April 2023: Competitive edge is at the heart of company selection

The competitive edge of a business is at the heart of what we look for, when looking at investment opportunities for our portfolio. Most markets in the world are highly competitive and the high profitability of a business cannot be sustained unless the company in question, has a competitive edge over its peers.

There are many sources of competitive edge. We list down the important ones here:

  1. Economies of scale: A very large extant market share can allow a company to spread its overheads over a larger base and hence allow it a competitive advantage. Amazon’s “scale economies shared” mantra is a very good example of this. By sharing the economies with its customers, Amazon continues to be the cost leader and a dominant player in its business.
  2. Intangibles : Examples of intangibles are a) Brands b) Patents c) Licenses
    1. Brands: A brand provides an emotional connect with the customer. It usually translates into high market share and an ability to charge a premium over competitors. Companies who have a dominant brand should have high rates of profitability as measured by return on equity.
    2. Patents: This presents itself as a technological edge, as competitors are unable to copy the company’s innovations. A technologically superior product or process can also impart a competitive edge to companies. However, in a highly competitive world, this edge can fade unless the company innovates continuously.
    3. Licenses: Licenses or other regulations can restrict the number of players in a business – examples of this are credit rating agencies, depositories, etc. These can create monopoly, duopoly or oligopoly situations which can result in very high profitability that can be sustained over long periods. There is however the ‘stroke of the pen’ risk in this – at any future point in time, for some reason or the other, the license can be taken away.
  3. Switching costs: Switching cost is the cost associated with switching from one supplier to another or one brand to the other. These can be monetary, psychological, effort-based or time-based. This hold on the customer can be a source of competitive edge.
  4. Network effects: This is a situation in which the value of a product, service or platform grows as the network grows and can impart a competitive edge to a company. For example, a social networking site, or a dominant stock exchange.

Whether a business has a competitive edge or not, is often debated by investors. The true test of whether a business has a competitive edge or not are a) Does the business have high return on capital employed? b) Are the relative market shares of the different players in the industry stable over time?

While judging the competitive edge of a business, it is important to think about how the competitive edge is strengthening or weakening. The best companies are razor focused on increasing their competitive edge and they keep working at it continuously.