FOOL ON THE HILL
The Importance of Strategy

Strategy is critical to creating sustainable competitive advantage. But how can an investor determine whether a company is pursuing the right strategy? As Whitney Tilson hopes to illustrate with three case studies, all companies he owns, one way is to look for companies employing strategies that are different and/or better then their competitors' -- and avoid "me-too" companies.

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By Whitney Tilson
August 7, 2001

I have argued in the past that strategy is critical to creating sustainable competitive advantage, which Warren Buffett has said is the most important thing he looks for when evaluating a company. Strategy, however, is an amorphous concept to many people. How can one determine whether a company is pursuing the right strategy?

Perhaps case studies of three stocks I own -- Office Depot (NYSE: ODP), AAON (Nasdaq: AAON), and TheStreet.com (Nasdaq: TSCM) -- will be illustrative. In addition, I highly recommend reading a March Fast Company interview with the godfather of strategy, Harvard Business School Professor Michael Porter.

Office Depot
Office Depot was one of the great growth stocks of the early 1990s, rising from a low of under $2 in 1990 to more than $21 at its peak in 1995. After a failed merger with Staples (Nasdaq: SPLS) in 1997, Office Depot launched a massive expansion plan, increasing its North American store base by nearly 50% between the end of 1997 to the end of 2000.

The new stores have been duds, by and large, due to an ill-conceived strategy. With Staples and OfficeMax (NYSE: OMX) also expanding rapidly, Office Depot was building in markets that were becoming saturated.  Poor execution compounded the strategic error, in part because most of Office Depot's real estate team had departed in anticipation of the merger with Staples. When the new stores' poor results became apparent, the stock tanked, declining more than 75% from above $25 in mid-1999 to a low of $6 last December. 

So why did I buy the stock in January? In large part because I believe new CEO Bruce Nelson has adopted the right strategy. Rather than investing in growing the low-margin North American retail store base, he wants it to generate cash -- the company is closing underperforming stores and improving operations -- to be reinvested into the higher-margin, faster-growing catalog, contract, Internet, and international businesses, where Office Depot has real competitive advantages. 

It's a classic strategy -- milk the cash cow and invest in the growth businesses -- and in the company's latest earnings report, there's evidence that it's beginning to work

AAON
AAON, a company I discuss in the latest issue of The Motley Fool Select, specializes in manufacturing commercial rooftop heating, ventilation, and air conditioning (HVAC) units. Its four primary competitors are all far more diversified, and each has more than 20 times AAON's revenues. In situations like this, a small company can often achieve impressive growth by stealing market share in a niche from slow-moving, bureaucratic conglomerates. 

The game often ends, however, when the giants wake up and squash the little guy.  I'm betting that this won't happen to AAON, in part due to its wise strategy.

AAON makes semi-customized HVAC units, which offer a compelling value proposition to customers. The HVAC industry is fragmented into two types of companies at opposite extremes: those that make standard HVAC units, and those that build custom units from scratch -- for three times the price. Many customers want some degree of customization, but are reluctant to pay triple the cost, so AAON has built a highly efficient manufacturing system that permits substantial customization at little incremental cost. This allows AAON to earn the highest margins in the industry while charging an average price premium of only 4% over a standard unit. The competition has found it difficult to match AAON, and I think the company will continue to take market share and maintain its high margins.

AAON's growth strategy is also wise. Rather than assaulting the core businesses of its huge competitors, AAON instead focuses on niches that are being poorly served, often because they're too small for large companies to spend much time on. AAON then develops a better product, builds scale, and expands from that base. This is exactly what happened in the commercial rooftop HVAC business, and AAON is now applying the same strategy to other niches. 

TheStreet.com
Revealing my position in TheStreet.com may ruin my credibility as a "value investor," but at least hear me out.  The core of my investment thesis -- which is more in-depth than I have the space to outline in a few paragraphs here -- is that TheStreet.com has had the wrong strategy since inception, but now has one that gives it a reasonable chance to make it to profitability. 

TheStreet.com aimed, at its genesis, to be a major news organization, and to provide opinion and commentary. But it's expensive to be a news organization, and TheStreet.com has no competitive advantage whatsoever in this area. I, for example, am quite content to get my business news from The Wall Street Journal and The New York Times. If I want late-breaking news on the Web, I can just as easily get it from Yahoo! (Nasdaq: YHOO) Finance, CBS MarketWatch (Nasdaq: MKTW), and elsewhere. 

Where TheStreet.com does have a franchise -- The Motley Fool does as well -- is in the area of opinion and commentary. With Wall Street's sell-side analysts discredited (have you read the shocking revelations from the recent SEC investigation?), there are few places investors can turn to for timely, insightful, unbiased opinion and commentary that can help them make money.

Having a valuable franchise has not yet translated into lots of revenues, however. TheStreet.com generates plenty of traffic -- it had 3 million average monthly unique visitors in Q2 -- but advertising revenues are plunging for nearly every Internet company and the number of paid subscribers is stagnant. I'm not expecting a rebound in the advertising market, but I think TheStreet.com has a big opportunity to increase its subscriber base.

To date, the great majority of TheStreet.com's opinion and commentary has been available for free a day after it appears on the paid site, RealMoney.com, which helps explain why the company has only 66,000 paid subscribers. If TheStreet.com were to only publish its opinion and commentary on RealMoney.com, something I would not be surprised to see by year's end, I believe the number of paid subscribers would rise materially. While this might reduce the overall number of readers, perhaps hurting advertising revenue, such a strategy -- which has no incremental costs associated with it -- plus additional revenue from a number of other new initiatives and further cost-cutting, could propel the company to profitability.

All that said, TheStreet.com is a very risky stock and is only a small part of my portfolio. With a mere $3.6 million in revenues last quarter and $9.0 million in expenses, the company has its work cut out for it. (The Motley Fool also counsels investors to avoid "penny stocks," which TheStreet.com -- with a share price and market capitalization of around $1 and $30 million, respectively -- is.)

Lessons
Office Depot, AAON, and TheStreet.com are vastly different companies, pursuing vastly different strategies, yet I believe each will be successful. Why? Because they are focusing their energies in areas in which they are different -- and in my opinion, better -- than their competitors.

As Harvard's Porter noted in Fast Company:

Strategy 101 is about choices: You can't be all things to all people... Strategy must start with a different value proposition. A strategy delineates a territory in which a company seeks to be unique... If all you're trying to do is essentially the same thing as your rivals, then it's unlikely that you'll be very successful.

Investors would be well served to keep that in mind, and avoid "me-too" companies.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Office Depot, AAON, and TheStreet.com at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.