Diamond in the Rough – Part II

Determining a Competitive Advantage:

Here’s a helpful list of what a C.A. should/does accomplish:
1. Achieve a cost advantage
2. Initiate a value creating process
3. Differentiate itself from competition
4. Never be easily replicated
5. Remain distinct
6. Proprietary in nature

Points 1 & 2 involve the same principles; a competitive advantage should provide some form of cost advantage through economies of scale, product/service pricing or be a part of a value creating process (customer relationships, IT, risk management, etc). If a company holds a value creating process over its competition – it can easily charge the same amount while enjoying the lower expenses. Both companies may sell their product for $2 each, but the one holding a distinct C.A. may have an average cost for that product which is 50% lower than its nearest competitor. Higher margins = higher profitability.

Point 3 involves what every company strives to achieve with brand strategies – the development of a perceived or material premium that consumers associate with their product or service. With a C.A. this is achieved most often through the use of trademarks, patents or access to technology that parallels the size and scale of competition. Consumers are willing to pay a specific quantifiable premium, travel longer distances or be more accommodating with speed of delivery for tangible or perceived quality. Brand loyalty is often an established and secondary side effect that comes along through this benefit.

Point 4 is when a company’s advantage is out of reach of its competitors through the sheer capital cost of replicating such an advantage. Obstacles frequently are formed from patents protection, intellectual property or established agreements through legal contracts (foreign governments, etc) that provide obstacles to competitive entry into the market or maintain/diminish the market share of competitors.

Point 5 compares a company’s ability to hold its own against all and any competition. The consumer’s perception of the product or service, although possibly the same as a competitor, is different enough to form persistent & loyal purchasing activity over an extended period of time. An example here is the no-name brand advantages in cost to premium brands of the same product. Although they may be the exact same product, the packaging and marketing of the product will always cause an emotional purchase in perceived quality with a dominant brand.

Point 6 is simply the element of ownership that a company benefits from with technology or some other legal protection that secures the advantage.

Of all the points mentioned above, there are three main categories for a competitive advantage that I use:
– Operational Excellence
– Product Leadership
– Customer Intimacy

Operation Excellence is the efficiency of a company’s operations and processes that allow it to operate at a lower cost than competition. Examples include efficiencies through supply chain management (WMT), strategic placement of operations (MCD) or product innovation (IBM).

Product Leadership is the technology or process that allows the highest quality good, product or service to reach the market. This advantage often stems from the application of patents (process technology), copyrights or trademarks owned by companies.

Customer Intimacy is the rarity that is often overlooked or misattributed to a company that does not hold any C.A. These select companies know and understand their customers in extraordinary ways by actively eng aging with them at the point of purchase and through concentration on the target markets’ needs. They have the distinct ability to anticipate needs/wants of the target market efficiently and often have the brand awareness and loyalty to charge a competitive premium over their competition. These companies strive aggressively to create the brand loyalty that others rarely attain, protect that brand and focus on quality with astonishing precision: PG, SBUX, KO, AXP, BUD, etc.

My last point deals with the difference between a Competitive Advantage and Sustainable Competitive Advantage: the time through which a company can benefit. Although many advantages are created, it’s only a short period of time before the competition reverse engineers, copies or develops new advantages that make prior ones obsolete (competitive advantage period). If a company is able to attain operational excellence, product leadership and customer intimacy – then most often you’ve found your sustainable competitive advantage. Patents expire, land can be lost or sold and costs or inefficiencies can develop through the manufacturing process over time as new technology is created. When a company holds all three essential categories for a C.A. then I’ve willing to invest heavily into the stock based on those principles regardless of short-term factors that cloud the markets views on the prospects or fundamentals.

Reflection – Why does this matter for investing?
– Any advantage has the potential to crush your competition over time
– Lower costs equal higher margins equals higher EPS
– Provides a margin of safety against competition
– Management of a Sustainable or Competitive Advantage has a strong history of indicating quality management
– If you EVER find an undervalued company with a true S.C.A…back up the truck