Sustainable Competitive Advantages: Consumer Preference
August 2, 2016
by Baijnath Ramraika, CFA and Prashant Trivedi, CFA with assistance from Ms. Siddhi Gujar
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“Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it’s the lack of change that appeals to me.” – Warren Buffett (emphasis ours)
“If you gave me $100 billion and said, ‘Take away the soft drink leadership of Coca-Cola in the world’, I’d give it back to you and say it can’t be done.” – Warren Buffett on challenges one would face in trying to overcome the moat of Coca-Cola
In one of the earlier articles in our series, we identified six distinct sources of competitive advantages. This is the fourth article and focuses on consumer preference as the source of a sustainable competitive advantage.
Defining consumer preference
Moats driven by consumer’s preference are widely thought of as brand-based moats or intangible assets-based moats. In some industries, there is a strong preference from the customer for brands, for example, with colas and cigarettes. Brand preference can emerge as an indicator of various things, including uniqueness or consistency of the product, status symbol and product quality.
Analysis framework: Consumer preference and sustainable competitive advantages
The reason we use the term consumer preference as opposed to brand- or intangible assets-based moats is because of a key factor behind these moats: consumers’ preference for a specific product at the expense of others. By terming businesses driven by consumer preference as “brand moats,” investors set themselves up for behavioral errors.
Not all brands are created equal. Indeed, even the most well known of brands may fail to endow its owners with any competitive advantage, let alone a sustainable one. For a consumer preference to lead to a sustainable competitive advantage, two elements need to be present: customer captivity and pricing power.
- Customer captivity
The key for consumer preference-driven moats is customer captivity – the consumer’s preference for the product should lead to some form of customer captivity requiring very strong incentives that deter the customer from switching. As highlighted in Buffett’s comments on Wrigley, customer captivity refers to a lack of willingness on the part of the consumer to change. Indeed, it is the customer’s continued preference for “a” specific brand at the exclusion of all others that is the basis of such a moat.
As discussed earlier, customer captivity may emanate from different factors, including uniqueness, quality and an association with happy memories. The important factor is that there should be a strong preference that the consumer should have for the brand in question.
- Pricing power
The other important element for the existence of consumer preference-based competitive advantages is pricing power. Unless the consumer’s preference for a specific brand endows its owner with pricing power, the competitive advantage of the brand is limited to non-existent.
So, what do we mean by pricing power? The pricing power we are talking about does not refer to an unlimited or unchecked ability of the business to raise prices at any rate that it desires. Indeed, we would suggest that if you have a product or service for which you can raise prices at any rate that you desire, you either have a Picasso at your hands – a rare product – or you have a Valeant at your hands – a source of trouble for your portfolio!
The pricing power of a business should manifest itself in two elements: the ability of the business to charge a higher price for its product as compared to a similar product that is not associated with a similar brand preference endowing the business with the ability to generate supernormal returns on capital; and the ability of the business to pass on any cost inflation to the consumer through price increase,letting the business maintain that supernormal profitability through business cycles.
Figure 1 summarizes the key elements of our analytical framework concerning consumer preference moats. C3P refers to the internal ranking term used at MAEG to define consumer preference businesses.