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Archive for March, 2010

As previously discussed, I think the most sustainable competitive advantages are, in descending order:  

  1. Economies of scale combined with customer captivity;
  2. A network effect;
  3. A government licence;
  4. Patent protection; and,
  5. Customer captivity[1].

In this post I will explain when I think a business has an economies of scale competitive advantage.  

When does a business have an economies of scale competitive advantage?

A business has an economies of scale competitive advantage when:  

  1. It has a much larger market share with a product or service than its competitors in a:
    • Geographic area; or,
    • Product or service space (for example Intel with computer CPU’s); and,
  2. Fixed costs make up a large share of total costs.[2]  

If this occurs the dominant business’s average cost per unit will be lower than its competitors. Its smaller competitors will have higher average costs because they cannot reach the same scale of operation. The dominant business’s lower average cost per unit means it can keep competitors at bay by using one or more of the following tactics. It can have:   

  1. A lower price for its product or service than its competitors; [3]
  2. A more technologically advanced product or service than its competitors (it can spend more on research and development); or,
  3. Better marketing for its product or service than its competitors (it can spend more on advertising and sales promotion).[4]

However, as Professor Greenwald points out, pure size is not the same as economies of scale.[5] It is the share of the relevant local market rather than size by itself that creates economies of scale. Economies of scale coincides with large businesses in only a relatively few products, for example, in Boeing’s airframes, Microsoft’s operating systems, and Intel’s CPU. Even these global businesses are dominant in only a few product lines, and are, thus ‘local’ in the sense of ‘product space’.[6]  

Why a business with an economies of scale competitive advantage also needs some customer captivity

Economies of scale by itself is not enough for a business to keep a competitive advantage. If a business has only an economies of scale advantage, its competitors will be able to take some of its customers and will eventually be able to capture enough market share to remove its scale advantage. The business with the economies of scale advantage needs to be able to keep its larger market share. It does this by keeping its customers. The way to do that is to have at least a mild form of customer captivity.  

How a business keeps this economies of scale competitive advantage

The overwhelming priority of a business with an economies of scale advantage is to protect its market share and, thus, keep its large size relative to its competitors. It can do this by matching the moves of an aggressive competitor price cut for price cut, new product for new product, niche by niche. If it does, then its customer captivity will secure its greater market share. Its competitor’s average costs will be higher than its average costs at every stage of the struggle. While this will reduce the profit of the business with the economies of scale advantage, its competitors will usually make very low returns on capital, or a loss, and will eventually stop competing.  

Another priority for a business with an economies of scale advantage is to increase this advantage. The best way to do this is to increase the proportion of fixed costs relative to the variable costs that is needed to produce the product or service. For example, the business can spend more on research and development to speed up product development cycles, or it can increase the number of features with the product or service.  


  

[1] Customer captivity refers to how a business has ‘captured’ a customer. This can be because the customer will have high costs in ‘switching’ to an alternative product or service provider, or high costs in ‘searching’ for this alternative, or simply because the customer has developed a strong ‘habit’ in buying the product or service. I will discuss this form of competitive advantage in much greater detail in a later post.  

[2] Fixed costs can be capital investments on plant, equipment, or information technology, or it can even be operating expenses like advertising or managerial supervision. See p32, ‘Measuring the Moat, Assessing the Magnitude and Sustainability of Value Creation’, Michael Mauboussin, 16 December 2002.  

[3] The dominant business can be highly profitable at a price level that leaves its smaller competitors, with higher average costs, losing money.  

[4] Even if its competitors can spend the same proportion of revenue on R& D, or sales promotion, they cannot sustainably spend the same dollar amount as the dominant business.  

[5] See, ‘All Strategy Is Local’, Bruce Greenwald and Judd Kahn, Harvard Business Review, 2005.  

[6] Also a business selling services is more likely to have an economies of scale competitive advantage than a business selling products, because services are usually provided ‘locally’. See, ‘All Strategy Is Local’, Bruce Greenwald and Judd Kahn, Harvard Business Review, 2005.

