#97 | 4 Visible Competitive Advantages | Part 1

🎁 Special Announcement: To celebrate Siem's upcoming wedding on July 1st, we are giving away 30 days of full, unrestricted access to the TDI Terminal completely free. No credit card required! Head over to thedutchinvestors.com to claim your access. If you want to drop us a wedding gift, please leave a 5-star review on your favorite podcast app!

Every investor has heard the word moat, but how do you separate a genuine corporate stronghold from a company that just had a few lucky quarters?

In part one of this special two-part series, we break down four traditional competitive advantages that leave a clear, visible trail right in the financial statements. These are the structural frameworks that allow elite companies to widen their market share, slash unit costs, and lock out the competition.

Transcript

SPEAKER_00 0:00

There is a single word you've heard a thousand times if you look at stocks. You've heard it on earnings calls, you've seen it in slide decks, you've read it in investment write-ups, more than you can count. And yes, to be completely fair, you've heard it from us too. The word is moat or competitive advantage, arguably the most famous thing Warren Buffett ever came up with. He always said that a truly great business is like a castle, and every castle needs a white moat around it, filled with water. The water is what keeps the enemies from rowing across and taking what's yours. So in the business world, a moat is whatever structural advantage that keeps your competitors from stealing your customers and cutting into your profits. It's a beautiful image, probably the most quoted idea in all of investing. The problem is, however, it's also one of the most abused words out there. Plenty of things people call a mode turn out to be nothing more than just a few good quarters, or a competitor who just hasn't gotten around to attacking yet. So in this two-part series, we are breaking down seven traditional competitive advantages with real company examples. But before we dive in, a quick heads up the TDI terminal is completely free for the next 30 days when you sign up at the Dutchinvestors.com. As some of you might know, I am getting married in just a few days on July 1st. So the team and I want to give you all a little sign of our appreciation for supporting us along the way. No credit card is required, no strings attached, just full access to our all-in-one investing terminal for 30 days. And hey, if you want to give me a little wedding gift in return, give us a 5-star review on whatever app you're listening this podcast to right now. It takes about 5 seconds and it's completely free, and it's the best way to support us and grow the show. Thank you so much. Alright, let's get into the four modes you can measure. Let's start with the very first mode. Economies of skill. Everybody thinks they understand this one. You have a big company, so you have lower costs, and game over. But it's not that simple. Simply being bigger is not a mode per se. There are plenty of massive, clumsy companies out there with zero cost advantages. A real skill mode is about the shape of a company's cost. It happens when a business has to spend a massive fortune up front to build something, whatever that is, a factory, a software platform, maybe an Amazon distribution network. But after the infrastructure is built, it costs them next to nothing to serve each additional customer. So when a business looks like this, every single new customer spreads those giant upfront costs over a bigger and bigger base. So your costs per customer keeps dropping as you grow. Think about what that means in a price war. If a smaller competitor tries to attack you, you can easily drop your prices to a level where they lose money on every sale just trying to keep up with you, while you stay profitable. For decades, Intel used this exact edge in chip manufacturing to sit on top of the market while AMD black money trying to catch up. But there is a warning for this mode, because scale isn't infinite. There is a point where getting bigger stops making you cheaper. If a company gets too big, without incredibly tight management, it flips. You get the opposite of scale. You get bloated, red tape, and a supply chain that ties itself in knots. So next time someone tells you a company has a scale mode, just ask yourself, is it big in a way that actually lowers its costs or are they just big and clumsy? Let me try to give you a real-world example of a company you might not have heard of before, even though they have almost certainly taken some of your money. They own dozens of brands, Rayban, and tens of thousands of stores as well, like Pearl Vision. They also hold the licenses to make glasses for luxury brands like Prada, Burberry, Chanel, and Versace. They control lens manufacturing at a scale no one can touch, and they own a massive chunk of the physical shops where you buy these glasses. So if a new competitor wants to try and make cheaper frames, they honestly can't, because they have nowhere to sell them. Asilor Luxotica owns the entire pipeline. You walk