Brian Lund: The second Rule Breaker criterion states that we look for companies with a sustainable advantage. What do we mean by that?

Jeff Fischer: To me, sustainable advantage means that a company has a moat around its sales, such that it will be difficult for another company to capture those sales. Of course, every company has vulnerabilities. But some companies have very meaningful "moats," or sustainable advantages.

In today's world, technological change arrives much more rapidly than in the past, as a recent report (.pdf) from Michael Mauboussin and former Fool writer Alex Schay points out. Finding companies that can maintain a lead in business is a challenge, but a necessary undertaking for investors who want to buy individual companies. If you aren't willing to seek lasting sustainable advantages in your individual holdings, then you should just buy an index fund. That's how important sustainable advantages are.

Brian: Can you give an example?

Jeff: Johnson & Johnson (NYSE: JNJ). Another company with the potential for outstanding sustainable advantages, although it is young, is eBay (Nasdaq: EBAY).

Paul Commins: I'd like to get back to Brian's original question for a sec. Do we say companies or products have sustainable advantages? Can a company sell two products -- one for which they have the market locked up and another where they're fighting to survive? I guess that's my question.

Jeff: Certainly. Oracle (Nasdaq: ORCL) is a good example. It has a database business in which it has sustainable advantages, and now it's moving into business applications, where it's fighting to get a toehold.

Tom Jacobs: Ditto the fiber optic components makers. They innovate strongly in certain areas and have product strengths in certain pockets. Both Corning (NYSE: GLW) and JDS Uniphase (Nasdaq: JDSU) have made acquisitions in order to combine their strong products with good products that didn't necessarily compete as well. They offer their customers a one-stop shop, so that, in the end, they compete better across the board. Oracle, I assume, is going in the same direction.

Paul: Well, it's trying to. I would argue that their attempt to take over all of enterprise software in one fell swoop has cost them advantage in any one sector. Brian's first question got me thinking about the difference between a company with a sustainable competitive advantage in a given market and companies with a proven knack for developing products with sustainable competitive advantages. As long-term investors, I'd think we'd look for the latter.

Brian: I'm hesitant to say that any of those companies has a sustainable competitive advantage. A company may have fine products and lead its market, so that its position seems unassailable, but then an innovation comes along and knocks 'em off. Intel (Nasdaq: INTC) CEO Andy Grove's point in Only The Paranoid Survive is that market leaders in technology have to keep an eye out for the disruptive technologies. They must embrace them, whether through internal research or acquisition.

Tom: Right. He'd rather switch than fight.

Brian: The question is: Can you sustain that model?

Jeff: Yes, I believe most investors would rather look for companies that have shown that they can create or acquire products that have moats around them -- sustainable advantages, again and again -- as opposed to just focusing on businesses that should offer sustainable advantages.

Brian: But what is the nature of the advantage then? Is it good management that can stay ahead of the curve? Is it the ability to develop good products? Or is it brand?

Jeff: There are many answers to that question. Sometimes good service is the sustainable advantage. Sometimes a great product  -- especially when the product is a recurring purchase item. And sometimes a great management team will create its own advantages year after year, like Warren Buffett at Berkshire Hathaway (NYSE: BRK.A).

Paul: Is this a reasonable goal for emerging companies like those we try to buy? It's tough for a Rule Breaker to have that kind of track record. Does anybody else get the feeling that it's getting tougher and tougher for technology companies to maintain any kind of advantage these days? I'm about to get back on my low-priced consumer brand horse. Let's find us another Starbucks (Nasdaq: SBUX)!

Jeff: I do believe technology has the most difficulty finding sustainable advantages. Changes are so rapid across technology.

Paul: And the products tend to be priced high enough that buyers shop carefully. Let's get a stake in [Berkshire Hathaway's] See's Candies.

Jeff: Seeing Buffett's performance the past 30 years (or anyone's performance who had just bought Coca-Cola or Pfizer, etc.), it's clear that investors needn't chase "hot" technology-based stocks to perform well. Quite the contrary, in fact. [NB: Berkshire's annual letter to shareholders came out on Saturday. As always, it's a must-read.]

Tom: Let me answer both Paul and Jeff. One of the reasons we have two biotech drug makers speaks to brand and tech. Company life cycles are getting shorter and shorter, according to Mauboussin, due to rapid changes in technology that displace leaders. Andy Grove and Intel can only buy so many new technologies, identify and buy or back only so many "discontinuous innovations."

Investors have some help in the area of drug stocks. The FDA approval process for drugs leads it to pick the winners and, along with patent protection, provide drug companies with sustainable advantages. But genomics has turned out to be the discontinuous innovation that turns everything upside down. Today's big pharmaceutical companies may be smaller tomorrow, while today's nimble biotech drug maker wannabees may rule the world. We own Amgen (Nasdaq: AMGN) and Human Genome Sciences (Nasdaq: HGSI) towards that end. They are companies using biotech and genomic advances to gain sustainable advantages. I exclude Celera Genomics (NYSE: CRA) because it's not currently a drug maker, though its officers have made public statements suggesting a shift.

