How To Analyze Competitive Advantage in 5 Simple Steps + Cheat Sheet For Competitive Analysis

Companies with a durable competitive advantage pay the highest dividends in the long term. Here is how you can assess competitive position and a cheat sheet to streamline it.

If I were to pick one property for investment outperformance, it would have been a long-term competitive advantage—moat, Buffett would say.

Not growth, not management, not even valuation…

A business with a moat can outgrow most hyper-growth companies in the long term through slow but steady growth, survive disastrous management, and even justify seemingly stretched valuation.

I am not making this up:

In 1973, you could pay 281 times for L’Oréal, 241 times for Altria (Philip Morris), 129 times for Hershey’s, 115 times for Heineken, 100 times for Pepsi, and you would still make a 7% compounded annual return for the next 46 years!

This is a freakishly powerful concept.

The key would be recognizing that these businesses had unique competitive advantages that would allow them to keep thriving for decades. It wouldn’t be enough that you looked at these businesses, you had to reach that conclusion.

This is by far the most powerful and, more importantly, the most replicable way of investing for superior returns.

There are new L’Oreals, Pepsis, and Heinekens of the world around just now.

There are some companies that people will look at 50 years from now and say that you could pay up 100 times earnings for them in 2025 and could still generate 7-10% annual returns for the next 5 decades.

The key? Recognizing giants’ moats that will stay unviolated.

How?

You have to understand where the moat comes from and how.

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My Exact Process for Analyzing Moats

1️⃣ Is The Industry a Favorable One?

Competitive advantage feeds on two sources—the market and the business itself.

The market where the company operates should be a favorable one to create a business with competitive advantages.

This is the first condition.

If the market isn’t a favorable one, it’ll be very hard for the business to create a sustainable competitive advantage.

It’ll be like trying to sell a hot coffee under a burning summer sun. Nobody would care.

Not all the markets are equally favorable for creating deep moats.

What markets are favorable?

Well, you have to understand where the competitive advantage comes from.

Michael Porter laid this out in his book “Competitive Strategy”, the bible of competitive analysis:

In essence, all competitive advantage comes up to lower prices or higher differentiation. You either sell the same product as competitors at a lower price, or you sell a product that is somehow different from others.

That’s the essence. These are the questions you have to answer.

• Does this market allow a firm to have continuously lower prices than competitors?

• Is this a market where consumers care about product differentiation?

If the company is selling a generic product, low prices stem from economies of scale and scope.

Imagine that a company is manufacturing duct tape.

If it’s fixed costs disperse over a million products rather than a hundred thousand products, its cost per duct tape will be lower, so it’ll be able to offer lower prices.

There is a critical question here.

For this advantage to be sustainable, it should be hard for others to replicate.

How do you assess that—you look at the minimum efficient scale.

This is the minimum scale you need to have to manufacture a product as efficiently as possible. When you reach that point, a larger scale won’t create any more efficiencies.

If the minimum efficient scale is low, everybody may achieve similar costs with little investment. The result is no sustainable competitive advantage despite lower costs.

Example: If the largest duct tape manufacturer has a capacity of 10,000 a day and if it takes just a $5 million investment to create a factory that would match that capacity, there is no competitive advantage. Everybody could do that.

If the minimum efficient scale is very high, the low-cost structure can be a sustainable competitive advantage.

Take Amazon as an example— it has over 185 fulfillment centers worldwide.

Each of these centers costs on average $200 million to build and an additional $500 million to equip with robots. This means that any e-commerce business will have to invest $130 billion just to match Amazon’s scale.

This is already a huge investment. The scale is too large to match easily.

Now add on the business risk. You could be crazy and invest all those dollars and still have a very low chance to succeed, making the cost of investment way higher than the face value of $130 billion.

This is a very high scale that could be matched by no company in the world. Low cost can now mean a durable, competitive advantage.

The second question is to determine whether the industry is favorable to competitive advantage by differentiation.

It’s simple, you just ask— do people even care?

Do people care about what color, shape, or brand of duct tape they use?

No. Duct tape should only do the job.

We don’t care about the color, branding, packaging, etc… The best duct tape is the one that does the job. Competitive advantage by differentiation isn’t viable.

