Competitive strategy is about being different. It means deliberately choosing a different set of activities to deliver a unique mix of value. -- Michael E. Porter
Business students, or at least business students of a certain age, will recognize the name Michael E. Porter, because he penned a seminal business book, Competitive Strategy: Techniques for Analyzing Industries and Competitors, first published in 1980 and recently in its 60th printing.
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The book laid out several powerful competitive advantages that companies can have and which can help them grow (and stay) more dominant and valuable in their industries. We investors would do well to favor companies with sustainable competitive advantages when seeking candidates for our portfolios.
Introducing competitive advantages
Here's how the Corporate Finance Institute describes competitive advantages:
Competitive advantage refers to the ways that a company can produce goods or deliver services better than its competitors. It allows a company to achieve superior margins and generate value for the company and its shareholders.
Sounds good, right? Below you'll find a (non-comprehensive) list of competitive advantages, along with some examples. Learning how to spot them can help you become a better investor.
Economies of scale
In general, the larger a company is, the less it can cost to produce each of its widgets, affording it higher profits, the ability to charge lower prices, or both. Higher profits can be used to pay workers more, invest in further growth, buy more advertising, and so on.
Valuable brand
A well-known and well-respected brand is very powerful. It can give a company a good reputation and pricing power, too, permitting it to hike prices without losing much business. Consider Disney and Toyota. If you want to see a movie, you'll likely assume that any Disney offering will be fairly high quality, and if you're in the market for a car, you'll think of Toyota models as ones that should be quite reliable. You may also pay up for such companies' offerings, seeing them as high-quality and worth the extra cost.
Bargaining powers
Buyers or suppliers can wield bargaining power. Think of Walmart, for example. It's so enormous that when it buys items for its 10,000-plus stores, it can make demands of its suppliers. Suppliers can sometimes wield bargaining powers, too, as when there are very few offering a certain product or service or if it would be a hassle for the buyer to switch to another supplier for something. In aviation, for example, when an airline needs to buy planes, there are mainly two options -- Boeing or Airbus.
Ecosystem of offerings
Having products and services that are interconnected can be an advantage. Apple, for instance, has a big ecosystem, with many customers owning or using multiple products and services (iPhones, Apple Watches, Macbooks, Apple TV+, iPad, etc.) that work well together. Since it would be troublesome to switch to other providers for some or all of these, many customers stick around.
Network effect
With many products or services, their value is tied to the number of people using them. That's a network-effect advantage. eBay, Etsy, and Amazon.com's marketplaces are bustling and valuable because of their many users. If you want to sell or buy something, you'll go to such places because that's where the buyers and sellers are. Social media sites such as Facebook, Instagram, and sites such as YouTube are succeeding in large part due to the many millions (if not billions) of people using them.
Barriers to entry
Barriers to entry can be a powerful competitive advantage, and some of the companies already mentioned have them. For example, it would be terribly difficult to start up an airplane manufacturing business, because it would cost a fortune. It would be hard, too, to launch a new social media site when so many people are already entrenched in other ones. Some companies' barriers to entry are the proprietary technology, patents, and/or licenses that they have.
Innovation
If a company is good at innovating, that's an advantage, because it may be able to introduce new products or new product categories as Apple did with its iPod years ago. Some companies, such as 3M and Google parent Alphabet, are also known for their innovation prowess.
Optionality
Related to innovation is the concept of optionality, which many investors seek when evaluating companies. When a company has optionality, it has options -- possible new directions it can go in, to generate new revenue. Netflix has many millions of subscribers -- and optionality: It can start offering games through its platform and can start running advertisements, too. Axon Enterprises, which started out making taser guns, has expanded into offering body cameras and the Evidence.com platform that permits law enforcement entities to keep track of evidence, among other things.
Switching costs
Some companies enjoy a "switching costs" advantage. Intuitive Surgical has installed thousands of robotic surgery machines in hospitals around the world. The hospitals have trained many surgeons on the equipment and buy service contracts and supplies for the machinery. It would be a big (and costly) bother to switch to another provider if there were a comparable one.
These are just some of dozens of possible competitive advantages that companies can have. A little online research will turn up many more. As you evaluate candidates for your portfolio, spend some time looking for sustainable competitive advantages, as they can help a company prosper.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Selena Maranjian has positions in Alphabet, Amazon.com, Apple, Axon Enterprise, Etsy, Intuitive Surgical, Netflix, and Walt Disney. The Motley Fool has positions in and recommends Alphabet, Amazon.com, Apple, Axon Enterprise, Etsy, Intuitive Surgical, Netflix, Walmart, and Walt Disney. The Motley Fool recommends 3m and eBay and recommends the following options: long January 2024 $145 calls on Walt Disney, long March 2023 $120 calls on Apple, short January 2023 $45 calls on eBay, short January 2024 $155 calls on Walt Disney, and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.
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