A bit over 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 nearly 70% 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 -- and 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, or whatever will disintegrate like a finely built sand castle on the beach.
As a brief example, look at what has happened recently to GPS giant Garmin (Nasdaq: GRMN ) . For the last few years or so, the company has been the dominant brand in a segment that was growing like wildfire: personal navigation. Garmin was making money hand over fist, but it didn't demonstrate an ability to keep it going.
Eventually, others like Tom-Tom and Magellan starting taking tastes of Garmin's market share, then nibbles, and now Nokia (NYSE: NOK ) has come in for gigantic bites. Today, there's even more vicious competition, with previously unexpected players like Apple, Google (Nasdaq: GOOG ) , Research In Motion (Nasdaq: RIMM ) , and Palm (Nasdaq: PALM ) .
It's a completely destructive scenario for a once-powerful brand like Garmin.
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. More and more each year will need to be invested, only to receive a smaller piece of the earnings pie in return.
That's precisely why Intuitive Surgical has delivered over 800% gains in the past five years. No one is even close to replicating the company's Da Vinci technology. And it explains why businesses like General Motors and Ford have stagnated for years while more industrious and innovative firms like Toyota have held strong.
Investing legends will tell you the same thing. For instance, Warren Buffett has made billions identifying companies that leverage products or brands whose edge was not in danger. You can look at Buffett's most recent purchases of General Electric (NYSE: GE ) and Goldman Sachs (NYSE: GS ) as good examples of this practice. Yes, he got great deals on both, but he's also gone after two corporate mainstays that represent the best and brightest in their respective industries. That's a competitive advantage to hold on to.
In general, 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 if they 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 this stock.
Foolish bottom line
If you own shares of a company that has no real barriers to hungry competition, and it doesn't have 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 over 26 percentage points since its 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.
Stock Advisor analyst Nick Kapur owns no shares of any company mentioned above and has zero material interest in the company whose CEO he interviewed. Garmin, Google, and Intuitive Surgical are Motley Fool Rule Breakers recommendations. Apple and Garmin are Stock Advisor picks. Nokia is an Inside Value choice. The Motley Fool has a disclosure policy.