Sustainable Competitive Advantage and Multibaggers

In the previous article, we examined how ASOS achieved remarkable returns and profits as a first mover in its industry, until growing competition caused its return on capital to decline. Now we'll explore how businesses can sustain their competitive advantage over time to avoid these failures.

Success breeds competition. ASOS struggled to maintain its returns as more businesses adopted the online-only model. As investors hunting the next multibagger, we need to identify profitable businesses that can withstand competitive pressures that might otherwise erode their returns on capital and share price.

The Castle and its Moat

Imagine a profitable business as a castle with a huge flag declaring, "I am very profitable!". High returns on capital and substantial margins inevitably attract competitors—invaders eager to storm the castle and claim their share of profits. As Warren Buffett once said “A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital”.

The “Seven powers” of Business

Good businesses need moats to defend their castles and sustain their competitive advantage. There's a great book by Hamilton Helmer called "Seven Powers" that provides one of the best explanations of what these competitive advantages may be.

Let’s dig into the seven ways businesses can defend their castles:

1. Cornered Resources - Having exclusive access to a valuable resource, be it some location, patent or even a very talented team.

• CVS group in the veterinary and pet care market has cornered resources through an acquisition strategy of local vets in local areas.

2. Counter Positioning - The new entrant adopts a model that an incumbent competitor cannot easily copy without harming its existing business. Having structurally superior business strategy implements lower costs and improved comparative operating margins.

• ASOS entered the market as an online only seller of fast fashion, while other competitors were predominantly bricks and mortar retailers - ASOS profited off this different positioning.

• A newcomer can benefit from fast first mover advantage profits while incumbents can be slow to respond.

3. Switching Costs - Businesses that have high switching costs will retain their customers in the face of competition.

• Apple create high switching costs due to the friction caused from moving from one product to another. Once you own an iPhone, Airpods and a Macbook, switching to Android means losing iMessage, iCloud, Airdrop and other convenient Apple systems.

4. Scale Economies - Simply growing can create scale economies, where businesses have better bargaining power with suppliers, lowering unit costs and creating better distribution. Having such a cost advantage allows businesses to underprice their competitors and increase demand for their products.

• Think of Jet2, as an example, as it got bigger it had more bargaining power with hotels and other chains to create even cheaper full package deals for its clients. Amazon has immense scale in warehouses and delivery fees, making it hard for smaller e-commerce businesses to match their prices.

5. Network Effects - In some markets, the more users or participants a business has, the more valuable the service becomes for each user—think of Facebook or LinkedIn’s power in their respective markets.

• Games Workshop benefitted from this greatly. The more gamers that join the offline and online Warhammer worlds, the more value there is to the community as a whole.

• And for YouGov, as the panellist breadth and depth grows in and across different verticals like branding and assessing governments, that creates more value to their clients.

6. Process Power - Some companies gain an advantage just from driving down the costs of production and manufacturing and building real quality into their operations. And that is a significant power which creates stability over the long term. Superior methods for manufacturing, technology, supply chains or service can be difficult for competitors to replicate.

7. Branding - A strong brand creates a barrier to entry. Customers’ trust drives repeat business and allows for improved pricing power. Apple can charge premium prices and still stay competitive because of the loyalty of their customers.

• We found five of the ten multi baggers had recognised brands. This widespread recognition helps businesses sustain their competitive advantage.

How long can competitive advantage last?

The ‘7 powers’ of competitive strategy can protect businesses from competitors. But how long can the moat last? A good method is to ask the questions which come out of Porter's Five Forces, which is a model for thinking about industry competition.

• How many competitors does this industry have and how intense is the competition? What are the barriers to entry in this market? Think about how easy it might be for new companies to enter a market. For ASOS, there were other competitors coming in, but also the incumbents who decided to go and build their own online models and actually compete with ASOS’s online model that already existed.

• Companies with many suppliers might be at more of an advantage than a company with just one supplier. Think about the bargaining power that suppliers have over a business's pricing and quality. Walmart works with thousands of suppliers globally and allows for pricing leverage and quality control between these suppliers.

• Another key factor might be the bargaining power over customers. How much power do customers have over the pricing and quality? If you only have one or two or three customers, they're going to have a huge bargaining power over you as a business.

• Is there a threat of substitutes and how easy is it for customers to switch to alternatives? This goes back to Helmer’s switching cost power, and the retention of customers in the face of competition. If you think about a cornered resource like the veterinary care market, you may find that there is no other local vet and therefore the ease of switching is quite difficult.

These factors are all important to recognise when assessing a company’s long-term sustainability.

Ultimately, potential multibaggers ideally develop a sustainable competitive advantage. The strategy of the business should focus on developing power in one of those seven ways at least.

In our next article, we will look into management and how trustworthy and skillful capital allocation can lead to potential multibaggers!