The #1 Principle Every Investor Must Learn (Competitive Advantage)

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This week's newsletter is an adaptation from my recent YouTube video on Competitive Advantages.

$12 billion.

That is how much this company was worth before dropping 99% in value.

Now, the crazy thing about this story isn't that investors lost billions of dollars, but is how predictable it was if you understood competitive advantages.

And so, in this week’s Five Minute Money, I’m going to teach you all about competitive advantages.

Now, this is what is going to allow you to understand as an investor what will make a company successful versus what could lead a company to bankruptcy.

Why Profits Get Attacked.

Now, just generally speaking in any sort of Econ 101 class, you are going to be taught that as soon as a company makes a profit, there are going to be competitors that try to take that profit from them.

That is why we like the simple framework of a great business being one that creates value, captures a portion of that value, and protects that value.

Now, today is all about how companies protect that value, which is what a competitive advantage is.

The 5 Categories of Moats.

Now, for those that are familiar with popular investors, they will have definitely heard of Warren Buffett, who is worth well over $100 billion.

He is not only one of the most successful investors of all time, he is also extremely apt at teaching people.

One term he came up with was this idea of moat.

Now this comes from the idea that if you have a castle in the olden days, you would build a moat around that castle.

That would make it harder for people to come into the castle.

The same idea holds in economics.

As I mentioned in Econ 101, you are taught as soon as a company makes a profit, everyone is going to be trying to attack that profit to take it for themselves.

Now, the only thing that will prevent that profit being stolen from you is moats, or competitive advantages.

Now, there are generally 5 categories of competitive advantages:

1. Network Effects

2. Switching Costs

3. Brand & Intangibles

4. Regulation

5. Cost Advantage

Below, I will go into each more in depth.

Network Effects.

This is probably most simply explained by the idea of a marketplace.

If you think of a marketplace like Amazon, people only shop on Amazon because there are a lot of sellers that sell stuff on Amazon.

Sellers only want to sell stuff on Amazon because there are a lot of buyers that buy stuff on Amazon.

What this is called is a two-sided marketplace, and it is one of the classic examples of a network effect.

Now the term network effect comes from this idea that the more people that are using a service, the more valuable that service becomes.

Now another classic example people use is telephones.

You can imagine the first person who ever got a telephone found it to be pretty useless until a second person got a telephone as well.

This is obviously because who are you going to call if there's only one telephone?

Now as more people get telephones and telephone numbers, the service becomes more useful, and so that is the idea of a network effect.

However, there are other subcategories of network effects besides that.

One of which is data.

This is not only really important today but is going to be increasingly important in the future.

Companies that have a lot of users are able to collect a lot of data on those users, which allows them to not only improve their product but in some cases also offer means of monetizing their product more efficiently, like advertising.

Now, if we think of Facebook, not only do they have the network effect of it being more valuable because half of everyone on Earth is on Facebook, it also is more valuable because of all the data they gather, which allows them to personalize the content for you as well as personalize the advertisements.

And so that is our first competitive advantage.

A company that has a network effect like this is going to be much harder to disrupt.

If you can imagine a competitor trying to go up against Facebook or Amazon today, it is very hard because you cannot build the same sort of user base that Facebook has or seller base that Amazon has very easily.

Switching Costs.

This is the idea that once you are on a service, it becomes much harder to leave that service.

Constellation Software is one of the pinnacle examples of this.

They buy vertical market software companies.

Now, these are very niche software applications that serve a very specific use case that is so important that it's usually called mission-critical.

Now, one funny example is chicken coop software.

So, if you are a farmer that has a chicken coop, you need to keep track of how many chickens you have, when they're being fed, their antibiotics and medicine, as well as how many eggs they're laying.

There's all sorts of different logistics involved.

This sort of software malfunctioning would potentially mean the death of your chickens.

It may sound funny, but it is a very critical business function.

And if you were to rip their software out, their business could potentially plummet.

That is why it is considered they have switching cost.

Even if someone else was to offer chicken coop software for less money, switching would potentially mean disruptions to the chicken farm.

And as a result of that, they are not going to want to switch.

Now, a lot of businesses have old legacy software that is just so ingrained in their everyday business process that it is considered near impossible to rip out.

It may be interesting, or scare you, to learn that most banks in the US actually run on software that was built on COBOL, which is a software program that is so old almost no one knows how to use it, except they cannot take it out of their bank's operational processes because it is so important.

And so if you were in a business who is selling these products that are so sticky that customers really cannot pull it out, period, then it is considered the product has a high switching cost.

One last classic example as a consumer could be something like your iPhone.

As soon as you put all of your data, your apps, your contacts, your passwords, your photos on your iPhone, it becomes much harder to switch to a different smartphone maker.

And so that is switching cost.

Brand & Intangibles.

Now, the third competitive advantage we're going to be talking about is brand and intangibles.

So why a brand is a competitive advantage is essentially because people know what they're going to get before they actually even have to use the product.

