Independent Financial Advice

Video Summary:  Companies can be evaluated on several aspects of their business including the firm’s competitive advantage over current or potential future competitors.  The four main factors utilized to define a company’s competitive advantage or “Economic Moat” are:

High Customer Switching Costs are the one-time expense or inconvenience a customer would incur to switch from one product to another.  The more customers are “locked in”, the more likely a company can pass along added costs to them without the risk of loser the relationship.  Consider the effort for a company to change their payroll system once it is installed.  Would a Paychex customer subject their company to the time, cost and hassle of changing providers to save a few dollars a month?  Not likely.  Would you go through the effort to change your Wells Fargo bank account to earn an incrementally higher interest rate on your balance?  Are you looking forward to changing your direct deposit, automatic mortgage and car payments, bill payment arrangements and learn a new online interface?         

The Network Effect occurs when the value of a good or service increases as more people use the product.  This is one of the more potent competitive advantages.  Consider Ebay, the online auction site…buyers are attracted to the site because of the breadth of items to be found…and sellers utilize the company because “that’s where all the buyers are!” 

Low Cost Production, often through economies of scale, bestows a tremendous advantage on companies.  They can either undercut their competitors on price…or price their products at the same level and generate greater profits.  Walmart is a notorious example of a dominant retailer that keeps it costs low.  Its size allows it to drive unusual efficiency throughout their system.  A lesser known “low cost producer” is USG, the most efficient company providing wallboard across the United States.  Despite operating in a mundane and cyclical industry, they have grown for decades as their cost advantage insures their survivability while the competition has terminally diminished. 

In assessing Intangible Assets, there are several types of competitive advantages including brand names, intellectual property rights, government, a unique company culture or geographic advantages that company may benefit from:

Brands – Not all brands are created equal.  The differentiating factor can be determined by this question: Is the consumer willing to pay a higher price for the product or service?  Ford Motor Company and United Airlines certainly have long operating histories and recognizable brands.  However, in these examples, the value of the brand is not compelling.  On the other hand, some companies possess such valuable brands that they command a unique position in the marketplace.  For example, consider a Tiffany’s engagement ring, a Snickers® bar, Harley-Davidson motorcycles or Johnson & Johnson Band-Aids®. 

Patents - Allow a company to recoup the research and development costs associated with developing that product which provides a monopoly position.  Patents are for a limited time and companies that rely on patents for their competitive advantage should develop a pipeline of products to minimize the impact of future expirations.  

Government Licenses or Approvals - If a product or service requires a license or approval by a government agency to operate, existing companies in the industry benefit from the barrier of entry by other firms, thus creating a competitive advantage.

To learn more, you may find it helpful to read our other articles about the traits of successful investors, how investor behavior is a key determinant to long term results or thinking outside the style box.  If you have specific questions about your current portfolio or retirement planning, please contact us for a complimentary consultation.  You can also learn of new articles if you Subscribe to Independent Financial Advice by Email