Just about one year ago, I sat down with the CEO of what used to be a $1 billion company. The company is well-known, and I can almost guarantee that you've heard of it. Here are some of the highlights of the conversation:
"We have to invest year after year to maintain our competitive advantage."
Ouch.
"There's little that we do that no one else can do."
Are you kidding?
"We continually have to adjust for some kind of 'vaporization' effect with respect to our write-offs."
Agghhhh! %$)(@No ...
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 over 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 -- 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.
Remember when IBM (NYSE: IBM) was the only company on the block mass-producing individual computers? The company was making money hand over fist -- yet it couldn't keep that pace going. Eventually, others, such as Dell and then Apple (Nasdaq: AAPL), starting taking tastes, then nibbles, and then gigantic bites. Only recently did IBM refocus and realign, but most companies aren't so lucky to be able to do that.
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 more than 1,500% gains in the past five years. No one is even close to replicating the company's Da Vinci technology. And it explains why General Motors (NYSE: GM) and Ford (NYSE: F) have stagnated for years, while more industrious and innovative companies such as Toyota (NYSE: TM) are prospering. Now GM and Ford are attempting to strike back into Toyota's new-found gold mine of hybrid technology, so you can see that this is a viciously competitive industry.
Investing legends will tell you the same thing. Among others, Warren Buffet has made billions identifying companies that leverage products or brands whose edge was not in danger. American Express (NYSE: AXP) and Johnson & Johnson (NYSE: JNJ) come to mind specifically. His 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 the CEO was willing to talk, I pushed harder. I asked him whether his 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 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 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.
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. Intuitive Surgical is a Motley Fool Rule Breakers recommendation. Apple is a Stock Advisor recommendation. American Express and Dell are Inside Value recommendations. Johnson & Johnson is a Motley Fool Income Investor recommendation. The Fool owns shares of American Express. Fool rules are here.
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