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Competitive Advantage 101

Understanding a company's competitive advantage is one of an investor's most important lessons, but it's not always easy. First, competitive advantage is a difficult concept without a standard definition. Second, the market already knows the best companies and typically prices them accordingly. Finally, it's difficult to predict which smaller, up-and-coming companies will have an advantage.

So should we just give up using competitive advantage? Absolutely not. While it's important to know how to survive the investment race, The Motley Fool wants to help put you in a position to win it, too. So in our interview with Michael Mauboussin, chief investment strategist at Legg Mason, I asked him how to think about competitive advantage, since it features prominently in his latest book, More Than You Know.

David Meier: The chapter "The Pyramid of Numbers" talks about how, in nature, there are a few big fierce animals out there and lots of smaller ones. The same can be said for companies. So I have a two-part question. First, what are your thoughts on equating competitive advantage and power?

Michael Mauboussin: Well, I think it depends. I think the classic way to approach competitive advantage would be that there are two sort of distinct strategies to get there. Strategy number one would be a low-cost strategy where "power" would be very important. That would be size, girth, efficiency, and there is a substantial body of evidence that larger organizations and larger organisms are literally more efficient than smaller organizations or organisms. So a cell in an elephant, for example, works much less than a cell does in a mouse, so there is plenty of evidence for that.

The second way to get the competitive advantage, however, would be a differentiation strategy, which would be a niche strategy which would be delivering a lot of value in an economic sense to a certain number of customers. So you are not pursuing efficiency per se, but rather differentiating yourself and finding a niche vis-a-vis the ecology, so I think there are probably a couple of ways to get there.

It is an interesting discussion and, ultimately, a debate about "Is one better than the other?" I don't know the answer to that, but my own sense is [that] low-cost producers is probably not a bad place to go.

DM: Second, is it better for investors to purchase companies that are big and fierce but that many people know are big and fierce, or can you gain an advantage as an investor by searching for smaller, maybe less-known companies that live in their niches?

MM: One of the points that we talk about in the book with the challenge of being big is that you become less nimble. So, large is often associated with less nimble, with less ability to change, and I think there is a lot of evidence in the corporate world that that has been the case historically. You have been successful. You tend to be profitable. You tend to be well known, and none of those things are conducive to radical change in what you are doing.

The other thing we know is that obviously upstarts, disruptive innovations, always come from smaller companies. We tell a story in the book about the wonderful nature show you are watching where you see the imposing but aging leader of the pride of lions. There are challengers to that leader, and eventually -- he can fend them off for a while using intimidation and some measured force, but eventually, a younger lion will take over as the head of the pride. So what we know is [that] not all competitors become leaders, but all leaders are formerly competitors or challengers. So to me, I think that the idea of constantly seeking challengers to the status quo makes sense.

Now, there is one caveat to all of that, of course, which is [that] in the stock market, the question is always, "What is the stock price?" versus "What is likely to be the financial performance?" So there is still an important dimension of understanding how much of this outcome or development the market has already anticipated.

Stupid stock market!
Although I don't like it, Michael's right. The market usually knows which companies have a competitive advantage, and it tends to award them higher prices. But that doesn't mean the market always gets it right. It just means that we shouldn't expect easy returns from great companies.

Why can't investing be easier? Stupid stock market!

But I digress.

Big, fierce animals
I think we all know who the big, powerful companies are. Companies like Wal-Mart (NYSE: WMT  ) and Dell (Nasdaq: DELL  ) are big, strong, and incredibly efficient, and for their size, they generate impressive returns on invested capital. It will be very hard for a newcomer to unseat them as leaders of their packs.

The key to generating good returns with these companies is to wait for the market to make a mistake in their valuations, then scoop them up when the opportunity arises. That's one strategy Philip Durell uses at Inside Value.

Smaller aggressors
Perhaps a more fertile ground to hunt for opportunities would be among smaller up-and-coming companies, ones unburdened by past successes, able to experiment with new ideas, innovations, technologies, and services.

There are many ways to make money with these companies, but I think success revolves around making the right judgment about how successful the company can be with its differentiated, or even newly created, market position.

For example, look at how pharmaceutical benefits management companies Caremark Rx (NYSE: CMX  ) and MedcoHealthSolutions (NYSE: MHS  ) have changed the way people get prescription drugs from their health plans. Sure, many people still go to their local CVS (NYSE: CVS  ) or Walgreen's (NYSE: WAG  ) . But I know I get more of my medicine using Medco than I do from my local pharmacy, and its specialized service reduces my costs. By finding a niche and providing a great, low-cost service, Caremark and Medco have moved from smaller aggressors to big, fierce animals today.

The law of the jungle
Competitive advantage can be an elusive idea, but taking the time to learn about it can pay off in higher returns. It can also prevent you from making a bad investment decision. For a great place to start learning about how competitive advantage fits into the investing process, I highly recommend that you read Michael's book More Than You Know.

Legg Mason, Wal-Mart, and Dell are all Motley Fool Inside Value recommendations. If you live for the moments when the market makes mistakes, join Philip Durell and his band of bargain-hunting Fools with a free 30-day trial subscription.

Retail editor and Inside Value team member David Meier does not own shares in any of the companies mentioned. He is currently ranked 619 out of 20,943 investors in The Motley Fool's CAPS rating service. You can view his TMF profile here. The Fool takes its disclosure policy very seriously. Dell is also a Stock Advisor selection.

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