Competitive Advantages

Why this matters

When a business earns high profits, competitors notice. In his 2007 letter to shareholders, Warren Buffett described this as competitors repeatedly attacking any business "castle" that earns high returns, and said a truly great business needs an enduring "moat" to protect those returns.¹ A competitive advantage, or moat, is whatever keeps competitors from taking a company's profits. Without one, high profits tend not to last.

The main kinds of advantage

Buffett's own examples of strong barriers include being the low-cost producer and owning a powerful worldwide brand.¹ Patents have a built-in end date: in the US, a utility patent lasts up to 20 years from the date the application was filed.²

STU Corp's advantage

STU Corp's cartridges click into its systems with a patented connector, so for now only STU Corp cartridges fit. Once a household installs a system, it's effectively locked in. That's a switching cost: changing brands means buying and installing a whole new system. It's the reason the razor-and-blades model from Business Models and Revenue Streams works.

The numbers suggest the advantage is real. STU Corp raised its subscription price from $150 to $160 a year, and its subscribers still grew from 500,000 to 625,000. Raising prices without losing customers is called pricing power, and it's one of the clearest signs of an advantage.

How to spot an advantage in the numbers

• High margins that last. One good year proves little. Margins and returns that stay above competitors' for many years suggest something is protecting them.
• Steady or rising market share, without buying it through price cuts.
• Price increases that stick, like STU Corp's subscriptions.

STU Corp's connector patent expires in three years. After that, other companies can legally sell compatible cartridges. Suppose they take 20% of STU Corp's cartridge sales in stores and marketplaces. This is a hypothetical scenario using this year's numbers.

$ millions	Amount
Cartridge sales in stores and marketplaces	140
Sales lost to compatible cartridges (20%)	28
Gross profit lost, at a 65% gross margin	28 × 65% = 18.2
As a share of STU Corp's total gross profit of 200	9.1%

STU Corp could instead cut its cartridge prices to keep customers, but a price cut comes almost straight out of profit, because the cost of making each cartridge doesn't change. Either way, the patent's end date is something an investor would want to know about.

Advantages wear away

Buffett's same letter warns that business history is full of companies whose moats turned out to be illusory.¹ Patents expire, tastes change, new technology makes old strengths irrelevant, and competitors copy what works. The useful question isn't only whether a company has an advantage today, but how long it's likely to last, and what would end it.

Key takeaways

• A competitive advantage, or moat, protects a company's profits from competitors.
• The main kinds are brands, switching costs, network effects, cost advantages, and patents or licenses.
• Look for margins that stay high for years, steady market share, and price increases that stick.
• Advantages erode. US utility patents last up to 20 years from filing, and STU Corp's key patent expires in three years.

Check your understanding

Which of these is the clearest example of a switching cost?

1. A company runs more TV ads than its rivals, so customers remember its name when they shop.
2. To change accounting software, a business would have to move years of records and retrain staff.
3. A company buys its materials more cheaply than its rivals, because it orders in larger amounts.

After STU Corp's patent expires, which numbers would best show whether its advantage is holding?

1. The number of employees, since a growing staff shows demand.
2. Sales of filter systems, which are what customers buy first.
3. Cartridge sales and STU Corp's gross margin on them.

What's next

An advantage produces profits. What happens to those profits next is up to the people running the company. The next lesson, Management and Capital Allocation, covers how to judge their choices.