It’s a freaking duct-tape.

Think about the soft-beverage industry, on the other hand.

We like how some drinks taste, but we don’t like some others.

Coca-Cola is the most consumed drink in the world because it has a taste that uniquely fits the palate of most people in the world.

You care about the taste, how it makes you feel, etc…

The same goes for the smartphone industry. People care about ease of use, design, branding, how the phone makes them feel… Whether you use an Android or an iPhone makes a difference.

Here you have it, two questions for a simple analysis of the industry:

• Is the minimum efficient scale low or high?

• Do people care about product features?

An industry may be receptive to none, one, or both of them. This determines what to look for in individual businesses.

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2️⃣ Are the Entry Barriers High?

From now on, you are trying to understand whether the business is exploiting the potential competitive advantages that could be created in its industry.

The first thing I look at is entry barriers.

Remember our example on scale? If anybody can put $1 million and start competing with you, entry barriers are low.

Think about a neighborhood coffee shop.

An average coffee shop costs anything between $80,000-$300,000 to open.

This is a very small fixed investment. Anybody can enter this business and steal sales.

Let’s put some extreme examples on the other hand—the cloud computing business.

You need a place to establish your data center, you’ll need cutting-edge server racks and chips, and the best engineers in the field.

These costs will easily climb over $100 million. Even if you have the money, there is no guarantee that you can get the equipment, as they are in short supply because of excessive demand. Suppliers won’t likely prioritize you over the hyperscalers like Amazon, Google, and Microsoft.

Very high entry barriers.

Yet, economies of scale and the high fixed investment it requires aren’t the only entry barrier. There are many others.

Brand loyalty: Consumers want to keep consuming what they already consume and like rather than switching to new brands.

Vertical Integration: Industry may necessitate for company to produce both the raw inputs and the final output itself. For instance, Apple makes its own chips to use in iPhones. If this is the general structure in the industry, suddenly a new entrant has to create many businesses, not just one, raising entry barriers.

Geographical Barriers: An example would be Oktoberfest beers. If you want to label your beer as an “Oktoberfest Beer” and sell it in a tent during Oktoberfest, you must use all Bavarian ingredients and get approval from the authorities. This is a high geographical barrier.

First Mover Advantage: In some industries, first movers can reach a critical mass of users, making entry inviable for potential competitors. For instance, Netflix was one of the first movers in digital streaming, and others still struggle to compete with Netflix because it reached a critical mass.

Patents: They give their holder a monopoly over an invention. If the product is protected by a patent, others won’t be allowed to replicate it.

They together determine how high the entry barriers are.

It might be hard to assess all those factors independently. Instead, you may look at the way they manifest themselves.

We look at capital intensity.

Generally speaking, the more capital-intensive the industry, the higher the entry barriers.

We determine this by looking at Property, Plant & Equipment Expenses-to-Revenue (PPE/Revenue).

This tells us how much capital needs to be tied to generate $1 in revenue.

Example: PPE = $5 B, Sales = $10 B → 50¢ of capital per $1 revenue.

The higher the ratio, the more capital-intensive the industry, hence the higher the entry barriers.

If the incumbent’s PPE/Revenue ratio is higher than that of the industry median, you can assume that it’s protected by high entry barriers.

Father of competitive strategy, Michael Porter, wrote a paper with Anita McGahan called “The Emergence and Sustainability of Abnormal Profits” and explained this.

If you are interested, you can read the full article here.

As a rule of thumb, if the business you are looking at has a 20% higher PPE/Revenue ratio than the industry median, you can assume high entry barriers and capital intensity.

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3️⃣ Low Supplier & Buyer Power

A business is just a unit in the overall economy, it’s a part of the system.

No business is 100% self-sufficient.

They buy some inputs or services from outside, add value, and sell to end users.

The more unique the product you sell to the end customer, the stronger you are as a business. This means that end users will depend on you for that product. If this is the situation, it means that buyers have low power.

Think Apple, as an example.

There are millions of buyers, and if they want an iPhone, Apple is the only company. One user has no power at all, he can’t affect Apple’s position by deciding not to buy from it. There are millions of others.

