A bit more than a year ago, I sat down with the CEO of what used to be a $1 billion company. The company is well-known, and I can almost guarantee that you've heard of it. Here are some of the highlights of the conversation:
"We have to invest year after year to maintain our competitive advantage."
"There's little that we do that no one else can do."
Are you kidding?
"We continually have to adjust for some kind of 'vaporization' effect with respect to our write-offs."
Out of journalistic considerations, I can't tell you the name of the stock. But the simple truth is that since the interview, shares have dropped 50% anyway -- so people are definitely getting the picture.
Dime a dozen
You might be able to find the stock if you looked hard enough -- actually, you could probably find dozens more in a similar predicament. While I thought the exec honorable for his candid truth-telling -- that's a big plus in my book -- it's not good enough for any investment of mine. The point here is universal: If the person I interviewed sounds anything even remotely like the CEO of a company in your portfolio, dump that stock. Now.
A lasting competitive advantage is a vital element of a great business. Without it, a company's brief edge in sales or technology will disintegrate like a finely built sandcastle on the beach.
Remember when Sony (NYSE: SNE ) had a lock on personal electronic devices like the Walkman? Shareholders were making money hand over fist in the 1980s and 1990s-- yet Sony couldn't maintain that momentum. Eventually, other companies like Philips (NYSE: PHG ) started taking tastes, then nibbles, then gigantic bites. The fat lady sang when Apple got in the game, and Sony has struggled to establish an identity of its own since.
A deadly trap
No matter how good a product or a service is, if it can be replicated by others, it's not worth much. In time, competitors will squeeze margins, batter revenue growth, and produce a red ocean of competition. Ever-greater investments each year will only yield smaller and smaller pieces of the earnings pie in return.
That's precisely why Intuitive Surgical has delivered more than 2,000% gains in the past five years. No one is even close to replicating the company's technology or products. And this explains why Dell (Nasdaq: DELL ) , a company that once leveraged excellent operational advantages atop a top-notch product, has nosedived. Formerly award-winning computers have been beaten by resurgent Hewlett-Packard (NYSE: HPQ ) , among others, leaving Dell to lick its wounds.
Of course, Dell has suffered from myriad problems, but its failure to manufacture a great product for years is certainly the company's biggest. Today, I think the opposite might be true. Dell is due for a mini-renaissance, but the point remains: Protect your advantages or buzz off.
Investing legends will tell you the same thing. Warren Buffett has made billions identifying companies that leverage products or brands whose edge was not in danger. Nike (NYSE: NKE ) , Costco (Nasdaq: COST ) , and Best Buy (NYSE: BBY ) come to mind specifically here. Buffett's track record confirms that looking for these types of businesses is a fundamental characteristic of a successful long-term investment.
Back to the horror story
I knew going into the CEO interview that I didn't really like the company's position in the industry. So when I got a sense that he was willing to talk, I pushed harder. I asked him whether the company had any kind of ringer in the pipeline -- perhaps a blockbuster project in one important segment that investors could look forward to. His response?
"There's no killer application."
Man. Sell that sucker.
Foolish bottom line
If you own shares of a company that has no real barriers to hungry competition and lacks anything in the works for the future, then what do you have? Not that much, really.
Instead, focus on the companies that do. Every single one of the recommendations in Motley Fool Stock Advisor leverages some kind of competitive advantage -- it's a crucial aspect of our selection process. And the strategy has paid off: We're currently beating the market by nearly 39 percentage points since inception in 2002. Want to take a look? Try the service free for 30 days.
This article was first published Oct. 15, 2007. It has been updated.
Fool analyst Nick Kapur owns no shares of any company mentioned above and has zero material interest in the company whose CEO he interviewed. Intuitive Surgical is a Motley Fool Rule Breakers recommendation. Best Buy, Costco, and Apple are Stock Advisor recommendations. Best Buy is also an Inside Value recommendation. The Fool owns shares of Best Buy and has a disclosure policy.