Jeff: Do you think, then, that large pharmaceuticals are being assailed now just like techs typically are? That biotechs will develop better sustainable advantages with the aid of new technologies?

Tom: Yes, I think the majority of today's Big Pharma is becoming the dinosaur, regardless of deep pockets. There will be more mergers and downsizing there.

Jeff: I agree with Tom's premise, but those deep pockets are a big advantage. They can buy the best small biotechs. Pfizer (Nasdaq: PFE) could, theoretically, scoop up HGS, Millennium Pharmaceuticals (Nasdaq: MLNM), and Celera (NYSE: CRA).

Tom: I suppose that Pfizer could buy some smaller ones eventually, when valuations decline or businesses justify the high valuations, but does Pfizer want to bet now on which will win? Pfizer and its deep-pocket siblings are trying to be the Intels of bio-pharmaceuticals. Intel went with Rambus (Nasdaq: RMBS) and is investing in Energy Conversion Devices' (Nasdaq: ENER) Ovonyx unified memory, thinking about discontinuous innovations. Pfizer is looking around and has the cash to figure out who the winner in genomics-based drugs is going to be. I'm just not as sure as others are that they will be able to buy the winners whole-hog, but they can continue doing as they do now -- adding the drug here and there to the pipeline, if the biotech is willing or has to sell.

Jeff: Yes, I think it is an Intel. Amgen, J&J, Pfizer -- they all buy pipelines or additions to their pipelines. J&J has bought several biotechs the past five years, and it claims it is the largest biotech operation in the world.

Brian: But, again, is it really a sustainable advantage? What if Pfizer buys HGS and it doesn't come up with anything? What happens to the advantage?

Jeff: Certainly Pfizer and other pharmaceutical companies will buy into the genomic leaders eventually -- many of them. And that is an advantage, when they buy active pipelines with drugs in trials. They evaluate the pipelines in much the same way that the Fool taught investors to do in the biotech seminar. They buy statistical successes, eventual successes. As Tom said, it may be too early yet for them to spend billions on biotechs, but they will. 

Brian: But, to get back to Paul's earlier question, how does this apply to Rule Breakers? If only Big Pharma companies have a sustainable advantage, what does that say about HGS?

Paul: When it comes to Rule Breaker investing, I think we're talking about a whole different animal. Not so much sustainable advantage, but the potential to wield such advantage in the future. My biggest question, in this regard, is how complete our list of Rule Breaker sustainable advantages is. We look for business momentum, patent protection, visionary leadership, and/or inept competition. They're different from traditional big, stable company advantages like brand. Is this list of advantages carefully chosen to match Rule Breakers or is it just generic?

Tom: I lean towards the latter. We're not the first people to address moat creators. Those items aren't original. We just think they're important.

Brian: Our list is not a list of qualities that provide a de facto sustainable advantage. For example, inept competition is simply not sustainable. One day, there will be ept competition, if your business is at all attractive. Patents, too, have a limited shelf life.

Paul: Nor is "visionary leadership," at least not in the product sense (although it may be in the company sense).

Brian: Exactly. Nor is business momentum. The point is to find companies that can become Pfizer. To get to that point, you've got to have a good start out of the gate. That takes a period of competitive advantage that can't really be expected to last forever. Then it's for the company to kick in with vision.

Paul: Take Amazon (Nasdaq: AMZN), for example. Its early advantage was to be first. It has translated into a great brand and great technology (and attracted a lot of venture capital). It was obviously a Breaker in every sense of the definition. But now? How do we predict whether these early advantages will translate into sustainable profits?

Tom: Good question. We've not used "tween" in the column for a long time, have we? That's where Amazon is.

Paul: Actually, to be honest, I think that Amazon's brand positions it for a better shot at the kind of long-term advantaged position I'm talking about, even though it's current financial picture is on the grim side.

Brian: I think so too. It's the most important thing that Amazon has. It's important not to overlook it, in spite of the company's mistakes.

Jeff: I find myself much more price sensitive online than off, though. I'm not as brand loyal online.

Tom: I buy books online on Amazon, but don't care whether I'm in Borders or Barnes & Noble offline.

Paul: I think the point I'm trying to make is merely this: There are two dimensions to consider. First, there is product advantages versus company advantages, the difference between a great market position for a given product or service and a company's ability to extend this position, either through talented management or a brand built from early successes. Second, there is the difference between early, momentum-based advantages that get you to the front, and the longer-term advantages that, say, Buffett looks for -- traditional stuff like pricing power. Microsoft would be a classic example of Rule Breaker-type early momentum and vision advantages that, later, become an unassailable longer-term advantage through network effects.

Continue to part II.

The Breaker Team is available to perform chats at half time during the Super Bowl, if the committee is interested. They own various stocks mentioned above. Check the profiles for Brian, Jeff, Tom, and Paul to view their holdings. The Motley Fool is investors writing for investors.