Most businesses earn ordinary profits most of the time. Competition does that. When something is profitable, others notice, copy it, cut prices and spread the profit thinly across everyone. Economists sometimes describe this as profits being “competed away”, and it is one of the most reliable forces in business.
A small number of businesses escape that pull. Year after year they earn more than their competitors, and the gap does not close. Warren Buffett built much of his fortune by finding these businesses and holding them for a very long time. Mary Buffett and David Clark’s book Warren Buffett and the Interpretation of Financial Statements is organised around a single question: how do you recognise one of these businesses from its numbers?
The term they use is a durable competitive advantage. Both words matter, and this article, the first in GoCore’s series on the book, explains each, shows where the evidence appears, and draws out what the idea means for anyone building a business rather than investing in one.
Why ordinary businesses earn ordinary returns
To understand why a durable advantage is valuable, it helps to understand why most businesses do not have one.
Imagine a new product that earns unusually high profits. Three things tend to happen:
- Competitors enter. High profits attract attention. Other businesses see the opportunity and start offering something similar.
- Prices fall. With more suppliers, customers have choices. Competitors cut prices to win share.
- Costs rise. Businesses spend more on marketing, features and service to stand out.
Squeezed from both sides, margins fall until the business earns roughly what it costs to stay in operation, plus a modest return. This is the normal state of most markets: airlines, generic manufacturing, many retail categories, commodity production. Good management can make a difference, but the industry structure sets a ceiling.
A durable competitive advantage is anything that blocks this process for a long time.
Advantage: why some businesses keep their profits
An advantage is anything that lets a business charge more, sell more or spend less than its rivals, without competitors being able to copy it quickly. The book describes three common forms.
A unique product that owns a place in the customer’s mind
When people reach for a particular brand without really comparing alternatives, that brand can charge a little more and sell a little more, every day, for decades. The product itself may be simple, such as a drink, a snack or a household cleaner. The advantage is in the habit and the trust.
This form of advantage is powerful because it is hard to copy. A competitor can match the product’s ingredients, but not the decades of experience and familiarity that make customers choose it automatically. A later article in this series, “Owning a place in the customer’s mind”, looks at it in detail.
A unique service delivered by an institution rather than by individuals
Some services are trusted because of the organisation behind them, not the particular person who delivers them. Customers choose a ratings agency, a payment network or a tax-preparation chain for its name and systems. If one employee leaves, the customers stay.
That distinction turns out to matter a great deal for where profits end up. When value depends on individuals, those individuals capture much of it in pay and partnership. When value belongs to the institution, more of it stays with the owners. The article “Institution or people?” explores this.
Being the low-cost buyer and seller of something people always need
Some businesses win not on uniqueness but on cost. If you can buy more cheaply than anyone else and still sell at the lowest price, you take volume from everyone. Large discount retailers, efficient freight networks and some warehouse clubs work this way. Thin margins on a huge volume can beat fat margins on a small one.
Cost advantages tend to come from scale (spreading fixed costs over more sales), purchasing power, efficient processes, location or network effects. They are durable when competitors cannot easily replicate them, for example because building a comparable network would take decades.
Other sources of advantage
The book focuses on these three shapes, but strategy writers describe other sources as well, including:
- switching costs, when it is costly or disruptive for customers to change supplier
- network effects, when a product becomes more valuable as more people use it
- regulatory or licence positions that limit competition
- unique assets, such as a location or resource that cannot be duplicated
Each can be durable, and each eventually shows up in the financial patterns described below.
Durable: why time is the real multiplier
An advantage that lasts three years is pleasant. One that lasts thirty years changes everything.
The book’s central argument is that durability is what creates wealth. A business that can keep selling essentially the same thing, to the same kind of customer, for decades does not need to keep reinventing itself. It spends less on redesign and retooling. That leaves more money to retain, to reinvest or to return to owners, and the effect compounds.
A simple illustration shows why time matters so much. Suppose two businesses each earn $1 million today, and each grows its earnings by 10% a year. The first keeps its advantage for five years and then reverts to an ordinary business with flat earnings. The second keeps its advantage for twenty-five years.
| Year | Business A (5-year advantage) | Business B (25-year advantage) |
|---|---|---|
| 5 | about $1.6 million | about $1.6 million |
| 10 | about $1.6 million | about $2.6 million |
| 25 | about $1.6 million | about $10.8 million |
These are illustrative figures, not data. After five years the two look identical. After twenty-five, the second earns nearly seven times as much. Durability, not the size of the advantage in any single year, is what separates them.
Durability and risk
Durability also changes risk. A business with a lasting advantage is far less likely to fail outright. In Buffett’s approach, as the book describes it, that means a falling share price can be an opportunity rather than a threat, because the underlying business is still intact. Buying such a business when its price falls actually reduces risk while increasing potential return, which reverses the usual assumption that higher returns require higher risk.