into an optician, and this one company gets paid twice, sometimes even three times, including insurance. Once for the frame, once for the lens, and insurance sometimes. It's a brutally empowerful scale mode. But scale economies can also emerge from sources beyond fixed costs. Lower per volume costs due to production costs tied to the area with utility tied to volume, think of warehousing, for example. Or, like I said, the distribution network density. Lower per delivery cost due to proximity recipients along the route. I think Amazon is the best example here. Or what about learning economies? Although a bit opaque, but if learning is correlated with production levels, then a scale advantage accrues to the leader. Think of TSMC for example. Or what about purchasing economies, where lower costs per item due to significantly larger order size? Walmart and Costco are good examples of this. Let's get into the second mode: network effects. If scale economies make a company cheaper, network effects make a product more valuable. They are essentially mirror images of each other. A network effect happens when a product gets more valuable to the people already using it every single time a new person joins. Think about a phone. One telephone in the world is completely useless. I mean, who are you going to call? But when everyone else gets a phone, your phone suddenly becomes an essential part of life. The physical phone didn't change. Its value came entirely from everyone else having one as well. This creates a massive barrier for competitors. By the time a challenger builds a copycat app, you already have the users. A newcomer could build a social media app or video platform that is genuinely than what's available on the market. And yet they will still lose most of the time. Because the thing users actually want isn't about having a nicer feel or the software. It's just where the other users are. Look at Google's parent company, Alphabet. They run two of the strongest network businesses ever built. Google Search and YouTube. Take search. Every time you search something, you type a query into Google, you are giving them free data. Google watches what you click and how fast you come back. It uses that data to make the next answer a tiny bit smarter for the next person, across billions of searches every day. To beat Google, a competitor needs a search engine that is just as good. But to beat that good, they need Google's data. And to get that data, they need billions of users. It's a closed loop that eats its own tail. This is exactly why Microsoft has spent billions of dollars on Bing for years and remains stuck in a distant second place. Because money wasn't the issue. Breaking Guga's data loop was. But there is also a risk here. Networks can run out of steam, and they can even flip negative. If a platform gets flooded with spam, bots, and junk, that very same engine that built the company can also tear it down. Every new user makes the experience worse instead of better. So network effects are definitely not unbreakable. They are one of the hardest to get rid of though. That brings us to mode 3. Counterpositioning. Now, this is a weird one, and it's a mode that most people actually get wrong. Every mode we've talked about so far protects the giant from a newcomer. Scale and network effects are walls that the small guy simply cannot climb. Counterpositioning goes the opposite way. It basically protects the little guy from the giant. And the craziest part is the wall isn't built by the newcomer. It's built out of the giant's own profit margins. Let me explain. It works like this. A small, nimble company shows up with a completely new and better business model. Now, the big corporate giant obviously has the money and the staff to copy it. But they won't. Because copying the new model would completely wreck the highly profitable business they already run. So the barrier isn't that the giant can't copy it, they won't. We all know the classic story of Netflix and Blockbuster. But the version people tell is usually wrong. People say Blockbuster was clueless, that they didn't see the internet coming. But that's not true. In the early 2000s, Blockbuster CEO actually saw the threat of Netflix and fought back hard. He launched Blockbuster Online, dropped late fees, and let people swap online rentals for free movies in physical stores. And it actually worked. Blockbuster started signing up online subscribers faster than Netflix. So why did Blockbuster still go bankrupt, you might ask? Because their counterattack was burning $70 million a quarter, and it was eating directly into the in-store late fees that was so highly profitable and kept the company alive. The biggest shareholders looked at all the cash going up in smoke. They panicked, forced the CEO out, and hired a new guy who brought back the late fees and killed the online budget. Blockbuster saw the future, they had the resources to fight, but they still couldn't survive the internal pressure to protect their old Fed profit margins. A couple other examples are Kodak who got disrupted by Digital or Borders by Amazon. Or what