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Why normalising a business’s earnings is so important

A crucial part of valuing a business is determining what is the likely future earnings, and earnings growth, of the business.[1] I think the best way to do this is to simply look at the business’s historical earnings data and make a naive prediction about what I think its earnings and earnings growth are likely to be in the future. However, when I make these estimates it is critical that I do not overestimate the business’s future earnings because its historical earnings have been boosted by an economic boom, high secular profit margins or some other reason. Therefore, I must attempt to normalise the business’s earnings when making these estimates. Robert Bruce explains how important normalising a business’s earnings is when he said in 2007 (pre the credit crunch): 

“Perhaps the most surprising thing to me is the inability of even market professionals to adjust for profit margins. People will talk about how the P/E ratio is reasonable at 19 times without mentioning that it is 19 times the highest profit margins ever recorded. The least we can do, as professionals, is to normalise between economic boom and economic bust, between low profit margins such as those in 1982 when they were ½ normal and very high profit margins such as those of today. A lot of people think profit margins can be sustained. Profit margins are the most mean-reverting series in finance.”[2]    

But can I normalise the business’s earnings? 

Before I normalise a business’s earnings I have to decide that I can normalise them. This is a very important decision.[3] As Joel Greenblatt says: 

“To figure out what (a business) is worth requires you to figure out what are normalised earnings down the road… Most of the time you will not be able to do that. Maybe the business is too uncertain or too tough or you do not really know (my emphasis). But if you can do that in the businesses you do know, than that is the whole analysis.”[4] 

If I think the business’s earnings can be normalised, I will use the following process to do so. I will normalise the business’s earnings for economic cycles, product life cycles and commodity cycles. 

How I normalise a business’s earnings

I largely follow the normalising process outlined by Richard Pzena.[5] I think Pzena has an excellent way of using a business’s earnings history to make a normalised earnings forecast. He makes a naive earnings prediction after looking at the main drivers of the business’s earnings, namely its unit demand and operating margins over 10 years. An example of how Pzena does this is when he normalised Hewlett Packard’s earnings: 

“Hewlett-Packard has grown its revenues 10.6% per year over the last 10 years. Its margins have averaged 8.1% over the last 10 years, and 4.5% for the last three years. We use an average weighting to come up with a naive margin projection. Our naive margin projection in this case is 6.7%. So if the business continued to grow at 10% a year and produce 6.7% margins, five years from now it will earn $2.40 a share.”[6] 

However, the one major problem with this approach is that the business’s 10 year earnings history may have been during a period of economic boom or during a period when there were no recessions. When I normalise a business’s earnings I try to adjust for economic cycles. 

How I normalise a business’s earnings for economic cycles[7]

Trying to normalise a business’s earnings for economic cycles is difficult because some businesses may be too young to have been through a recession (unlike most of the developed world the last severe recession in Australia’s was over 17 years ago). In addition, even if a business has been through a recession a future recession may be of a different length and severity as previously. Despite these problems, I think the following approach is a reasonable way to normalise a business’s earnings for economic cycles. 

If the business has not been through a recession in the last 10 years

I will use logic[8] to guess at the likely impact of a future recession on the business’s earnings. The following factors will influence this estimate: 

a) The length and severity of a future recession. I will assume, unless there are good reasons otherwise, that any recession will be of average length and severity; and, 

b) The business’s operational leverage.[9] 

If the business has been through a recession

I will normalise its earnings by mainly looking at the impact a previous recession had on the business’s earnings.   

How I normalise a business’s earnings for product and service life cycles

The earnings of some businesses will be cyclical, not just because of economic cycles but also because of life cycles for the product or service the business sells. For example, the Australian ‘bionic’ hearing aid manufacturer Cochlear has a life cycle with its cochlear hearing aid. Its earnings will increase when they bring out the latest version of their Cochlear hearing aid, and will fall as their product ages (and their main competitor brings out a newer product). If a life cycle affects the business, I will normalise its earnings by averaging its earnings over the life cycle. 

