Supernormal Profit

Supernormal Profit (also known as 'Economic Profit' or 'Abnormal Profit') is the extra profit a company earns over and above the minimum required to keep its resources in their current use. Think of it this way: normal profit is just enough to cover all your costs, including the opportunity cost of the capital invested (i.e., what the investors could have earned elsewhere with similar risk). Supernormal profit is the juicy extra bit on top of that. It's the true measure of a business's success, distinguishing it from merely surviving. While accounting profit simply subtracts explicit costs from revenue, economic profit goes a step further by also subtracting the often-hidden opportunity costs. A company might look profitable on paper (positive accounting profit) but could be destroying value if its returns don't beat what its capital could earn in a simple index fund. For a value investor, spotting a business that can consistently generate supernormal profits is like finding gold.

For disciples of value investing, supernormal profit is the holy grail. It's the clearest signal that a company possesses a durable competitive advantage, what the legendary investor Warren Buffett famously calls an 'economic moat.' A business that is just making normal profit is essentially in a fierce battle for survival, constantly at risk of being undercut by competitors. Any player can enter the market and earn that same minimal return. However, a company that consistently churns out supernormal profits is doing something special—something its rivals can't easily replicate. It has a fortress protecting its profitability. This fortress, or moat, allows the company to fend off competitors and maintain high returns on capital over many years. As an investor, your goal isn't just to find profitable companies; it's to find companies with wide, sustainable moats that can generate these excess returns long into the future, compounding your wealth along the way.

Supernormal profits don't exist in a vacuum. The market is a dynamic and competitive arena, and excess profits attract attention.

In a competitive market, supernormal profits are like honey to a bear. They attract new entrants who see an opportunity to grab a piece of the action. This influx of competition typically leads to:

• An increase in market supply.
• Downward pressure on prices.
• An increase in costs as firms compete for resources (e.g., talent, advertising space).

Over time, this process erodes supernormal profits, driving them down toward zero until only normal profit remains. This is the natural state of affairs in industries with low barriers to entry, approaching a state of perfect competition. This is why you see so many copycat restaurants or mobile apps pop up—the initial success of one inspires many to follow, quickly eroding the profitability for everyone.

So, how do the great companies defend their honey pot? They build and maintain a powerful economic moat. This structural advantage makes it incredibly difficult for competitors to attack their business and steal their supernormal profits. The primary sources of an economic moat include:

• Intangible Assets: Powerful brand equity (think of Coca-Cola's name), patents (protecting a pharmaceutical drug), or government licenses that limit competition.
• Switching Costs: When it's a major hassle or expense for customers to switch to a competitor. Think of changing your company's entire software system or your personal bank account of 20 years.
• Network Effect: When a product or service becomes more valuable as more people use it. Social media platforms like Facebook or payment systems like Visa are classic examples. The more users they have, the harder it is for a new player to compete.
• Cost Advantages: The ability to produce goods or services at a lower cost than rivals, often due to massive economies of scale (like Amazon's distribution network) or unique access to a cheap resource.

When Apple launched the first iPhone, it was a revolution. The company enjoyed enormous supernormal profits because it had a unique product with little direct competition. The high prices and massive sales margins were a clear signal to the market. Predictably, competitors charged in. Google developed the Android operating system, and companies like Samsung, HTC, and others flooded the market with alternatives. This intense competition drove down prices and forced everyone to innovate constantly. For many manufacturers, the supernormal profits quickly vanished, turning into a brutal, low-margin business. Apple, however, managed to defend its profitability. Why? Its economic moat. Its powerful brand, the iOS ecosystem that creates high switching costs, and its control over both hardware and software allowed it to continue commanding premium prices and generating supernormal profits, even in a crowded market.

Supernormal profit is more than just a number; it's a story about a company's unique position in the market. While accounting profit can tell you if a company made money last year, consistent supernormal profit tells you if it has a truly great business. As an investor, your task is to look beyond the headlines and find those rare companies with deep, wide moats capable of defending their supernormal profits for decades to come. That is the essence of long-term value creation.