Competitive Advantage: Navigating Changing Themes

A competitive advantage gives a company an edge over its rivals and an ability to generate greater value for the firm and its shareholders. The more sustainable the competitive advantage, the longer the business in question will be able to produce outsized returns for shareholders. Warren Buffett was one of the first to recognize the benefits of a competitive advantage, or what he calls an “economic moat”, which is defined by Investopedia as

“…a business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.”

But nature of competitive advantage is changing. Technology is breaking down barriers to entry, the abundance of natural resources is reducing the costs for producers of all sizes, and digital, not physical scale is now the goal for companies seeking a size advantage over peers.

The changing nature of competitive advantage is one of Goldman Sachs’ current investment themes. The bank’s analysts outlined the key risks and themes of the changing competitive environment in their “Fortnightly Thoughts” research booklet, which celebrated its fifth year of publication last week.

The effect of abundance on competitive advantage

In the new world, abundance is changing the nature of competitive advantage at the country level. Emerging countries that used to have an advantage bestowed by being a resource exporter have seen the advantage reduced. Similarly, the advantage of low-cost labor has diminished, owing to the increasing supply shock of automation and artificial intelligence.

As Goldman goes on to point out, as the access to resources becomes less of a competitive advantage, then the country-level competitive advantage will revolve around the ability to generate and monetize intellectual property, the ability to attract skilled labour and the strength of the legal system, as well as support system for small businesses to allow innovation to prosper. Out go countries like Brazil, South Africa, India and Canada, to be replaced by the US, with the Nordics not far behind. However, one country that leads the pack is China, which has strong linkages between government, academia, the military and the private sector.

What’s more, abundance implies deflation, so investors should seek scarcity and pricing power:

“What is left in the world that is scarce? Some types of content (sports, blockbuster movies), unique experiences (live events), prime real estate, few resources (such as lithium and rare earths), clean air and water in some places, valuable brands, private networks, anonymity, life-extending drugs, quality jobs, pockets of high-skilled labor (e.g. computer science).”

Digital scale is becoming ever more important

Digital scale is now becoming increasingly important in the battle for competitive advantage. Indeed, digital scale has now become so important that it is often the first digital scaler, not the first mover who wins the battle for customers and margins. Because of this effect, there are several natural monopolies that have developed in the digital world e.g. Google in search, Facebook in social media and LinkedIn in professional social media. Networking effects drive up the scale of these digital monopolies. Goldman:

“They all [these digital monopolies] have user dominance versus product dominance and low to zero average selling price. Their touchpoints with users can be so frequent and so high in number that they can distribute a series of products at effectively zero marginal cost. This means they can enter new product areas very easily, giving them option value in terms of what they will look like in say 10 years’ time.”

Barriers to entry are being eroded

Traditional industry entry barriers are facing downward pressure from technology; a great example is the rise of cloud computing which negates the need for expensive hardware investments upfront. This is just one of the many factors that’s now made starting a business much cheaper and easier than even five years ago. Start-ups now favor low-cost web shops rather than high-cost brick and mortar stores.

Still, other barriers are proving harder to erode, such as brand strength, physical/digital scale and those industries that are subject to high levels of regulation, which can often serve as an entry barrier through cost, complexity and capital. The battle between fintech and financial services incumbents as well as the tobacco industry are two excellent examples.

Also, industry consolidation is helping to prop up traditional barriers to entry and competitive advantages. Many industries are more consolidated today than they were a decade ago, a trend that’s helped keep profit margins high, and economies of scale in place.

Investing in change

Investors are going to have to overcome the changing nature of competitive advantage, and this is going to present some challenges.

Where could disruption happen? Unfortunately, there’s never going to be a clear, or easy answer to this question but investors will be able to avoid a great deal of possible disruption by seeking out those sectors that generate very high returns on capital and businesses that benefit from high friction costs. Further, investors need to consider the economics of the new entrants versus incumbents, i.e. how much revenue does the new entrant need to make the same return on capital as the incumbent? That gives clues as to how far the industry’s clearing price could fall and where it could come to rest.

However, it shouldn’t be assumed that disruption is going to affect every sector. As Goldman explains:

“This is wrong for several reasons. First, a lot of what is labelled disruption is actually just the cut and thrust of normal competition. Secondly, incumbents can respond, especially if they are well-capitalized and the new product isn’t significantly different. And thirdly, the industry response can be self-disruption, M&A or invoking regulation. All of these can reduce the probability of disruption. In a world of abundant capital, the pain can be delayed, and so thinking about timeline is very important.”

Buy-and-forget investing is dead

The changing nature of competitive advantage is seriously threatening the buy-and-forget investment style. With the timeline around disruptive threats to industries uncertain, being nimble is becoming increasingly important. However, the changing structure of the market — lower liquidity and erratic price movements driven by high-frequency trading — means that being nimble is becoming harder and the increasing ubiquity of information, partly owing to technology and partly owing to regulation reduces the near-term informational advantage.

Value investing as a style is also coming under threat. One of the fundamental principles of value investing (see: The 6 General Principles Of Value Investing) is the assumption that over the long-term valuations will revert to the mean. But mean reversion investing is tough in industries with deteriorating economics, meaning the terminal value decline needs to be factored into the estimation of value to avoid value traps. As Goldman’s chart below shows, the relative valuation of low-return companies has fallen back to lows versus the market overall, supporting the above point.

Low return, no premium

Another factor to consider is the rise of the passive investor, and passive ETF. These passive funds may well impact company management decision making by being silent.

Good companies still exist

Many firms are seeing their competitive advantage eroded by technology, abundance and a lack of digital scale. However, there are companies out there that are fighting through these technological and demographic changes. Here are Goldman’s top picks:

(click to enlarge)

Goldman’s picks