about Tower Records by iTunes? Or Encarta by Wikipedia. The graveyard of disrupted incumbents is full of executives who saw it coming but couldn't move, because the people who owned the old business needed it to keep paying. Counterpositioning only exists in the narrow band where the incumbent is fully capable of responding and fully unwilling because responding would hurt more than standing still. I think it's worth diving into another case study for counterpositioning because I think this is one people get wrong most often. Vanguard against the active management industry is a very clean case. Jack Bogle launched the first index investment trust in 1976. On a single thesis, most active fund managers underperformed their benchmark after fees. So the solution is to stop paying them. Every active manager in the industry had access to the same data. The counterposition was so obvious. Fidelity's chairman at the time responded that investors would never be satisfied with merely average returns, which is precisely the kind of sentence an incumbent says when they're standing in front of the mode they can't cross. A $10 billion fund at a 1.5% management fees generates $150 million in annual revenue. The same fund in a Vanguard-style vehicle at 0.08% fees generates $8 million. No asset manager migrates their clients voluntarily from one to the other. Fascinating mode. Which brings us to the fourth and final mode of this episode. Switching costs. This simply means that leaving a vendor or a software provider, for example, is much more expensive and painful for a customer than just putting up with price increases. And notice, this is not about whether a better product exists. A better option almost always exists. The real moat is whether a company can actually afford the time, money, and risk required to switch over. The pain of leaving comes in a few forms. There's the direct financial cost of buying a new system, there's the massive headache of retraining hundreds of employees, there's the risk of losing years of historical data. Usually these problems hit the business all at once. The sneakiest thing about this mode is that it's strongest when it's completely invisible. When you sign up for a new software tool, you never think about how hard it will be to leave. You only think about how easy it is to join. That's smart, and smart companies know this. So they make onboarding incredibly cheap and simple. Then, as you use the tool month after month, your data accumulates, your workflows adapt, the switching cost quietly builds up in the background until leaving becomes completely unthinkable. Look at the German software giant SAP. They handle back office systems, financing, HR, supply chains, boring stuff, for a massive portion of the world's largest companies. Installing SAP can take 3 to 5 years and cost upwards of $100 million. It hooks into every single payroll run, supplier payment, and inventory report. Now, you want to leave SAP. This company would have to tear out its entire operational spine and replace it live while the business is running, praying nothing breaks or losing money. Customers don't stay with SAP because they think it's the best software or they love the product. They usually stay because leaving is a life-threatening risk to the business. If you want to spot this mode from the outside, look at revenue quality. If a company's existing customers keep spending more year after year, and profit margins are slowly creeping up without the company spending a fortune on marketing, you are looking at the fingerprint of switching costs. The customers are just accepting the price hikes because staying still makes more sense than leaving. But the catch with switching costs is that they are highly vulnerable to platform shifts. When the world moves from desktop to cloud or from cloud to AI, companies are forced to migrate their data anyway. And once a customer is forced to move regardless, the question stops being, should I leave you? but becomes where am I going next? That is the exact moment a switching cost mode dries up. And we are seeing this right now, through IBM, cloud providers, Wix, and many other examples. So those are the first four: economies of scale, network effects, counterpositioning, and switching costs. These are the modes you can measure, because they leave a visible trail in the financial statements, usually. You can see the cost curves dropping, you can see the user base widening, or retention rates staying well above 100%. In the next episode, we are going after the four modes that are harder to see, but even harder to break. The modes you cannot buy your way into, no matter how much capital you have. Until then, when you look at a company, keep asking the only question that really matters in the long term. What exactly is stopping everyone else from taking or eating their lunch? That's it for today. Thank you for listening to the Dutch Investors Podcast. Don't forget to sign up for free to get 30 days free terminal access at thedutchinvestors.com. We will see you next week, and like always, stay curious, keep learning, and happy investing!