The story is told that in ancient Rome, when a conqueror was paraded in front of the masses, one of his slaves would whisper softly in his ear, “All fame is fleeting.” At the height of his popularity and fame, the conqueror would be reminded that fame is quickly forgotten.

I would suggest that in our present-day capitalist system, a young manager should whisper softly in the ear of the CEO when he reviews the market share reports, “All competitive advantages are fleeting.” Like fame, competitive advantages are temporary and hard to hang on to for most products and businesses.

Businesses that have a large market share and are able to increase it over time are doing something right, and most probably have some type of competitive advantage within their industries. One of the criteria that Warren Buffett uses when buying a business is how big the company’s competitive edge is. He even coined a phrase for it: the economic moat. He explains that in days of old, castles were protected by moats. When enemies tried to storm a castle, they had to contend not only with archers and catapults but also with the moat that surrounded the castle. The wider the moat, the harder it was for enemies to attack the castle.

Buffett tries to buy businesses that have very wide economic moats around them. This makes it very difficult for competitors to take market share away from them. He also wants to know that management is continually increasing the size of the moat. The wider the moat, the more protected the business; the narrower the moat, the less defensible. As Buffett writes, “In business, I look for economic castles protected by unbreachable moats.”

There are several types of competitive advantage that a business may have, which include costs, patents and trademarks, brand and the high cost of switching. Over the long term, it is very difficult for a business to maintain a competitive advantage. The reason is simple: Once competitors see the higher profit margins a business is earning on a certain product, they then spend a considerable amount of time, money and energy trying to get in on the action and take market share.

Encyclopedias

When I was growing up, all my friends owned a print edition of an encyclopedia. Parents were made to feel guilty by door-to-door encyclopedia salesmen who insinuated that if parents didn’t buy a set for their children, the kids would spend their lives flipping burgers at McDonald’s or working at the local car wash.

As a teenager I could always tell the economic standing of a family by which encyclopedia they owned. My rich friends owned Encyclopedia Britannica and my middle-class friends owned Funk & Wagnalls. As for me, my parents said whatever the public library had was good enough.

Encyclopedia Britannica was the gold standard. It had a competitive advantage due to its 237-year reputation and contributions by world-renowned experts and Nobel Prize winners. The publisher was able to charge over $1,700 a set, while cheaper editions of other encyclopedias were sold at the supermarket for $1.99 per volume.

In the 1980s, Microsoft approached Encyclopedia Britannica with the idea of putting its content on CD-ROM, but the publisher declined, believing its print sales would suffer. Britannica did not make a wise decision.

In 1993, Microsoft published Encarta, a digital multimedia encyclopedia that sold for a fraction of the cost of bound print volumes of other encyclopedias. Some time later, Microsoft gave away free copies of Encarta with computer systems. In a very short time, many other encyclopedias, such as Collier’s, Funk & Wagnalls and New Merit Scholar’s, stopped print editions, as Encarta rendered them obsolete.

The end for Britannica came in 1996, when it was sold for less than book value, as print sales couldn’t compete with free CD-ROM copies of Encarta. Printed encyclopedias had fallen by the wayside in a very short period of time because of technology. While they all had considerable market share, all was lost when a new way of delivering information came on the scene.

But the story doesn’t end there, because on March 31, 2009, Microsoft announced that it would discontinue Encarta reference websites as well as Encarta software. This time the competition was Wikipedia. Microsoft said, “Encarta has been a popular product around the world for many years. However, the category of traditional encyclopedias and reference material has changed. People today seek and consume information in considerably different ways than in years past.” Encarta’s 42,000 entries couldn’t compete with Wikipedia, which offers more than 5.1  million user-generated articles for free–in the English language alone!

Change

iPods and encyclopedias are just two small examples of the fight for market share that takes place each day in the marketplace. The size of a company does not guarantee that its competitive advantage will endure.

To be added to the Dow Jones Industrial Averages (DJI), a company needs to be among the biggest, best-known, most prominent companies in the United States. The index was founded on May 26, 1896, and represented the 12 most important American industries. The only company that was among the original 12 and is still currently part of the index is General Electric.

In the table below, I looked at the companies that were dropped from the DJIA since 1991. These companies at one time represented the strongest and most promising companies in the country. A few of them were on the list for 90 years before being dropped, proving once again the difficult challenge of trying to stay relevant in a changing world.

Finding companies with moats

While there is no surefire way to find companies that will consistently increase the size of their moats, there are certain things to look for that can help you avoid companies that see their moats shrinking rather quickly.

1. Consistent business: Stick with companies that sell products that cannot quickly become obsolete. There is a big difference in the competitive advantages of Coca-Cola and Motorola. The Coke brand is the most recognizable brand in the world, and the company has been able to increase its dominance in the beverage industry for over 100 years.

Motorola, a manufacturer of wireless telephones, started selling the RAZR mobile phone in the fourth quarter of 2004. It was ranked 12th in the PC World list of “The 50 Greatest Gadgets of the Past 50 Years” and sold over 110 million units in four years. By the beginning of 2008, Apple’s iPhone dominated the market and RAZR failed to achieve significant market share.

2. Relative performance: Professor Phil Rosenzweig writes that while Kmart improved its performance dramatically from 1994 to 2002, it still ended up in the boneyard. The reason: Over the same eight years, its rivals were driving down costs and improving logistics at an even faster pace.

The Polish Army had a very well trained cavalry in 1939; unfortunately, it was no match for the Nazis’ Luftwaffe, the most modern, powerful and experienced air force in the world. When looking at a business, don’t look at its performance on an absolute basis; you don’t want to own well-trained horses in the age of the airplane. See how the company performed relative to its competitors to get a better read on the business.

Conclusion

The nature of business is to make decisions under conditions of uncertainty. Mistakes will be made—you can count on it. To increase the odds in your favor, try to invest in businesses that can withstand mistakes and poor execution and/or strategy. For a business with a competitive advantage in a consistent and predictable industry, mishaps will not be terminal and it will find a way to survive.

While foolish management can find a way to destroy any business, it would take superpower foolishness to cause irreparable damage to companies such as McDonald’s, Colgate or Kellogg’s. These businesses have brand power that has been built up over decades.

Selecting companies that have an enduring competitive advantage is the first step in building a portfolio of businesses that produce industry-leading performance and, eventually, higher stock prices.