to a lower cost of capital (interest rates). As a result, the firm can charge less for a given product and maintain the same profit margin. Economies of scale are often referred to as “comparative advantages”.
Brand Recognition
Brand recognition falls into the “differential” competitive advantage category. When a company is able to differentiate its product or service from the competition, it can become the provider of choice for its customers. A classic example (no pun intended) is Coca-Cola. Brand recognition for the company has become so strong that the term “Coke” is often used to refer to any soft drink (e.g., “They had Cokes and snack food at the party” is understood to mean that soft drinks and snacks were provided at the party).
The “Network Effect”
The Network Effect is kind of like a snowball on a ski slope: The more momentum it gains as it rolls to the bottom, the bigger the snowball gets. OK, so maybe that only actually happens in cartoons, but you get the basic idea. As more customers adopt and use a product, it actually becomes more useful to the entire customer base. A good example of this is the Apple iPod. As more and more consumers realized how easy the iPod was to use - they told their friends, and their friends told their friends. Further, a myriad of manufacturers started creating products to complement the iPod such as high fidelity radios, docking stations, and car adapters. All were built to accommodate the proprietary Apple connection and technology. This created a path of least resistance for consumers, since they knew that plenty of additional products were available that would be compatible with the device.