“So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that’s tenuous in any way – it’s just too risky. We don’t know how to evaluate that. And, therefore, we leave it alone. We think that all of our businesses – or virtually all of our businesses – have pretty darned good moats. And we think the managers are widening them.” ― Warren Buffett
In a few posts I will analyze the Swedish grocery retail industry, and try to understand the companies operating and competing within the industry, industry stability (and/or change), profitability etc.
This post contains the first step in my analysis, an industry map – see below. Click on image to enlarge.
This analysis is all about assessing competitive advantages (if any).
The subsequent text is an excerpt from Competition Demystified, a great book about analyzing competitive advantages.
“Because the concept of competitive advantage lies at the core of business strategy, it is essential to determine whether a company benefits from a competitive advantage, and if it does, to identify the sources of that advantage.
There are three basic steps to doing such an assessment:
1. Identify the competitive landscape in which the firm operates. Which markets is it really in? Who are its competitors in each one?
2. Test for the existence of competitive advantages in each market. Do incumbent firms maintain stable market shares? Are they exceptionally profitable over a substantial period?
3. Identify the likely nature of any competitive advantage that may exist. Do the incumbents have proprietary technologies or captive customers? Are there economies of scale or regulatory hurdles from which they benefit?
The first and most important step is to develop an industry map that shows the structure of competition in the relevant markets. This map will identify the market segments that make up the industry as a whole and list the leading competitors within each one. Deciding where one segment ends and another begins is not always obvious. However, if the same company names show up in adjacent market segments, then these segments can usually be treated as a single market. Mapping an industry helps a company see where it fits in the larger picture and who its competitors are, even if the segment breakdowns are not always precise.
The second step is to determine for each market segment whether it is protected by barriers to entry, or in other terms, whether some incumbent firms enjoy competitive advantages. There are two telltale signs of the existence of barriers to entry/competitive advantages:
- Stability of market share among firms. If companies regularly capture market share from each other, it is unlikely that any of them enjoys a position protected by competitive advantages. In contrast, if each firm can defend its share over time, then competitive advantages may be protecting their individual market positions.Stability in the relative market positions of firms is a related issue. The key indicator of this is the history of the dominant firm in the segment. If the leading company has maintained its position over a period of many years, that fact strongly suggests the existence of competitive advantages. If, on the other hand, it is impossible to single out a dominant firm, or if the firm at the top changes regularly, then no single company is likely to enjoy sustainable competitive advantages.The history of entry and exit in a market segment provides another clue. The more movement in and out, the more turbulent the ranking of the companies that remain, and the longer the list of competitors, the less likely it is that there are barriers and competitive advantages. Where the list of names is short and stable, the chances are good that the incumbents are protected by barriers and benefit from competitive advantages.
- Profitability of firms within the segment. In a market without competitive advantages, entry should eliminate returns above a firm’s cost of capital. If the companies in a market maintain returns on capital that are substantially above what they have to pay to attract capital, the chances are strong that they benefit from competitive advantages/ barriers to entry. These sustainable excess returns may be restricted to a single dominant firm, or they may be shared by a limited number of companies who all enjoy competitive advantages over smaller firms and potential entrants. There are a number of ways to measure profitability. The approaches that permit comparisons across industries calculate returns either on equity or on invested capital.After-tax returns on invested capital averaging more than 15 to 25 percent—which would equate to 23 to 38 percent pretax return with tax rates of 35 percent—over a decade or more are clear evidence of the presence of competitive advantages. A return on capital in the range of 6–8 percent after tax generally indicates their absence. There is one major difficulty in measuring returns on investment in any particular market. Corporations report their results for the company as a whole; they may include breakdowns for highly aggregated industry segments and for continental-sized geographic regions. But the markets where competitive advantages are likely to exist will often be local, narrowly bounded either in geography or product space. A typical company of even medium size may benefit from barriers to entry in several such markets, but stellar results there will be diluted in the financial reports by being combined with returns from other, less profitable operations. Identifying historical profitability for particular markets often requires extrapolation. The best way is to look at the reported profits of “pure play” companies, whose operations are narrowly focused within these markets. The resulting profitability calculations for focused segments are critical to any strategy for exploiting competitive advantages and minimizing the impact of competitive disadvantages.
When the analysis of market share stability and profitability are consistent with one another, the case for the existence of competitive advantage is robust. For example, Enron reported only a 6 percent return on capital for the year 2000—its most profitable year—and it needed the help of accounting manipulations to do even that. This result by itself should have cast doubt on its claim to competitive advantages in trading markets for new commodities like broadband and old ones like energy. The history of the trading operations of established Wall Street firms, in which changing relative market positions are the rule, makes the case against competitive advantage for Enron even stronger.
If market share stability and profitability indicate the existence of competitive advantages, the third step is to identify the likely source of these advantages. Do the dominant firms in this industry benefit from proprietary technologies or other cost advantages? Do they have captive customers, thanks to consumer habit formation, switching costs, or search costs? Are there significant economies of scale in the firm’s operations, combined with at least some degree of customer captivity? Or, if none of these conditions seems present, do the incumbent firms profit from government intervention, such as licenses, subsidies, regulations, or some other special dispensation?
Identifying the likely source of a firm’s competitive advantage serves as a check to confirm the findings from the data on market share stability and profitability. Even when market share is stable and profitability is
high, a close look at the business may fail to spot any clearly identifiable cost, customer captivity, or economies of scale advantages.
The likely explanation for this discrepancy is either that the market share and profitability figures are temporary, or that they are the consequence of good management—operational effectiveness—that can be
emulated by any sufficiently focused entrant. Identifying the sources of competitive advantages should help predict their likely sustainability, a necessary step for both incumbents and potential entrants when
formulating their strategies.”