That is a big advantage in standing out versus many competitive products.

You can go check out the soda aisle and see hundreds of different options of drinks, except everyone knows Coca-Cola and they know what to expect with it.

That is a competitive advantage.

As many marketers will say, a brand is a promise.

And so for the consumer to know ahead of time what is being promised with that brand is very helpful.

Apple, for instance, has in the minds of many consumers this idea that they are going to be very high-end technology that is very easy to use, especially when compared to other alternatives like Dell.

This is one of the reasons why Apple has such a strong brand amongst consumers.

Now intangibles, which is also being grouped together here, will include anything like IP, which is going to be any sort of intellectual property that a company has.

Now, a brand can be intellectual property, but so can something like a patent.

Now, why a patent would be an advantage is sort of obvious.

You created a design of something that no one else can copy.

So, to the extent that it's actually popular, that means now you have the actual law preventing competitors from doing the same thing as you.

And it should be pointed out that patents don't just have to be for new sort of designs.

They could also be for process improvements, stuff within the manufacturing process that makes it easier to make a device or makes it higher quality, a better material that maybe consumers don't even realize.

That is another advantage.

Regulation.

Now, we're going to move on to the fourth advantage, which is regulation.

Now, this one is also pretty straightforward.

There are certain businesses that are regulated in such a way that it actually becomes an advantage.

One example is telecom companies, which actually are able to bid on different spectrum wavelengths that they will then own, and then no one else is allowed to broadcast anything within that wavelength.

While it's an older school business, a radio station would own that literal radio wave band, and no one else is allowed to send out any sort of signals on it.

So there's no competition there.

Now there are many different radio bands, but not an infinite number.

And as a result of that, if you were able to bid on those licenses, especially early on, you probably would have been able to get them pretty cheaply, and no competitor was able to come in and steal it from you.

So that is one advantage when regulation is helpful.

Another one, and a really pinnacle example, is when you are looking at credit agencies.

Now, in short, whenever a company issues any sort of debt, they usually have to get it rated.

By getting it rated, they are able to actually lower their interest cost, and so it is in their benefit to get it rated.

But who is allowed to rate the debt is actually regulated, and as of now there's only 3 providers, S&P, Moody's, and Fitch, that are allowed to provide these ratings, and so as a result of that their business is more protected from competitors.

Cost Advantage.

Now the fifth example, and one of the most common advantages a business can have, is a cost advantage.

Now a cost advantage can come from a few different reasons.

It could be because you created a product in a more novel way that's cheaper to produce.

A lot of Japanese manufacturing firms have a process called kaizen, which is known to take a lot of little improvements in the manufacturing process to cut out cost along the way.

And all of these little improvements add up to be meaningful cost savings to the end user.

Now there can also just be simple scale advantages.

That is when it is much cheaper to produce a million of an item rather than one.

This is often because you are able to take advantage of automation, bulk processing, as well as buying raw materials in higher volume.

And so all of these cost savings can allow a company to still make a profit at a lower price.

And of course consumers love lower prices.

And so a cost advantage is a very strong advantage you could have.

Now another sort of advantage umbrella within that is a resource advantage.

This is another sort of cost advantage.

But imagine you're Saudi Arabia.

You are sitting on oil fields that are very cheap to access and have billions of barrels of oil.

That is a cost advantage relative to other oil producers, because the oil they produce may only cost $10 a barrel, where some competitors' barrels may cost up to $40 to extract.

And so if oil prices fall, they can still make money at much lower oil prices than competitors.

There could be other resource advantages, such as having valuable land which is very highly foot trafficked, that you can imagine is very helpful for a retail store, or even if you're a manufacturing plant, being close to something like a railway or a port could also save you on transportation cost and can be a cost advantage as well.

Now with an understanding of competitive advantages, we can go back to the intro and analyze this company that lost billions of dollars of investors' money.

And that company is GoPro.

Why GoPro Had No Moat.

And so as we go through these 5 competitive advantages, we could see that they really didn't have any.

Sure, some people would prefer the GoPro brand to an alternative, but not if the alternative was much cheaper, and so that weighed on their sales.

People could get cameras of very high quality for much cheaper.

And not long after GoPro rolled out, the cameras in smartphones drastically improved, further competing against a standalone camera that people will have.

Now, they do still have a little bit of a niche, and sort of these explorer adventurers that want to put a camera on and go surfing, but even within that realm, there are competitor products that are just as good, and many people are not willing to pay a premium price for GoPro.

And that is why today they are a suffering business, with their stock price down over 99%.

Now I said if you understood competitive advantages you could have seen this coming, because you would have seen that the earnings they were generating early on were not going to be protected, because they didn't have protection in a network effect.

They didn't have it in regulation.

They didn't have it in switching cost.

They didn't have it in branding, and they didn't have it as a cost advantage either.

And so you would have been able to, as an investor, avoid this situation entirely.

For More on AI Agent Risks, check out the video below.

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