How I normalise a business’s earnings for commodity cycles

A business’s earnings may also be cyclical because they are heavily impacted by the price of a particular commodity. If this is the case, I will normalise the business’s earnings by assuming that the price of the commodity will be its 30-year price average[10], unless there are good reasons to do otherwise. 

How my normalised earnings estimates, and scenarios fit together

As previously discussed, I estimate an upside, central case and downside scenario for a business depending on what I think are the major risks for the business, or upside factors likely to affect the business. I do not include the risk of a recession, a change in commodity prices, or where the business is in its product life cycle, as risk or upside factors. I do this because I think it is easier to deal with these risks when normalising the business’s earnings. 


[1] I use this normalised earnings estimate in my valuation to estimate the ‘central case’ value for a business. 

[2] P4, ‘Robert Bruce Lecture Transcript’, ‘Value Investing Class’, Bruce Greenwald, Columbia University, March 27, 2007. 

[3] This problem is usually taken care of by only valuing businesses in my ‘circle of competence’. However, even if a business is within this ‘circle’ I may decide that I cannot normalise its earnings. 

[4] P7, ‘Greenblatt Special Situations Class Transcript’, Value & Special Situation Investment Course, Joel Greenblatt, Columbia University, November 30, 2005. 

[5] See P99, ‘The Market Masters: Wall Street’s Top Investment Pros Reveal How to Make Money in Both Bull and Bear Markets’, Kirk Kazanjian, 2005. 

[6] P99, ‘The Market Masters: Wall Street’s Top Investment Pros Reveal How to Make Money in Both Bull and Bear Markets’, Kirk Kazanjian, 2005. 

[7] I could try to protect myself from the risk of buying businesses with cyclically high earnings by buying index puts. I do not do this because they provide limited protection for any business that has more cyclical earnings than the average of businesses in the index. 

[8] I must never use inductive logic without deductive logic. As Taleb explains: “the following inductive statement illustrates the problem of interpreting past data without logical method: I have just completed a thorough statistical examination of the life of President Bush. For 55 years, close to 16,000 observations, he did not die once. I can hence pronounce him as immortal, with a high degree of statistical significance.” See P103, ‘Fooled by Randomness’, Nicholas Taleb, 2001. 

[9] A business has operating leverage when its cost structure has a high proportion of fixed costs. Having a high proportion of fixed costs means the business’s profit margins will be highly sensitive to changes in sales volumes. For example, for every 10% increase in sales, the business will report a greater than 10% increase in earnings and vice versa. 

[10] This is arbitrary period chosen because it is likely to capture a commodity price cycle. However, I will shorten or lengthen this period if I think 30 years does not capture the particular commodity’s price cycle.

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Why my valuation model assumes a business will only have profitable asset growth for five years  

Searching for the ‘Holy Grail’

I think the most difficult part of valuing a business is deciding what value, if any, to attach to the business’s earnings growth prospects. In this post, I discuss how I value a business’s potential growth. This post is unavoidably quite technical.   

Why profitable asset growth is important to a business’s valuation

As previously discussed, a business’s earnings growth will only be profitable to me if the business earns more on these new assets than the minimum return I need to provide the capital (my discount rate) to fund this growth. For example, when a business’s ROIC is equal to my discount rate, asset growth by the business will have no value to me because the return the business will earn on the new capital will just equal the opportunity cost to me for letting the business use my capital. Thus, while the business has increased in size, simply because it has more assets, the net return to me is zero.   

When a business’s ROIC is lower than my discount rate, asset growth by the business will actually destroy value for me. This is because the business earns less on the new assets than the opportunity cost to me for letting the business use my capital.   

Only when a business’s ROIC is higher than my discount rate is asset growth by a business profitable to me. It will be profitable because the business earns more on the new assets than the opportunity cost to me for letting the business use my capital. As a shareholder, I will receive these additional earnings. I will receive these additional earnings directly, either by dividends, or indirectly, by the business increasing in value because it has retained all or part of these earnings.     

