Taking the definition from Wikipedia, a competitive advantage occurs when an organisation acquires or develops an attribute or combination of attributes that allows it to outperform its competitors.
In 1980, Michael Porter identified five competitive forces that shape every industry and that are used to analyse a company's corporate strategy. Porter argues that these five forces – Threat of Substitutes, Bargaining Power of Buyers, Threat of New Entrants, Bargaining Power of Suppliers and Industry Rivalry – can affect the competitive environment. But, unlike Porter and many of his followers, Bruce Greenwald does not think that those forces are of equal importance. In his book entitled "Competition Demystified", Greenwald argues that one is clearly much more important than the others. That force is barriers to entry - the force that underlies Porter's "Threat of New Entrants".
In business, profitable industries that yield high returns will attract new firms. In other words, if demand conditions enable any single firm to earn high returns, other companies will notice the same opportunity and flood in. This results in new entrants, which will eventually decrease profitability for all firms in the industry. Unless the entry of new firms can be blocked by the incumbents, the abnormal profit rate will trend towards zero (perfect competition), meaning that no returns above the costs of the invested capital can be achieved. If a company is to generate higher profits over longer periods of time, it has to have some kind of relative competitive advantage.
According to Greenwald, either the existing firms within the market are protected by barriers to entry, or they are not. No other feature of the competitive landscape has as much influence on a company's success. He differentiates between three kinds of genuine competitive advantages:
1. Cost advantages that allow the company to produce and deliver its products or services more cheaply than its competitors.
Most frequently, cost advantages are due to proprietary technology that is protected by patents or by experience (know-how). That technology must be produced within the firm to be truly proprietary. Lower cost of labour (e.g. by locating production in China) may gain a temporary benefit over rivals who are slower to move, but the benefit soon disappears as others follow.
2. Customer captivity that is based on habit, on the costs of switching, or on the difficulties and expenses of searching for a substitute provider.
High customer captivity will exist when customers perform frequent and virtually automatic purchases of the same brand (e.g. drinks, cigarettes) simply by habit. This behaviour generally relates to a single product, not to a company's portfolio of offerings. High switching costs, defined by the time, money or effort it takes to find and replace one supplier, will also add to customer captivity.
The latter might be inherent to the nature of the product, like software, but it can also be "created". Customer loyalty programs (frequent-flier miles, affinity credit cards, and other rewards plans), have the same goal, keeping customers captive as switching costs increase. The famous Gillette strategy of selling the razor cheaply and then making money from the regular purchase of blades has been copied by other industries (e.g. printers and ink cartridges). Apple is constantly trying to increase the switching costs for their existing customer by enhancing the interconnectivity between the firm's devices and by offering applications that are not easily transferable. The network effect in social media is another illustration of high switching costs.
3. Economies of scale that lower the costs per unit as volume increases.
The competitive advantage of economies of scale depends not on the absolute size of the dominant firm but on the size difference between it and its rivals, that is, on market share. Furthermore, economies of scale can only exist if fixed costs (e.g. research & development, advertising & promotions, capital expenditure) represent a significant level of total costs.
If average costs per unit decline as a firm produces more, smaller competitors will not be able to match the costs of the large firm (even though they have equal access to technology and resources) unless they can reach the same scale of operation. The larger firm can be highly profitable at a price level where smaller competitors, with their higher average costs, lose money.
The global beer market is a good illustration of how economies of scale (in the form of market share) and profitability are closely linked. Let's take the example of Germany and the US. Both countries have well-known beer brands, both have highly automated production facilities, both are operating in a mature beer market and yet the leading company in each market has a very different margin profile. The chart below shows that the highly fragmented beer market in Germany leads to much lower profitability compared to a consolidated market like the US, where Anheuser-Busch commands a near-50% market share.
Market share and operating margin of the leading brewer in each country
Source: Plato Logic, Company data, JP Morgan estimates (2013)
Beer production is a very scalable business. Whereas initial fixed costs are high to build an automated production facility and to set up the business, the variable cost of producing an additional bottle of beer is minuscule. As the scale of the enterprise grows, the fixed cost is spread over more bottles and the average cost per bottle declines. The dominant company is entering a virtuous cycle where it is able to outspend its competitors, whether on research & development, advertising & promotions or capital expenditure.
