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Competitive advantage: how to recognize a lasting edge

What a durable competitive advantage is, its most common forms, the traces it leaves in an annual report, and the traps to avoid when you assess one for a company.

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Definition

A competitive advantage is an asset that lets a company keep margins and returns above those of its competitors for a long time, without them being able to copy it easily. It can come from a brand, patents, a network of users, lower costs or how hard it is for customers to switch suppliers.

Formula

No formula: a judgment, backed by figures such as a ROIC durably above the cost of capital and a gross margin that stays stable over 10 years.

Where to find it in an annual report

The management report, at the start of the annual report, presents the strategy, the markets, the competition and the risk factors. The supporting figures are read over several financial years: margins in the income statement, ROIC from the income statement and the balance sheet, market share when the company discloses it.

Common thresholds

There is no threshold, only clues. Long-term quality: ROIC above 15% and a stable gross margin over at least 5 to 10 years. Reasonable growth: a rising market share and a high gross margin despite competition. In the preset strategies, this criterion is a yes or no with a note, or an unscored text.

In the preset strategies

Preset strategy Criterion met To monitor Criterion not met
Long-term quality Competitive advantage Yes No
Reasonable growth Target market and edge Not scored

Pitfalls

  • Mistaking a good product for a lasting advantage: a successful product can be copied within a few years.
  • Judging on a single year of high margins, which may reflect a favorable cycle rather than a real edge.
  • Taking the management report’s description at face value without checking it against the figures: every company presents its strengths in the best light.
  • Forgetting that an advantage wears off: a technological or regulatory change can wipe it out.

Where it does not apply

  • Commodities and undifferentiated products: the advantage lies mainly in production costs, which show up better in margins than in a description.
  • Young companies with no track record: the supporting figures are missing, so the judgment rests on assumptions.

The most common forms

  • Brand: customers pay more for a name they know and trust.
  • Switching costs: leaving the supplier costs time, money or risk, as with business software at the heart of a company.
  • Network effect: the service becomes more valuable as the number of users grows, which makes it harder for a competitor to break in.
  • Low costs: scale, a process or a location makes it possible to produce more cheaply than others.
  • Protected assets: patents, licenses, administrative permits that are hard to obtain.

What the figures show

A fictitious company, called Company D here, posts a gross margin between 58 and 62% and ROIC between 18 and 22% over ten financial years, while its competitors hover around 35% and 9%. This gap, sustained through several cycles, is a clue to a competitive advantage. It does not say where the advantage comes from: that is the job of the free note on the sheet. See also the ROIC entry.

Sources