Warren Buffett repeatedly emphasizes that an investor must invest into a company that offers a durable competitive advantage. Any company that has a lasting competitive edge is likely to be able to maintain its profitability over a long period of time. Competitive advantage is meant to signify that the company must have a product or service line that is distinctively unique. However, a unique product or service does not make a company financially sound. Rather it is a durable competitive edge that ensures that the company would be able to maintain its advantage over a long period of time. The product and service must enjoy an advantage such as a brand name, a patent, a natural or regional monopoly. Firms also enjoy an advantage if they offer high quality products and are able to develop customer loyalty.
Warren Buffett states that any business that enjoys a durable competitive advantage is likely to have a long history of profitability that is based on a narrow range of products or services. A company that has a competitive edge is likely to remain in the industry for the foreseeable future. The fact that the organizations products are profitable would mean that their spending on research and development would be minimal whereas the company would also not be in need of continuous marketing. Furthermore, a company that enjoys less competition is likely to offer a product that has a rising or stable pattern of demand.
Any company that enjoys this edge is likely to be in a monopolistic position within the market. This is because its unique products and services are likely to generate sales due to their high quality and distinct image. This allows the firm to increase prices while still maintain profitability and sales. This is of immense importance to shareholders as increasing sales and returns signal higher returns for the stock owners. Furthermore, competitive advantage allows a business to refrain from entering into price battles with other competitors and the company is able to dominate the market. This advantage allows the firm to lead the market and generate high profits from the stable product line. Finally, the fact that the business has a durable advantage would mean that it would be able to maintain the current earnings per share in the foreseeable future.
So how exactly is the durable competitive advantage beneficial to investors like Warren Buffet? Warren Buffet states that any company that enjoys a sustainable competitive advantage is likely to invest a minimal amount into research and development and new plant and equipment. This would free up cash for other investing purposes such as expansion that would allow the business to increase its sales and profitability. The availability of cash is also likely to prevent the company from taking on debt and incurring the cost associated with servicing of debt. A company that enjoys this financial advantage is likely to have high amounts of free cash flow according to money forum which could be passed on to shareholders in form of high return on equity.
Although this article is focused on only one of Buffett's investing principals, feel free to follow this link to for other Warren Buffett Book. The link will take you to a YouTube video where more Buffett rules are explained.
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