FOOL ON THE HILL
Some of the best investments of the last decade were companies that were never "cheap" by conventional valuation standards. Certain companies have properties that allow investors to project their earnings well into the future: the protections of sustainable advantage, such as superior brand, high switching costs or customer attachment. That's partly why Gillette, Disney, and Microsoft have been on top of the world for so long.
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Three questions. What is this sustainable competitive advantage? Why do companies that have it seem so desirable? And why are many of 'em so darn expensive? The fuel that makes companies work is cash. Any company bringing in lots of cash can grow quite large, but it is the company that has some of that cash stick to its bottom line that is truly superior. Although companies within sectors often ebb and flow together, those within the sector that prove most able to retain cash will often make the best long-term investments. What is it that allows a company to charge more, derive higher margins, or take a larger share of a market than its competitors? Why is it that, even in growth industries, certain companies rise to the top? There are as many different reasons as there are sectors and markets. Why do people in my neighborhood drive the extra few blocks to go to a Giant -- owned by Ahold (NYSE: AHO) -- for groceries, driving past the relatively empty Safeway (NYSE: SWY) en route? The answer (or answers) has to do with a competitive advantage. Maybe Giant is cleaner, or its produce is fresher. Maybe the labor relations in this particular area are different from one company to the next, making the employees at Giant just a little bit more helpful. Whatever the reason -- and disregarding the global or national superiority of one chain over the other -- in my neck of the woods, the Giant is packed while the Safeway is not. Is this advantage sustainable? I'd say that it is, but not very. People are creatures of habit, and for many, going to the Giant may just be part of the routine. They may fail to even consider going to the Safeway, having ignored it for a long period of time. But what if the Safeway remodels, or starts aggressively marketing itself, or makes its pricing appreciably cheaper? With some effort -- and perhaps some short-term losses -- Safeway could put itself right back on the map. Sustainable competitive advantage comes in the form of a franchise so strong that competitors have almost no chance of breaking it. Warren Buffett calls these advantages "moats." Gillette (NYSE: G) is a good example: It controls more than 80% of the shaving market, with Schick and Wilkinson far behind. Decades ago, Gillette started selling its razors essentially at cost, making its profits on the blades. And since no other company's blades fit Gillette's razors, the company has built up a cost -- no matter how slight -- that keeps its customers from switching away. One of the most obvious places for this type of competitive advantage is in technology. Microsoft (Nasdaq: MSFT) built up nearly insurmountable leads by taking advantage of the network effects of enterprises wanting their computer systems to be compatible with the largest possible number of other systems. Cisco (Nasdaq: CSCO) is another: It is often said that a network administrator cannot be fired for buying Cisco equipment. It has become the de facto standard in routing. Sustainable competitive advantage need not be technological, though. Disney (NYSE: DIS) has created an unbelievable advantage over its competitors, including AOL Time Warner (NYSE: AOL), through the emotional attachment it has helped people form with its products. Mickey Mouse elicits strong emotions in people, and as a result a vacation at one of the Disney properties has nearly been built into a rite of childhood. Knott's Berry Farm has some cool rides, but it doesn't have Mickey and the gang, and as such has played second fiddle to Disneyland. These types of sustainable competitive advantage create almost annuity-like cash flows to the companies that boast them. Gillette will receive money on blades as long as people retain their Sensor shafts. Regardless of how much the owners and players try to screw it up, Major League Baseball has planted its roots so deeply into the American psychology that it creates a new generation of Bill James and George Wills in spite of itself. Ever wondered why it is that soccer has never caught on in the U.S.? It's in part because most people only have the emotional -- and, these days, financial -- capacity to grow attached to a limited number of teams, players, or sports. Baseball is in America's inner sanctum, soccer is not. Baseball, to turn the phrase, has competitive sustainable advantage in the United States. Why is this important? Go back to Microsoft for a moment. In spite of the fact that its stock has never been at a level that would be considered "cheap," it has grown its market capitalization several hundred times, providing those investors who paid up for it early on some very healthy returns. But Microsoft's base product was not particularly superior to other competing ones such as Apple's (Nasdaq: AAPL) Macintosh format. What Microsoft had was a superior distribution network built into its relationship with IBM (NYSE: IBM), then the dominant PC manufacturer. This deal not only gave Microsoft its desired competitive advantage, but it also actually shielded the company from significant competitive forces. The moat is a great allegory for sustainable advantage. In medieval times, when an army laid siege to another's fortress, it often had to contend with things like moats that impeded their attacks to the point that, even if they got past it, they would have expended so much energy in doing so that they would be unable to overrun the fortress. As such, defense of a fortress could be done with far fewer resources than it would take to attack one. These advantages, while almost never impenetrable, could make the cost of attack too high for a rival to contemplate. Do your companies have a sustainable competitive advantage? Do they, like the Baby Bells, have a network so extensive and expensive that companies seem to have grown tired of challenging it? Does your company have a brand, like Coca-Cola's (NYSE: KO), so strong it can charge just a little bit (or a lot) more per sale than its competitors? Those companies are the ones with a far better chance of surviving the inevitable ups and downs in every sector. Finding a company with a competitive advantage is the beginning of the battle, but a shrewd determination of sustainability could mean the difference between a good investment and a great one. Fool on! Bill Mann, TMFOtter on the Fool Discussion Boards Bill Mann's column is sponsored by Fred's Croissants and Fill Dirt. He owns shares of Coca-Cola and Cisco. His stock holdings can be viewed online, as can the Fool's disclosure policy.
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