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Different Types of Competitive Advantages in Companies and How You Can Find Them

Billionaire investor Warren Buffett is someone who loves to invest in companies that have competitive advantages, or what he would call an economic moat. Competitors of the companies Buffett invests in usually find it hard to knock them off their market leadership positions.

In a December 1999 article published in Fortune Magazine, Buffett said (emphasis is mine):

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

Investor Pat Dorsey wrote in his book The Five Rules for Successful Stock Investing that an economic moat or competitive advantage can come about due to a few factors. They are:

  1. Real product differentiation through superior technology or features
  2. Perceived production differentiation through a trusted brand or reputation
  3. Being a low-cost producer
  4. Locking in customers by creating high switching costs
  5. Locking out competitors by creating high barriers to entry or success

Many of the companies Buffett owns, either fully or partially, exhibits at least one of the factors above. Furthermore, many listed companies that have businesses and stock prices that do well over the long-term have at least one of the competitive advantages mentioned.

To know if a competitive advantage is sustainable, the investor has to identify what the source of the advantage is and then investigate what the company is doing to widen its economic moat. Is the company resting on its laurels or is it constantly trying to find ways to strengthen its competitive advantages?

This can be known by looking at the company’s annual reports, announcements made, and/or general news surrounding it.

If a company is widening its moat, some evidence will also show up in its financials, such as its gross profit margin, net profit margin, and return on equity (ROE). The gross profit margin, net profit margin and ROE will generally be increasing or at least be kept stable over the years if the company has been strengthening its competitive advantages.

If the gross profit margin of a company is 40%, it means that for every dollar of revenue earned, 60 cents is used to produce the goods or services sold and 40 cents is what remains after these expenses are deducted. A high and increasing or stable gross profit margin over time is a sign that a company has (1) a sustainable competitive advantage, (2) pricing power, and (3) a business that is not based on selling commodity-like products or services.

As for the net profit margin, it tells us how a company’s managers and business operations are performing. If the net profit margin of a company is 20%, it means that the company earns 20 cents in profit for every dollar of revenue it brings in after deduction of all expenses. A rising net profit margin over the years would indicate that the company is becoming more and more efficient at translating sales into actual profit.

Coming to the ROE, it reveals how much profit a company generates with the money shareholders have invested in it. A growing ROE is an indication that the company is increasing its ability to generate profits from shareholders’ capital. It’s worth noting though, that a company can increase its ROE by taking on more borrowings – heavier borrowings tend to increase the financial risks faced by a firm, so that’s something to keep an eye on for investors.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.