Some businesses, on the other hand, have just a few customers buying all their products. Think about a farmer who sells all their crops to the only warehouse in their locality. Buyer has a huge power now. If he tells to farmer, “I won’t buy from you if you don’t plant all the tomatoes this year,” the farmer will surely plant only tomatoes.

Less buyer power, more competitive strength, and vice versa.

Conversely, just as the farmer depends on the warehouse, the warehouse may solely depend on the farmer, too.

Imagine you are a grocery wholesaler there are only two farmers that are selling to you. They’ll have higher power over you as your business depends on them. They may ask higher prices, and you’ll have to pay.

However, if you had 100 suppliers, you could just tell them—go fu*k yourself!

The best position to be in is that your suppliers and buyers have very little power over you.

Take Apple again.

There are hundreds of companies that could produce casing for iPhones, and they will race to offer the cheapest price. Apple can change them at the whim without feeling any adverse effects. A buyer also doesn’t mean anything. If a buyer ditches iPhone and buys an Android, Apple won’t feel it.

I have developed a rule of thumb over the years:

If no single supplier makes up more than 20% of all input costs and no buyer is responsible for more than 10% of the total revenue, supplier and buyer power are pretty low.

This is the best position to be in terms of supply and demand balance.

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4️⃣ Network Effects

Some products become more valuable as more people use them.

Social network platforms are the prime examples.

Think about Instagram.

It becomes more valuable when more people use it because you’ll find more friends & more content on the platform.

This is what network effects are.

What’s critical is that once the size of a network reaches a point called “critical mass”, the market tips. This is the point where, for any potential new user, joining the incumbent platform is a better option than joining a smaller competitor.

Again, thinking in terms of Instagram, it reached this point when any potential user in the world had more friends on Instagram than on any other similar platform.

This creates a giant, giant moat because nobody wants to leave their extensive network on the platform.

This is one of the most valuable competitive advantages and one of the hardest to disrupt.

The good news is that it’s easily observable in most cases.

Just look at the business model—is it based on creating connections between users?

These connections could be between the same group of users as in Instagram or different groups of users as in Amazon marketplace, where buyers are sellers are connected.

So, how do you know whether network effects are working, and where do you observe them?

Simple, look at the user count and revenue per user.

Companies with strong network effects demonstrate growing revenue per user in parallel with user growth.

Look at how both metrics grew for Meta:

In sum, if active users are growing together with revenue per user and you have a platform business, you are likely looking at strong network effects at play.

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5️⃣ Not Too Many Substitutes

The more substitutes the company has, the weaker its competitive position.

It’s simple.

Just go back to the duct-tape example.

Every duct-tape brand is a substitute for each other, and beyond that, other types of tapes and most types of glues can also be substitutes in most situations.

But if you want to train high-performance AI models, you only have a few alternatives— Nvidia H100 and later series, AMD MI300 series, and a few custom-made chips of hyperscalers.

You can simply observe how many perfect substitutes there are and how many companies are producing competing products.

The good news is that this is also perfectly quantifiable most of the time.

The more unique the product, the higher the premium on cost the company can charge.

What does it mean? It means higher gross margins.

If the gross margins stay stable, that means that the company’s competitive position is also stable; if they are rising, it means the pricing power of the business is rising too.

Comparison of Intel’s and Nvidia’s gross margins draws the perfect picture:

As you see, Intel’s gross margins have consistently eroded since 2010, while Nvidia’s margins have consistently expanded.

In sum, take a look at gross margins; they tell the story.

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Connecting the dots…

If you analyze many companies and don’t have much experience with competitive analysis or find this process boring, no worries. I got you.

I have created a simple model that quantifies all my competitive assessment processes explained above.

You just gather the data and answer 10 Yes/No questions, the model gives you an estimate of the overall competitive strength of the business.

The model gives you four results: Deep Moat, Relatively Strong Moat, Moderate Moat, and No Moat.

Giving this for free to celebrate reaching 15,000 members, I hope it’ll be helpful!

Competitive Position Analysis

9.66KB ∙ XLSX file

Download

Download

This is a simple model but it goes a long way in streamlining competitive assessment.

I hope you’ll largely benefit from it!

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