By contrast, the variable costs at an airline company are very high and directly linked to each plane (e.g. crew, maintenance, fuel, cleaning, catering). A bigger fleet size does not meaningfully reduce the incremental cost for each passenger even taking account of better bargaining power with some suppliers. The airline business is therefore less scalable.
The highest barrier to entry might be achieved by the combination of economies of scale together with some customer captivity. Basically, as customers are not willing to switch to another product or service offered at the same price, the incumbent player can easily defend his market share just by matching the price of a new entrant. New entrants never catch up and stay permanently on the wrong side of the economies of scale differential.
Prefer local dominance to global presence
As mentioned before, economies of scale are not purely equal to size. Most competitive advantages based on economies of scale are found in local and niche markets, where either geographical or product spaces are limited and fixed costs remain proportionately substantial. Competitive advantages are almost always grounded in what are essentially "local" circumstances. If sales are added outside the territory, fixed costs rise and economies of scale diminish. The same is true when a company adds a product line.
Greenwald argues that there are only a few industries in which economies of scale coincide with global size (e.g. semiconductors, software, commercial airframe industry). Most other large companies focus on the relative market share in the regions they operate in (e.g. Coca-Cola). The key is to "think local". These companies do not dominate in every country, whereas companies like Microsoft or Boeing are global product line dominators.
"Growth" might lower barriers to entry – "Change" will make them obsolete
Interestingly, Greenwald claims that growth of a market is generally the enemy of competitive advantages based on economies of scale, not the friend. The strength of this advantage is directly related to the importance of fixed costs. As a market grows, fixed costs, by definition, remain constant. Variable costs, on the other hand, increase at least as fast as the market itself. The inevitable result is that fixed costs decline as a proportion of total cost. This allows competitors to come into that market more easily than would be the case in a slower growing market.
Online shopping might be a good example of these fast-growing market segments. Fixed costs are high in terms of creating the platform and investing in research & development, whereas variable costs are relatively low. Such businesses are very scalable, but the growth in these markets is very high and allows new entrants to pay for these fixed costs as they can spread them over a fast growing customer base.
Change is a major threat to competitive advantages. As Warren Buffett puts it: "Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it is the lack of change that appeals to me. I don't think it is going to be hurt by the Internet. That's the kind of business I like." Porter addresses this risk in his "threat of substitute products or services". Eastman Kodak is a very famous example of a once dominant company that fell victim to change, as digital became the new norm in photography. The strongest competitive advantages will be worthless if the business segment in which the company operates is morphing.
BL-Emerging Markets and "Business-Like Investing"
At BLI, we take an entrepreneurial approach when it comes to investing in equities. With this mindset, we are taking a financial stake in a business, rather than buying shares. As entrepreneurs, we want to participate in the long-term success of a company and therefore need to make sure that its businesses will be able to compete successfully and remain profitable for the years to come. Analysing the competitive advantages of companies is therefore a cornerstone of our investment process.
When applying this approach to emerging markets, we come across numerous companies that do not fulfil our criteria of competitive advantage. By definition, emerging markets include a large number of:
- Companies offering commoditised products or services. They essentially manufacture identical products to price-sensitive customers and face an intense struggle for economic survival.
- Companies lagging in terms of technological know-how compared to their developed market counterparts. They do not have the scale or expertise to be leading edge in terms of research and development.
- Pure assembling companies whose single competitive advantage is cheap labour. While some of these companies are very effectively managed, the risk of their key advantage getting copied by competitors or eroded by rising labour costs is too high. Furthermore, they generally tend to be the "price takers" and the weakest link within the whole production chain.
- State-owned-enterprises (SOEs) or companies with a high degree of political interference. Some of these companies enjoy competitive advantages emanating from governmental interventions (e.g. authorised monopolies, subsidies, financing) and might be very profitable for the time being. But the competitive advantages are not inherent to the company and therefore not sustainable in the long-term.
In the BL-Emerging Markets fund, we therefore hold many locally dominating companies in terms of market share that enjoy sustainable competitive advantages. Most companies have been present for decades in their home countries. They have been building economies of scale, growing brand equity, perfecting their distribution networks and catering to local preferences. Rather than a large number of global dominators, emerging markets tend to have many local ones that are highly profitable as they have built their barriers to entry over time.
References:
"Competition Demystified: A Radically Simplified Approach to Business Strategy"; Bruce C. Greenwald, Judd Kahn; 2005
"Competitive Strategy"; Michael E. Porter; 1980