This is a very important point for investors to understand. Many investors think earnings growth by a business is unambiguously good. It is not. In many cases earnings growth will reduce the business’s value.     

What is a business worth without asset growth

A business can be highly profitable and, thus, have a very high ROIC[1] (well above the average return for a commodity business) without asset growth, however, as Costantini points out:   

“If assets do not grow and are not expected to grow, then the asset multiple of any business, however outstanding it is, should be in line with its relative return” (that is its ROIC/Discount Rate).[2]    

In other words if a business cannot grow its assets the maximum the business should be worth is its Earnings Power Value (Earnings/Discount Rate). This is equal to the business’s replacement value multiplied by the business’s ROIC/Discount Rate.   

Why my valuation model assumes a business can only have profitable asset growth for five years

How do you value growth?

Costantini says:   

“We recommend that any valuation work should always start without any reference to growth … it is always possible to refine the analysis further. However, even if one did nothing else and selected stocks on that basis, the worst that could happen is that genuinely high-growth businesses would be more expensive than they should. Granted, this could be an opportunity cost, but would never lead to a situation where growth stocks are entered at the wrong price in a portfolio or, worse, some stocks are taken for what they are not… Yet we know that growth in assets significantly influences the valuation of high return (ROIC)[3] businesses in particular. There will be, therefore, certain instances where it is necessary to (incorporate growth).”[4]   

Therefore, asset growth is arguably important only for valuing high ROIC businesses. That is Costantini’s view. He says:   

“Growth only really matters for the valuation of the smaller universe of high CROCI[5] (ROIC) businesses… the reason why economic growth only matters to the valuation of high CROCI businesses is easily explainable… only high CROCI businesses can fund growth internally.” [6]   

So what evidence is there that asset growth is only important for high ROIC businesses? Costantini refers to a study by Tobin, which showed the impact of asset growth on the market price of businesses. The study found that:   

“The effect of growth on valuation was marginal, up to 10 times less important than that of economic earnings… the overwhelming marginal factor contributing to the asset multiple is CROCI (ROIC)… this measure accounts, on average, for 77% of the q ratio[7] (asset multiple) in the US from 1989 to 2004. In contrast, growth has a mere 12% weight in the makeup of the q ratio.”[8]   

In fact Costantini believes investors do not usually attach high asset multiples to even high asset growth businesses. He says:   

“At some point, additional growth does not produce additional valuation. Investors in aggregate know better. They know that businesses routinely attempt to get near the sun (i.e. grow very fast) and burn their wings, mainly by accumulating too many financial liabilities. They also know that a real trend growth of more than 10% per annum is already close to three times GDP, which may be called breakneck speed…the market’s conservatism in the price of growth is properly entirely justified… investors seem to be incredibly cautious about the sustainability of above GDP growth rates”.[9]   

I think Costantini is right when he points out:   

“In the end, growth (in assets) of course matters, but nowhere near as much as the average investor thinks…[10]    

How I value growth

Based on this evidence my valuation model is conservative and assumes that a business will only have profitable asset growth for five years. This means that asset growth will, except for high ROIC businesses, only have a small impact on my valuation of a business. I think this is a prudent assumption to make.   

Of course, if a business can sustain an ROIC above my discount rate, and high asset growth, it will, because of compounding, dramatically increase in value and be a wonderful investment. This compounding effect is why Buffett says:   

 “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”[11]   

However, I am no Warren Buffett and I recognise how hard it is to predict which business’s will be able to sustain a high ROIC, and asset growth, over the medium to long-term. If I buy these types of businesses, and I am wrong about the sustainability of their ROIC, and asset growth, these businesses will be a very poor investment. That is why my valuation model is conservative and assumes there will only be profitable growth for 5 years.[12] [13] For most businesses, this means I will value them at close to their earnings power value (Earnings/Discount Rate).   

