A company’s competitive advantage derives from an attribute or collection of attributes that enable it to achieve superior performance relative to its peers.

There are a number of different ways in which a company can achieve a competitive advantage.

The most spectacular competitive advantage belongs to the company that can turn a market upside down by providing a totally new product that renders its competitors obsolete (think digital cameras vs. photographic film, calculators vs. slide rules, or temporary storage in the computer industry where floppy disks were supplanted by CDs which were supplanted by memory sticks which were supplanted by online storage).

On the other hand, a company can achieve dominance in an industry, simply by doing things better than its competitors. Costco didn’t invent retail, but a fastidious attention to detail has made it one of the most respected companies in the industry. Investors holding the stock in 2009 will have more than trebled their money over the succeeding six years for a return of around 23% annually.

A company that can dominate an industry through holding a rock solid patent in an emerging technology will be able to sustain a competitive advantage more easily than a company that has to knock it out of the park with strong execution year in, year out.

In order to evaluate how a company derives its competitive advantage, it can be helpful to place the company in a suitable category:

• Disruptive Innovators
• Sustaining Innovators
• Financial Engineers
• Brilliant Executors
• IP Kings

Some companies may fit more than one category.

Let’s take each one in turn.

Disruptive Innovators

Disruptive innovators derive their advantage by completely changing an industry, often rendering competitive firms or products obsolete by introducing a new and better way of doing things. The classic analysis and description of disruptive innovation can by found in Clayton Christensen’s book, ‘The Innovator’s Dilemma’.

Christensen shows how young, growing companies with disruptive products can beat established market leaders – often with fatal consequences for the former champion.

By taking a detailed look at a number of disparate industries, such as disk drives, mechanical excavators and steel making, he shows how the entrenched players were unable to react to the disruptive innovator until it was too late.

Seagate was the dominant player in the market for disk drives for desktop computers. Seagate’s drives were 5.25” in diameter. When Conner introduced a new 3.5” format drive, Seagate was unfazed. Their customers were not asking for a new size, they wanted more capacity. Seagate’s engineers were actively engaged in producing a 3.5” drive, but when Seagate found no enthusiasm for the drive from their customers, they decided to shut down the project.

Conner’s smaller, lighter 3.5” drive may not have had the capacity of Seagate’s drives, but it had key advantages in the burgeoning market for portable computers. With orders from Compaq Computer, Conner had the resources to improve the speed and capacity of its drives. Eventually everyone recognized the advantages of the 3.5” drive, and Conner displaced Seagate as the dominant supplier of disk drives in the market for both portable and desktop computers.

Conner was the disruptive innovator.

Ironically, in an earlier period when the 5.25” drive was first introduced, it was Seagate that was the disruptor. Seagate displaced the manufacturers that produced the 8” drives originally used in mini-computers.

Being a disruptor offers no protection against being disrupted.

Another classic example of disruptive innovation is the Kodak company. Kodak led the photography industry for many years but then succumbed to bankruptcy when digital cameras replaced the need for photographic film.

Sustaining Innovators

Sustaining Innovators take an existing technology and keep developing it to produce better and better performance.

In the market for 5.25” disk drives, Seagate was a sustaining innovator – maintaining their dominance by continuously improving their drives.

Apple didn’t invent the personal computer, digital music player, or mobile phone. But it has produced products in all three categories that are arguably better than those produced by Apple’s competitors.

Apple is brilliant at taking an existing product and constantly refining it until it reaches its full potential. The company has established a solid reputation for elegant design and high quality. Customers are prepared to pay high prices for Apple’s products. Although Apple does not sell as many phones as its competitors, it makes far greater profits. Apple’s pricing power enables it to sell products with much higher margins than its rivals.

Apple is the epitome of a successful sustaining innovator. The danger for Apple is that it relies heavily on sales of mobile phones. If a disruptive innovator arrives on the scene with a product that can replace the mobile phone, Apple could be in trouble.

In the automobile industry, cars have been using the internal combustion engine (ICE) for well over a hundred years. Over this time, companies such as BMW have been refining the product to produce levels of performance and efficiency that would have seemed fantastic to the original engineers. BMW is another great example of a sustaining innovator.

Tesla is producing cars that are powered by electricity. The engine has been replaced by a battery. The complex, highly-developed ICE with over two thousand moving parts has been replaced by a simple electric motor with fewer than twenty moving parts.

Tesla is attempting to be a disruptive innovator.

If Tesla is successful it could prove catastrophic to several of the largest automobile firms in the world.

BMW is responding by introducing electric cars of its own. Christensen contends that it is very difficult for an incumbent company to survive a challenge from a disruptive upstart. It will be interesting to see what happens.

Financial Engineers

It may seem natural to assume that great business leaders are masters of corporate management. They build efficient operations based on modern computer systems. They know how to motivate managers and staff. And they have a superior understanding of their products and how they fit into the market.

Surprisingly, an analysis of the businesses that have produced the best returns for their shareholders shows that the best CEOs are not these type of people at all. To be sure – the skills mentioned above are all necessary to run a business. But great leaders delegate these tasks to great operational managers. The best CEOs rise above the humdrum day-to-day concerns of management and instead focus on Capital Allocation.

When Tom Murphy was running Capital Cities, producing a staggering average annual return of twenty percent over twenty nine years, he focussed almost all of his energy on capital allocation. His colleague, Dan Burke, was given a free rein to run the business as efficiently as possible. Burke’s job was generating the cash. Murphy would decide what to do with it.

