Do Competitive Advantages Lead to Higher Future Rates of Return?

Economic theory suggests that firms can gain competitive advantage, thereby impeding the normalization of risk-adjusted returns relative to industry peers. Thus, these advantages directly impact a firm’s future profitability as well as the assumptions incorporated into forecasting and valuation models. This paper utilizes realized operating performance, adjusted by estimates of operational risk, to establish which proxies for competitive advantage (i.e., expenditure of resources and effort) are effective at protecting profits. We demonstrate that the inclusion of proxies for competitive advantages in future profitability models significantly increases explanatory power. We find several proxies for competitive advantages that generalize across the entire sample including proxies for power over suppliers and the ability of a firm to credibly signal expected retaliation. Firms that develop these advantages experience a three percent premium in risk-adjusted return on net operating assets (RNOA) on average over their industry peers. This is economically significant given that the mean risk-adjusted RNOA for the sample over a 30 year period is 3.3 percent. The empirical evidence suggests that traditional variables used to capture competitive advantages such as proxies for product differentiation, innovation, and capital requirements do not result in persistent economic rents for the majority of firms.