Friday, January 2, 2015

Market Share and Moats

From The Little Book That Builds Wealth:
Surely, companies with large market shares must have economic moats, right?

Unfortunately, bigger is not necessarily better when it comes to digging an economic moat. It is very easy to assume that a company with high market share has a sustainable competitive advantage—how else would it have grabbed a big chunk of the market?—but history shows us that leadership can be fleeting in highly competitive markets. Kodak (film), IBM (PCs), Netscape (Internet browsers), General Motors (automobiles), and Corel (word processing software) are only a few of the firms that have discovered this.

In each of these cases, a dominant firm ceded significant market share to one or more challengers because it failed to build—or maintain—a moat around its business. So, the question to ask is not whether a firm has high market share, but rather how the firm achieved that share, which will give you insight into how defensible that dominant position will be.

And in some cases, high market share makes very little difference. For example, in the orthopedic-device industry—artificial hips and knees—even the smaller players crank out very solid returns on invested capital, and market shares change glacially. There is relatively little benefit to being big in this market, because orthopedic surgeons typically don’t make implant decisions based on price.

Also, switching costs are relatively high because each company’s device is implanted in a slightly different fashion, so doctors tend to stick with one company’s devices, and these switching costs are the same for all industry players, regardless of size. Finally, technological innovations are incremental, so there is not much benefit to having an outsized research budget.

So, size can help a company create a competitive advantage...but it is rarely the source of an economic moat by itself. Likewise, high market share is not necessarily a moat.