Competitive advantage:
what makes it last?

At Sanlam Private Wealth, our investment philosophy centres on price relative to our assessment of intrinsic value, which we believe is the dominant driver of long-term investment performance. We also recognise that, over the very long term, a relatively small group of listed companies generates the vast majority of overall market returns. These are businesses that consistently earn returns above their cost of capital and can reinvest those profits effectively to sustain growth for many years. They are the companies we seek to own.

Economic theory – backed by real-world experience – tells us that companies earning superprofits inevitably attract competition, which in turn drives returns down towards the cost of capital. What ultimately makes a company valuable is its ability to continue generating superior returns relative to competitors and other industries over time. It can do this only if it possesses a sustainable competitive advantage – or what Warren Buffett calls a ‘moat’.

Staying the course

Looking back over the past 36 years, however, only a select few of the world’s largest companies have managed to sustain success over very long periods. Of the top 10 global companies by market capitalisation in 1990, none remain on the list today. Just one survives from 2000 – Microsoft – and only three from 2010: Microsoft, Apple and Alphabet (Google). Technology and competitive environments evolve rapidly, and today’s market leaders can easily become tomorrow’s laggards.

The question is: how does one determine which companies will endure, and which won’t? In other words, is the competitive advantage a business enjoys at any given point in time truly sustainable over the long term? Every listed company will claim to have something that sets it apart, but it is up to investors to distinguish between advantages that are durable and difficult to replicate, and those that are more fleeting.

For most shares listed on the JSE, more than three quarters of their value is attributable to events expected to take place more than four years into the future. Yet we know that predicting the future – particularly beyond the next year or two – is an inexact science at best. To gain a better sense of which companies are more likely to emerge as long-term winners, investors need to think broadly about businesses and focus more on enduring concepts than short-term specifics.

At Sanlam Private Wealth, a key part of our work involves assessing how a company’s competitive advantage may change over time – whether strengthening or weakening – and what this could mean for its long-term profitability relative to current market expectations. A strong but eroding moat is less valuable than a moderate but strengthening moat.

We’ve identified more than 30 potential sources of competitive advantage, ranging from internal culture to technology and systems, exclusive rights, relationships and location. However, in our view, only six of these qualify as truly sustainable competitive advantages:

• Network effects (think of the advantages enjoyed by Instagram or WhatsApp)
• Switching costs – in terms of both money and effort (imagine, for example, moving your entire office away from Microsoft products)
• Brand or patent strength (Apple, Coke, Ferrari, Cartier and Pfizer come to mind)
• Economies of scale (such as those enjoyed by Amazon, Walmart, BHP or Saudi Aramco)
• Proprietary data (where data is unique and continually refreshed – think Google’s vast data lake or Tesla’s autonomous driving dataset)
• Licences (which limit the number of players in the market – think Vodacom).

The strongest businesses typically benefit from more than one of these. Multiple reinforcing moats are often what enable companies to generate outsized returns over the long term.

In addition to the six advantages above, corporate culture – particularly a culture of innovation, as seen at companies such as Amazon and Nvidia – can also be a meaningful source of competitive strength. The challenge, however, is that culture is inherently harder to sustain over long periods and often proves less durable than the factors listed above. It should therefore be viewed with a degree of circumspection.

Network effects

The most powerful of these advantages is network effects – the more customers a business has, the more attractive it becomes to new customers. Instagram is a simple example: anyone joining a social network naturally gravitates towards the platform with the largest number of potential connections. The same principle applies to classifieds businesses such as Property24 and Gumtree, or dating platforms like Tinder. Once established, this self-reinforcing flywheel can be very hard to dislodge.

For network effects to translate into a meaningful advantage, companies also need downward-sloping average cost curves – something the global tech giants all have. Technology allows them to add new users to their core platforms at virtually zero marginal cost, enabling them to avoid many of the logistical constraints faced by traditional multinational businesses selling physical goods.

One of the key concerns about artificial intelligence (AI), however, is that the incremental cost of AI tokens is real. Adding users to platforms such as OpenAI's ChatGPT or Microsoft Copilot therefore carries a tangible cost, potentially limiting the extent to which these businesses benefit from traditional network effects.

Companies with strong network effects are often natural monopolies. This creates the potential for sustained superprofits – Facebook parent Meta, for example, generates operating margins of around 41% – but it also tends to attract regulatory scrutiny. History shows that governments are often inclined to break up or constrain monopolies, although policymakers may find it harder to argue that free services provided to consumers constitute an abuse of monopoly power.

On the JSE, there is arguably only one company with genuine network effects: Naspers/Prosus, whose key holding, Tencent, has more than 1.4 billion users. Yet compared with many of its US peers, Tencent continues to trade on a relatively modest valuation multiple. Most other large South African-listed companies rely primarily on economies of scale and brand strength which, while still durable, tend to be weaker forms of competitive advantage.

On our broader proprietary scoring system – which incorporates a range of factors beyond the sustainable competitive advantages outlined above – Naspers/Prosus consistently ranks among the strongest South African-listed companies. By contrast, Kumba Iron Ore has very limited sustainable competitive advantage, given its relatively small scale within the global iron ore industry.

While valuation will always be top of mind when we at Sanlam Private Wealth build an investment thesis around a particular asset or share, determining whether it has a sustainable competitive advantage is one of the ways we seek to understand the asset better. It helps ensure that we apply the appropriate long-term perspective when determining what that asset is truly worth.