In conclusion, I think Costantini is right when he says:    

“The asset multiple (Enterprise Value/Replacement Value) …can be used in an efficient and successful way for (valuing) most of the investment universe, despite ignoring growth in assets, in a manner most disturbing for growth reliant investors.” [14]   

 


   

[1] A business’s ROIC is its Return on Invested Capital. It tells you how profitable a business has been. It does this by telling you the amount of capital the business needed to produce its profit.   

[2] P176, Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.   

[3] All words in brackets in the quotes on this post are my comments. They are not comments from the authors of the quote.   

[4] Ibid at P117.   

[5] See the CROCI definition at: http://www.investopedia.com/terms/c/croci.asp. I use ROIC as a proxy for CROCI.   

[6] P117, ‘Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.    

[7] See the definition of the ‘q ratio’ at: http://www.investopedia.com/terms/q/qratio.asp.   

[8] Ibid at P115.   

[9] Ibid at P120.   

[10] Ibid P116.   

[11]Letter to Berkshire Shareholders’, Warren Buffett, 1989.   

[12] As Montier points out, theoretically investing in great (high growth) businesses, “… is a good investment. However, identifying growth ex-ante is very difficult. We are all too confident and too optimistic about our ability to pick winners. Growth investing often means buying expensive stocks. Value investing is an admission of our limitations. It offers protection against mistakes, and it outperforms!”, P307, ‘Behavioural Investing’, James Montier, 2007.   

[13] A further problem with assuming that a business’s prior asset growth rate is sustainable is that its historical asset growth rate may reflect rapid consumption of available franchise opportunities. Once exhausted the potential for profitable asset growth can decline dramatically. See P10, ‘Growth delusions’ in ‘Franchise Value: A Modern Approach to Security Analysis’, Martin Leibowitz, 2004.   

[14] Ibid.

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I have spent a lot of time on this blog discussing a number of qualitative factors that I think are very important in determining the value of a business. In this post I will discuss how I ‘quantify’ the value of a business.

My quantitative valuation model is a basic ‘Economic Value Model’. I determine the ‘central case’ intrinsic value of a business based on my estimate of its future ROIC[1], and asset growth.[2] My model assumes a business can sustain this predicted ROIC, and asset growth, for five years. After five years, I assume the business’s predicted ROIC will slowly revert to my discount rate and that there will be no further profitable asset growth.[3] I discuss why I assumed this further below. But firstly I want to make some general points about my quantitative model.

How I limit the risks of forecasting, in my valuation model

Using a valuation model requires me to make predictions about a business’s future. The major risk with making such predictions is that I may value a business for far more than it is probably worth. I try to limit this risk by:

  1. Assuming the business’s ROIC, and asset growth, will never be higher than it has been historically; [4]
  2. Assuming that the business will only sustain its predicted ROIC, and asset growth, for five years; and,
  3. Most importantly, having a large ‘margin of safety’[5].

Despite the risks of using a valuation model, I think Damodaran is correct when he says:

“Those who disdain valuation models for their potential errors end up using far cruder approaches (such as comparing P/E ratios or applying EBIT multiples)… they choose to sweep the uncertainties (of valuation) under the rug and act as if they did not exist”.[6]

Why I do not use comparable market valuations

I do not value a business by using ‘comparable’ private or public market valuations because market sentiment can heavily influence these valuations.

Why my valuation model assumes that a business will only sustain a high ROIC for a maximum of five years before it slowly falls to my discount rate

I assume this because of competition and ‘reversion to the mean’.

My valuation model assumes that a business with both a sustainable competitive advantage and a high ROIC, will only sustain its high ROIC for a maximum of five years before it slowly falls to my discount rate.[7] I have assumed this because I could easily overestimate the strength and sustainability of a business’s competitive advantage. If I am wrong, and I do not make this assumption, I could dramatically overvalue the business.

I will discuss the more detailed issue of why my quantitative valuation model assumes a business will only have profitable asset growth for five years in my next post.


[1] A business’s ROIC is its Return on Invested Capital. It tells you how profitable a business has been. It does this by telling you the amount of capital the business needed to produce its profit.

