Compelling Companies With Competitive Advantages

A strong competitive position is one of a company's most valuable assets. Fast growth and healthy margins are all well and good, but they aren't worth much if any old competitor can easily waltz in and snatch them away.

Great investors seek great competitive advantages. Warren Buffett has exhorted his managers to "widen the moat, build enduring competitive advantage, delight your customers, and relentlessly fight costs." In his 1993 letter to shareholders about Coca-Cola (NYSE: KO  ) and Gillette, he wrote: "The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles. The average company, in contrast, does battle daily without any such means of protection."

To sharpen your skills in evaluating competitive advantages and finding the best companies, get familiar with the philosophies of Michael Porter, a professor at Harvard Business School. Let me save you two years of business school, and $90,000 in tuition, with a quick overview of Porter's famous "Five Forces" of competition:

1. Threat of new entrants
The harder it is for new competitors to enter an industry, the better it is for that industry's existing players. It would take a huge investment for anyone to compete with Boeing's (NYSE: BA  ) massive manufacturing facilities and decades of aerospace experience. But it's relatively simpler to design and make a fashionable new kind of shoe, leaving Crocs far more vulnerable to attacks from its rivals.

Any number of factors can lessen the odds of new competitors: government policies, strong brands, access to distribution channels, cost advantages, and switching costs are just a sampling. Once you've set up your portfolio with Schwab, you'll be loath to move it, making rival brokers less likely to attract your business. And rivals can't easily duplicate the network effects created by eBay's (Nasdaq: EBAY  ) huge base of buyers and sellers.

2. Suppliers' bargaining power
The fewer suppliers a company has for the goods, services, and raw materials it needs, the more those suppliers can charge for their wares. An abundance of rival suppliers reduces this pricing power.

Beyond physical goods, this truth applies equally to labor; by effectively limiting the sources from which a company can recruit workers, labor unions can reduce a company's competitive advantage. Airlines, automakers, and large manufacturers often find that union issues reduce their profits, which may explain why Wal-Mart has worked hard to resist the unionization of its workforce.

However, the megaretailer turns the tables when dealing with its other suppliers. Since Wal-Mart is such a big customer, the companies that provide its merchandise are often forced to meet Wal-Mart's pricing demands, or lose the company's business to an eager rival.

3. Customers' bargaining power
If they don't like Target's (NYSE: TGT  ) offerings, shoppers can just mosey on over to Wal-Mart. The switching costs between the retailers are often little more than the gas involved in driving from one store to another and the potential hassle of finding a parking space.

On the other hand, robotic surgical equipment maker Intuitive Surgical (Nasdaq: ISRG  ) enjoys a much greater advantage over its customers. Once a hospital has bought and installed its machines, its doctors and staff must continue to buy and use the associated surgical supplies. Switching to a rival's systems would be expensive and time-consuming for a hospital currently using Intuitive's devices. That advantage may help explain Intuitive's amazing performance -- it's averaged more than 50% annual returns over the past five years.

4. Threat of substitute products
Rival drugs such as GlaxoSmithKline's (NYSE: GSK  ) Boniva aren't the only competitive danger to Merck's (NYSE: MRK  ) osteoporosis treatment, Fosamax. Non-industry threats could also cut into Fosamax sales, including changes in diet, increased exercise, quitting smoking, and various vitamins and minerals, all of which are easily available at a much lower overall cost.

5. Competitive rivalry within an industry
All the forces above combine to reflect on an industry's competitive rivalry, which in turn can reflect on a component company's attractiveness as an investment. The less difference customers see between competitors' offerings, the fiercer those companies' rivalry will be. A swarm of smaller companies will also fight more tenaciously than a market dominated by a handful of big players, who are more likely to find more peaceful ways to coexist.

Paying attention to competitive advantages can pay off well for your portfolio. Fool co-founders David and Tom Gardner scour the market for stocks with wide moats to recommend in our Motley Fool Stock Advisor newsletter. Their focus on a company's business model and competitive strengths has helped their picks trounce the market by more than 47 percentage points overall since the newsletter's inception. To peek at David and Tom's top 10 "Best Buys Now," try Stock Advisor free for 30 days.

Longtime Fool contributor Selena Maranjian owns shares of Coca-Cola, Google, Intuitive Surgical, eBay, and Wal-Mart. Coca-Cola and Wal-Mart are Motley Fool Inside Value picks. Google and Intuitive Surgical are Motley Fool Rule Breakers selections. eBay and Charles Schwab are Motley Fool Stock Advisor recommendations. Coca-Cola is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a bull call spread position on eBay. The Fool owns shares of GlaxoSmithKline. The Motley Fool is Fools writing for Fools.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 04, 2010, at 8:55 PM, ds10 wrote:

    "Abundance of Rival Suppliers"

    There's another strong reason to have several


    For example, in electronic products it's wise to

    have several chip sources. Manufacturers often

    change the chips available in their product lines.

    It can spell doom if you rely on one manufacturer

    who decides to drop the chip you require.

    Chip designers recognize this and often supply their masks to others to encourage the use of these chips in new products.

  • Report this Comment On February 07, 2010, at 12:00 PM, d4winds wrote:

    Part 1: Buy companies with large, easily sustainable raw economic power. Sounds good.

    Part 2: Hope no one else has noticed. Uh-oh.

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