There is no special mystique surrounding the techniques used by great capital allocators. When shares are cheap – they buy them back. When shares are expensive – they use them for acquisitions. When debt is cheap – they borrow for expansion or acquisition.

Techniques which are directed towards the use of capital rather than towards the operational side of the business are commonly referred to as Financial Engineering.

Great capital allocators have three essential qualities:

• Patience
• The ability to spot an opportunity and seize it
• Adaptability

If necessary, the best capital harvesters will bide their time for years while they wait for an opportunity to arise. When the opportunity comes, they strike quickly. They adapt their actions to the circumstances. At one time they may be acquiring businesses. At another they may be disposing of them.

In short, they do whatever is necessary in order to achieve the highest possible return on their capital at any given time.

All this may seem like common sense, but very few CEOs possess the discipline to manage capital effectively. Most CEOs think like operational managers. On the occasions when they do make a capital decision – such as to buy back shares – they are likely do it for the wrong reason, and, often, at the wrong time. A common reason for buying back shares is to reverse the effect of using stock to pay employees (usually referred to as stock-based compensation) – a decision made to a fixed timetable, regardless of whether the stock is trading at an attractive price or not.

Many successful companies with household names achieved their success despite being poor capital allocators. Perhaps it is too much to ask that a company should have a CEO that is a both a creative innovator and a great capital allocator?

For the best example of the power of capital allocation, there is no better place to turn than to the master himself, Warren Buffett.

Berkshire Hathaway may be a three hundred and fifty billion dollar company, but Buffett runs it from an office in Omaha with just twenty five staff. Each business unit is totally independent. Buffett sits at the centre perusing the brief summaries of operational performance sent in regularly by his managers. Any surplus cash generated by the various business units is remitted to Berkshire. Buffett’s job? Allocating the capital in the most efficient way.

Using this simple model, Buffett has become a legend. ‘Knocking it out of the park’ doesn’t even begin to describe the performance of Berkshire Hathaway’s stock which has outperformed the S&P by a hundredfold.

Often, these days, Financial Engineering is referred to rather condescendingly. If a company has just raised its earnings per share by buying back stock, a commentator may say – ‘well they raised their EPS but that was just financial engineering’, as if to say, ‘OK – but the business hasn’t performed any better so that doesn’t justify an increase in the share price’.

Like most daft statements this can be countered by a reductio ad absurdum. If the 1.6 billion shares in Walt Disney were reduced to one, would that share be worth any more than it was before the reduction? Answer – of course it would, as it now represents the value of the entire business (in fact, it would be worth 1.6 billion times as much). Increasing the EPS by reducing the share count is not ‘just financial engineering’, it’s a valid way to permanently increase the value of each share.

If you are tempted to downplay a company’s worth because it has been ascribed to ‘financial engineering’, simply remember this – the companies that have produced the best returns for shareholders have all been run by great capital allocators.

Brilliant Executors

Some companies excel simply by being good at what they do.

Take Starbucks, for example. There is no impediment stopping any competitor from setting up a coffee chain to rival Starbucks. In fact, Starbucks success has attracted a whole host of new entrants to that market.

But through simply being a great executor, Howard Schultz has propelled Starbucks to be the leader of the pack. As the company’s brand and reputation has grown it has become more and more difficult for new entrants to mount a successful challenge.

Another great example of execution is Costco.

Jim Sinegal believes in an ethical approach to business. He builds trust from his customers, nurtures his staff and treats his suppliers fairly. Founding Costco in 1983 with fellow entrepreneur Jeffrey Brotman, he paired this stakeholder-friendly approach with a lean business model and a laser focus on low prices. By sticking fastidiously to this approach, he took Costco from nothing to be the second largest retailer in the world in 2015.

Costco’s decision to give priority to other stakeholders over shareholders has not always resonated well with Wall Street. But early shareholders who recognized Sinegal’s dedication and ability to execute have been far more richly rewarded than those who were tempted to seek the short-term, quick-buck on offer elsewhere.

IP Kings

IP is a commonly used abbreviation for Intellectual Property, such as copyright in a software product, a trade secret, or a patent for an industrial process.

A great way to secure long-term returns is to invent something useful and then sit back and collect royalties.

IP based companies will often invest heavily to create some kind of intellectual property that they can then exploit at high margins for many years to come.

A software company may spend years creating a product, but once it exists the product can be sold for a high price with minimal cost of sale. Microsoft is a great example. It invested heavily over the years producing MS-DOS, Windows and Microsoft Office. Once created, all of these products became huge cash cows for the company and continue to do so to the present.

In the computer industry, micro-processor companies like Qualcomm and ARM holdings are able to license their designs to other companies and collect a steady stream of royalties with no ongoing costs.

Companies like Facebook and LinkedIn have to invest heavily in building a platform to host billions of users – but once the platform is built they can grow revenues for years with little additional capital cost for infrastructure.

One danger to be aware of with IP centred companies is that their product may be displaced by a new technology. This is a particular danger with patents, which have a relatively short term before expiry. Businesses that invest heavily in research and development (R&D) may be able to protect against obsolescence by creating new IP to replace the old. But there is always a danger that a disruptive innovator will supplant their IP and render it worthless.

Any business that is ‘capital light’ has great potential to be highly profitable – and the IP kings are the most profitable of them all.

Summary

A sustainable competitive advantage is the most important quality that you should look for in a business in order to achieve superior investment returns.

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