[2] These are determined on both quantitative and qualitative criteria.

[3] My valuation model is very similar to the one used by Deutsche Bank’s CROCI model. The good news is that Deutsche Bank’s research has shown that their CROCI based valuations closely approximate the market’s valuation of a business, over the medium term. This means that my valuation of a business is a good proxy for the price that the market will ultimately pay for a business. See P203, Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.

[4] Except for the last year.

[5] For a detailed discussion of the concept of ‘Margin of Safety’ see: http://thefallibleinvestor.com/2010/02/17/my-investment-process-the-basics-part-2/

[6] Chapter 23 P 30, ‘Investment Valuation’, Aswath Damodaran.

[7] Many business’s with a high ROIC will have this return driven down to the average ROIC for a business in 5 years or less, see Great 10-year Record = Great Future, Right’, Tweedy, Browne Company.

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I define the replacement value of a business as what the business’s assets would be worth if it’s ROIC was equal to its cost of capital.

The market value of a business with a high ROIC and no sustainable competitive advantage should (assuming the market eventually prices a business at its intrinsic value[1]) fall to its replacement value. This should happen because if an incumbent business has a high ROIC, and no sustainable competitive advantage, other businesses will enter this industry, or expand within the industry, to seek these higher returns. These competitors will drive down the incumbent business’s profits until its ROIC declines to the average return of a commodity business. Once this occurs, the incumbent business can only be worth the cost of replacing the business’s assets.

Professor Greenwald has another way of describing this process. He points out that if an incumbent business, with no competitive advantage, has a replacement value of $100 million and its market value is $200 million[2], competitors will drive its market value down to $100 million. Competitors will calculate that by spending $100 million to reproduce the assets of that business they can also create an enterprise with a market value higher than $100 million. These competitors will think, correctly, there is no reason for why they should have a different economic experience from the incumbent because there is nothing it can do that they cannot. Remember the incumbent business has no sustainable competitive advantage. Competitors, by reproducing the assets of the incumbent business, will increase the supply of products or services in the industry. There will now be more competition for the same business. Either prices will fall or, for differentiated products, each producer will sell fewer units. In both cases, the incumbent’s profits will decline and the market value of its business will decline with them. This process, capacity continuing to expand, and the profits and the market value of the incumbent’s business falling, will continue until the incumbent’s market value falls to the replacement value of its assets ($100 million). Its competitors will suffer the same fate.

Greenwald points out that while this process does not happen smoothly or automatically it will eventually turn out this way. It happens because the incentives for businesspeople to take advantage of the market’s excessive valuation of the incumbent’s business are too powerful.[3]

The market value of a business with a sustainable competitive advantage can, by contrast, stay much higher than its replacement value simply because it can sustain a high ROIC.


[1] The intrinsic value of a business is what I think the business is worth to a rational businessperson.

[2] Assuming the business has a high market value because it has a high ROIC.

[3] P38, ‘Value Investing: From Graham To Buffett And Beyond’, Bruce Greenwald et al, 2001.

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As previously discussed, I want a business, which I have predicted will have a high ROIC, to have a sustainable competitive advantage. However, I think a sustainable competitive advantage is limited to a small number of competitive advantages.[1] I think it is very useful, when deciding whether a business has a sustainable competitive advantage, to understand what is not a sustainable competitive advantage.

Greenwald and Kahn in their seminal book, ‘Competition Demystified’, have outlined the following factors, which they think, and I agree, are not a sustainable competitive advantage. They think these factors will only temporarily allow a business to have a high ROIC.[2]

Having a cost advantage based on superior technology, which cannot be patented

A business with superior technology, which cannot be patented, does not have a sustainable competitive advantage. This is because the technology will usually be either rudimentary, which its competitors can easily reproduce,[3] or technology developed by specialist third parties (like Accenture or IBM), which is likely to be sold to its competitors.[4]

The inability to make this superior technology a sustainable competitive advantage is a major problem for businesses in the services sector.