Where the evidence shows up
The book’s practical claim is that durable advantages leave fingerprints on a company’s financial statements, and that those fingerprints are consistent from year to year. The authors point to patterns such as:
- consistently high gross margins
- modest spending on overheads relative to gross profit
- little need for heavy research spending or constant capital investment
- low debt, and interest costs that are small relative to operating profit
- steadily rising earnings and retained earnings
- strong returns on equity without relying on borrowed money
- cash accumulating from operations, often returned through dividends or share buybacks
None of these signals proves anything on its own. Together, and over many years, they tell a story that is hard to fake. The rest of this series looks at each signal in turn.
Why consistency is the key word
A single year of high margins can come from a temporary shortage, a lucky product cycle or a one-off contract. Ten years of high margins, through recessions and competitive challenges, is much harder to explain without a genuine advantage. The book returns to consistency again and again, and so does this series.
How advantages erode
Advantages are durable, not permanent. The book acknowledges this, noting that once-powerful positions in newspapers and television weakened as the internet changed how people get news and how advertisers reach them.
Common causes of erosion include:
- technological change that makes the product or channel less relevant
- changing customer habits that weaken the place a brand holds in people’s minds
- new competitors with a different model, such as lower costs or a better experience
- complacency: a business that relies on its position and stops serving customers well
- regulation that removes a protected position
Watching for erosion is part of understanding an advantage. A business whose margins are slowly declining, or whose customers are drifting to alternatives, may be losing its advantage even while profits still look healthy.
Reading a business through this lens
Whether you are evaluating a listed company, a potential acquisition, a supplier or a competitor, the lens suggests a set of questions:
- What exactly is the advantage? Brand, institutional service, cost, switching costs, network, licence or something else?
- How would a well-funded competitor attack it, and why would they fail?
- Is the advantage visible in the numbers (margins, returns, debt, capital needs) consistently over many years?
- Is anything eroding it? Technology, habits, regulation, new models?
- How much does the business need to spend just to keep its position?
For listed Australian companies, the evidence is in annual reports, which include the income statement, balance sheet and cash flow statement, usually with several years of comparisons. Reading ten years of reports side by side is the practical starting point the book recommends.
What this means for someone building a business
Buffett’s lens is an investor’s lens, but it reads just as well as a design brief for founders. It shifts the question from “can this make money?” to “can this keep making money once others notice?”
Practically, that means asking early:
- Will customers choose this out of habit and trust, or only on price? If only on price, can we genuinely be the lowest-cost provider?
- Does the product need constant reinvention to stay relevant? If so, that cost never ends.
- Is the value tied to the organisation or to a few individuals? If it is tied to individuals, they will capture much of it.
- Will this still be needed, in roughly this form, in twenty years?
- What would make switching away from us inconvenient for customers, in a way that genuinely serves them rather than trapping them?
These are hard questions to answer honestly at the start of a venture. They are much harder to fix later.
Building advantages deliberately
Most advantages are not discovered fully formed; they are built. A small business can work towards one by:
- becoming the default choice in a narrow niche, where trust and familiarity accumulate faster
- systematising service so that quality belongs to the business, not just to individuals
- investing in processes that lower cost in ways competitors cannot easily copy
- choosing markets with lasting needs rather than fashions
- protecting reputation relentlessly, because trust is slow to build and quick to lose
A worked example
Consider two hypothetical small businesses that both make commercial signage.
The first competes on price for one-off jobs found through online quote sites. Each job is won against several competitors. Margins are thin, customers rarely return, and the owner must constantly find new work.
The second focuses on a niche: compliant safety signage for industrial sites. It builds a reputation for knowing the regulations, keeps records of each customer’s sites, and offers a maintenance service that replaces faded or outdated signs on a schedule. Customers come back automatically, refer other sites and rarely shop around, because switching would mean re-documenting everything.
The second business has the beginnings of a durable advantage: trust, institutional knowledge and switching costs that genuinely serve customers. Over time, those advantages would show up in exactly the patterns the book describes: steadier margins, recurring revenue, low marketing costs and earnings that grow without heavy reinvestment.
Common misunderstandings
“A great product is an advantage.” Not if competitors can copy it quickly. The question is what stops them.
“High profits prove an advantage.” Only if they persist. A single good year proves little.
“Big companies always have advantages.” Size helps only when it creates a cost or network benefit competitors cannot match.
“Advantages are permanent.” They erode, sometimes slowly, sometimes suddenly.
“This only matters to investors.” It matters most to the people deciding what business to build.
Bringing it together
A durable competitive advantage is what allows a business to keep earning more than its competitors for a long time. It usually takes one of a few shapes (a product that owns a place in customers’ minds, a service trusted as an institution, or a genuine cost advantage), and it shows up in the financial statements as consistent patterns: high margins, low capital needs, low debt and steadily rising earnings.
For investors, the idea explains where long-term value comes from. For founders, it is a challenge: build something that will still be valuable, and still hard to copy, long after others have noticed it.
Source: Mary Buffett and David Clark, Warren Buffett and the Interpretation of Financial Statements (2008). Figures in this article are illustrations, not data. This article is general information, not financial or investment advice.
