Looking for Real Competitive Advantages in the Stock Market

competitive advantageOver the years, I have noticed an interesting phenomena. Many participants in the stock market discuss competitive advantages of their investments and why these advantages will guarantee a bright future for their investments. However, it seems to me that most of these advantages revolve around a key brilliant (and charismatic) manager, a newly found technology or “may-be” advantages such as the company “deep pockets”.

In reality, we need to remember talent can leave. Technology can become obsolete as soon as another company “embraces” it and improves on it and cash may be used for the wrong cause by incompetent management and reduce the value of the company.  Sometimes you need to look beyond the basic SWOT analysis for investments.

I want to discuss two types of competitive advantages, which I believe to be stronger and deeper advantages than the former ones – the network effect and customer captivity. I think finding companies which possess these competitive advantages might be a good place to look at as potential investments.

 

Real Competitive Advantage #1 – The Network Effect

network effectLet’s start with the network effect. What is the network effect? In business, it’s what happens when the number of users (or customers) increases the value of a company. I know that sounds a bit confusing, so an example is in order.

In the old days (before the Internet), newspapers used to create a network effect; the more people read the same newspaper, the more the value of that paper’s classified ads increased, and the value of the paper to all of its subscribers increased, as well. So the number of readers (the network) of the newspaper gave it its value, even though the readers didn’t intend to create value for other readers by subscribing to the newspaper.

Of course, we can see immediately how the network effect can be a competitive advantage for an organization. When a successful company reaches a certain volume of users, each additional user will increase the value of the company.

What are some companies that make use of the network effect? You can discover some of these companies by asking yourself the following questions:

  • What social network do you use on a daily basis? Why do you use it?
  • Who is your cable provider?
  • On which stock exchange are high-profile companies being traded?
  • Where did you post your ad to sell that old sofa?
  • How many commercial railroad companies are in the United States?

Think about the volume of the companies’ user bases when answering the above questions. Do the user bases create a network effect? Who will benefit from an increase in the number of users? (Answer: the company.)

Companies who have successfully made use of the network effect will usually have better economics than other companies.

When evaluating a company’s network effect, ask the following questions:

  • What could erode the network effect of a company? (Think newspapers.)
  • Could government regulations impact the network effect?
  • Does a niche business have a stronger network effect then a global one?
  • Will the network effect of your researched company exist ten or twenty years from now? What will sustain it? What could destroy it?

 

Real Competitive Advantage #2 – Customer Captivity

customer captivityThis leads us to the second competitive advantage that a good company will have: customer captivity. Customer captivity breaks down into two key aspects - switching costs and habit.  The higher the cost for a user to switch from one service or product to another, the higher that company’s user captivity is.

With habit, companies that can create an “addiction” to their product by encouraging consistently high frequency of use of its products or services can create a habit of consumption of their product. These companies will have greater costumer captivity and a competitive advantage over companies that have to convince their customer to buy their product every single time instead of just the first time. As an added bonus, companies with habits of consumption will have greater pricing power as well.

Think about some of the products you are using on a daily basis.

  • Where do you get your coffee on your way to work? What type of coffee do you drink?
  • Why do you think daily soap operas TV shows are daily?
  • What is the first Website you visit each morning?
  • What brand of soda and orange juice do your kids drink?

How do companies increase their customers’ habit? Let’s look back at the psychological factors that impact our decision process. Especially when we aren’t sure what is the right behavior or decision, our tendency is to assume the people around us possess more knowledge about the situation than we do, and we think following their decision will make the most sense. Sometimes this tendency is referred to as “social proof.”

Think about your favorite soda commercial. Remember the great 1970s Coca Cola commercial? How many people were in that commercial? There were many people, and they all drank the same drink. Think about your favorite fast food commercial. Yes, it will show the food, but usually it will show people just like you (or people like you want to be) all doing the same activity—consuming the product and enjoying it.

Let’s look at another example. How do you buy music? Have you ever seen any commercial that influenced you to buy it that way? What was in the commercial? People, many people…

 

Developing Real Competitive Advantage

Think again about the two competitive advantages we just talked about—network effect and customer captivity. A company with both of these advantages would have an immense value. More people will consume its products or use its services (customer captivity), and by doing that, they will increase its value (the network effect). Does the company you’re researching have these qualities?

Let me conclude by leaving you with the following questions to ask prior to investing in a company:

  • Is the company a predictable one? How will it look like in the next ten or twenty years? You will find that it is difficult to evaluate a company that changes frequently.
  • Is it a simple company? Remember your circle of competence. Do you understand the company? If you do not understand a company, do not even try to evaluate it.

 

What competitive advantages do you look for in the stock market before you invest?

This article was written by Amir Avitzur author of author of “Why Do We Sell Low and Buy High? The Guide You Must Read BEFORE You Invest“.  The book can be ordered from Amazon.com or at www.AmirAvitzur.com.  Amir Avitzur is the president of Avitzur Asset Management, LLC, an independent money management company that has provided continuous management of investment portfolios for individuals and small businesses since 2004. 

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  • http://financiallyintegrated.com Integrator

    Great post. I tend to automatically gravitate to businesses that have network effects. These businesses have a tendency to generate rapid momentum and scale with additional users, further deepening their economic moats. CME, EBAY, VISA are good examples of such businesses in my view.

    • http://thecollegeinvestor.com Robert Farrington

      Great list and great reminder about the network effect deepening the moat.

  • http://www.dropdeadmoney.com William Cowie

    Great article. (Actions speak louder than words: I bought the book.) There are other sources of competitive advantage: sheer capital size barriers to entry. The immediate example that comes to mind is UPS/FedEx. Another is domination of distribution, such as Coke/Pepsi, Frito-Lay, etc., where competitors (even much better competitors) simply cannot gain access to the distribution channel.

    On the network effect: how do you identify “the next thing” (eBay, Facebook, etc.) that’s investable, i.e., already traded? By the time the hot startups reach the market, they’re usually over-hyped and consequently overvalued… no? Interested to hear you take on that.

    Thanks again.