Having a cost advantage based on lower labour costs

A business with lower labour costs (for example it uses cheap labour in China or India) does not have a sustainable competitive advantage because its competitors can, and usually will, source the same cheap labour.

Having a cost advantage based on lower capital costs

This usually means getting cheap capital from a Government. Having access to cheap capital from a Government is not a competitive advantage. It is a subsidy.

Having product differentiation

Product differentiation is not a sustainable competitive advantage because if a business has a high ROIC, due to product differentiation, competitors can, and will, enter that market and sell their own differentiated product. This will cause the business’s sales volume to fall and, because its fixed costs remain the same, the lower volume will mean its profit margin also falls. Its profit margin and sales volume will continue to fall until its high ROIC disappears.[5]

Having a strong brand

Having a strong brand is not a sustainable competitive advantage.[6] Brands are assets just like property, plant, and equipment. A business must spend cash to build or buy the brand, and cash each year to offset the depreciation of the brand. A competitor can easily spend its own cash to create a brand. If a competitor has an equal opportunity to create its own brand, the business with the brand has no competitive advantage. Brand investments are, thus, no different from many other investments: they return the cost of capital and do not provide any excess return to shareholders.[7]

Being the first mover in an industry

Being the first mover in an industry is not a sustainable competitive advantage. Being the first mover may give that business learning curve cost advantages. This means that as the business moves down the learning curve it becomes more efficient and can produce the product with lower variable costs than businesses just learning how to produce the product. However, as the industry matures, and its competitors learn to be efficient, this disadvantage usually disappears. The business may even find itself at a competitive disadvantage because it now suffers from vintage effects. That is it has less efficient plant and equipment than later entrants into the industry.

Being the latest entrant in an industry

Being the latest business to enter an industry and, therefore, usually having the latest technology or the ‘hottest’ product design will not give the business a sustainable competitive advantage because these advantages are, by their nature, only temporary. Moreover, once the business enters the industry it becomes an incumbent. The same advantages it enjoyed, when it first entered the industry, will now apply to any new entrant.

Having lower variable costs from new capital expenditure

A business (in a commodity industry) which reduces its variable costs by undertaking new capital expenditure has not created a sustainable competitive advantage because its competitors can easily do the same thing.  

Good operational efficiency

Good operational efficiency is usually only a temporary competitive advantage (there are exceptions). It is usually only temporary because this operational efficiency can naturally decline, or a competitor can reproduce it.

 A business’s good operational efficiency can naturally decline because:

  1. Management dies, or retires, or is poached by other businesses; or,
  2. Management becomes sidetracked by some major internal or external issue (for example they make a takeover offer, or are involved in a major lawsuit); or,
  3. Management simply loses its drive.

 A competitor can reproduce another business’s good operational efficiency by copying the successful business’s operational practices, or by recruiting better management.


[1] Economies of Scale combined with Customer Captivity; a Network Effect, a Government Licence; Patent Protection;  and, Customer Captivity.   

[2] See Chapter 2, ‘Competitive Advantages 1’ in Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[3] Rudimentary technology (simple products and simple processes) is hard to patent because this technology will often look like common sense. Thus, a business with this technology will often have its competitors duplicate the technology by hiring away its the employees.

[4] Technology developed by specialist third parties (such as Accenture and IBM) is likely to be sold to any business that wants to buy it. These third parties make their living by disseminating their innovations as widely as possible. See P 29, ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[5] Businesses which only rely on product differentiation must also be very efficient. Not only must they be very efficient with their production costs (which obviously applies to any business without a competitive advantage) but they must also be very efficient in those aspects of the business which allows it to differentiate its product (advertising, product development, service, distribution channels and a host of other functions). Inefficient businesses selling differentiated products will struggle to remain viable. See P23, ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[6] Greenwald and Kahn believe that while a brand is not a competitive advantage, it can lower the cost of entry into another market because the business may not have to build a brand from scratch. See ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[7] See P39, Measuring the Moat, Assessing the Magnitude and Sustainability of Value Creation’, Michael Mauboussin, 16 December 2002.

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