[For part one of our conversation about sustainable advantage, visit yesterday's Rule Breaker report.]
Tom Jacobs: If we think that brand is the best sustainable advantage, why do we buy non-brand companies such as Amgen (Nasdaq: AMGN), Celera Genomics (NYSE: CRA), and Human Genome Sciences (Nasdaq: HGSI)? If a company benefits from being first, and then it uses the brand it's built and vision to survive tweening, why do biotech drug makers and bioinformatics companies make up almost half of our portfolio?
Let me answer my own question. I think it's because we think that genomics advances mean that there's a ton of money to be made. The peculiar nature of the drug business -- namely, the long process of drug evaluation -- presents challenges to our strategy. We may not know the answer yet, but we know there's gold in them thar hills. So we look at the companies in the lead.
Jeff Fischer: True. We believe biotechnology is the largest, life-changing rule breaking "industry" (really technology) that we may see in our entire lives. Eventually, we believe, the leaders will become household names. What is more important to us than our health?
Tom: Although we don't want to invest in a technology, but in an industry.
Paul Commins: Patents make biotech a whole different ballgame, don't they?
Tom: Absolutely!
Brian Lund: We talked yesterday about what makes Pfizer's (NYSE: PFE) advantage sustainable, but can we apply it to Human Genome Sciences (HGS)?
Paul: Personally, I can see the sustainable advantage in HGS -- the patented discovery techniques and information -- while I'm not so sure I can see the same for Celera.
Brian: Patents offer biotech a guaranteed competitive advantage period, just as they do to other tech companies with the best fiber or chip, but....
Tom: But at a huge price. The risk is that the Food and Drug Administration gets to decide whether your product is any good after spending 10-15 years and $500 million on it.
Brian: Not only that. Even in a best-case scenario, they may not be able to maintain their advantage, should another, better solution come along. In pharmaceuticals you have quite a bit of warning about such innovation, but it can happen. So what is it about HGS that tells us it has a sustainable advantage? There's nothing about it that tells me it will be the next Pfizer. I have no idea how well it will be able to spot acquisitions.
Tom: No, but HGS may own the bulk of the protein therapeutic real estate for 20 years. And according to Mauboussin, the average life of a company is 15 years. If we can beat that, we may be doing well, whether tech or biotech.
Brian: All right, let's grant that it has staked out valuable real estate there. Biotech is special for the intermediate-term advantage that its patents convey.
So is that sustainable advantage? Look at Rambus (Nasdaq: RMBS) as an example. Rambus has patents for RDRAM and possibly SDRAM and DDR, and people say that they may cover any type of DRAM. But what happens if a different type of memory emerges, like Energy Conversion Device's (Nasdaq: ENER) Ovonyx Unified Memory? Suddenly Rambus' advantage is not sustainable through patents alone.
That's why I don't trust technological advantages. They don't seem truly sustainable.
Tom: You may have a good five years, then what? Exactly. It's not enough to say, "They'll buy the next advance."
Brian: Brand is much better, so long as -- to paraphrase Harry Beckwith's Selling the Invisible -- the company fulfills on the promise that its brand makes.
Paul: Can a company's structure or business plan be a sustainable advantage?
Jeff: I don't think a business plan can be a lasting sustainable advantage, because most business plans need to evolve continually, even if in small ways.
Brian: Right. Ability to adapt is key to sustainability, too.
Paul: I'm thinking of Cisco (Nasdaq: CSCO) -- the whole idea of a "virtual manufacturing company" that it has pioneered.
Tom: And now everyone does the Cisco.
Jeff: Well said, Tom. So we've come full circle. What is a sustainable advantage? Maybe there isn't one. Maybe the ability to adapt is the biggest advantage.
Tom: It may be... a brand!
Brian: I think that the long-term sustainable advantage has to come from brand and vision.
Jeff: In consumer businesses, I'd agree that brand is a large part of it.
Brian: Coca-Cola (NYSE: KO) is the one. Of course, there's more to it. Technology companies with strong brands, like AT&T (NYSE: T) and Xerox (NYSE: XRX) -- blowups. IBM (NYSE: IBM) has made it, but it's had significant periods of underperformance in its history, and may well again soon.
Jeff: You would have called IBM a blowup a decade ago.
Tom: It extended its competitive advantage period through brand -- and visionary management.
Brian: Visionary management helps, but folks die -- unless Haseltine has his way.
Tom: Brand lives on.
Jeff: So tech companies are going through endless cycles and must always reinvent. Buffett loves companies that are much more likely to continue earning lasting, steady profits. Endlessly. [Berkshire Hathaway's (NYSE: BRK.A)] See's Candies. Coca-Cola. But what does this obvious admission gain us? What have we learned?
Tom: That our Rule Breaker criteria get you a competitive advantage to start, but that brand is what makes you a Rule Maker?
Paul: Here's a radical notion: Maybe we should start taking profits instead of holding forever?
Brian: Paul may be on to something. If you're in tech, you'd better be prepared to sell. You have to watch carefully for the drop-off. You have to pay close attention to the quality and the diversification of product offerings at your company.
Tom: So the Rule Breaker Port should not be afraid to buy tech or biotech, though, as long as it's willing to sell.
Jeff: Sell when sustainable advantages begin to wear thin, because that actually -- when you're buying Rule Breakers -- serves as an indicator that the young business isn't progressing as hoped. It is beginning to fail on reaching its grand vision. For example, if HGS's advantages (meaning its extensive protein knowledge and protein patents) cease to regularly produce more drug candidates.
Brian: Can we have one concluding statement from everyone?
Paul: As we've defined them in our Rule Breaker criteria, sustainable advantages are things that get emerging companies to the head of the pack. Our preference for strong brands (and patents in the case of biotech) gives us better odds that our emerging Rule Breaker will eventually wield pricing power too, and the visionary leadership criterion helps us with the long-term adaptability and innovation part. If we're going to be purely business-focused investors, however, I think we may need to focus even more on the sustainability piece.
Tom: This is tough for me, because I see a lot of money to be made in technology and biotech, and I like to go where the money is. But I'm coming around to the view that brand is an inescapable part of long-term sustainable advantage. We see that lousy management may not advance a brand for a while -- maybe even kill it -- but brand can survive bad management better than good management can be sustained without brand.
I'm just going to do some more thinking about what sustainable advantage is for biotech drug makers, because, while patents clearly help HGS because of the gene-protein land grab, I just don't know about Amgen or Celera. I'm not ready to say that patents are a sustainable advantage for biotech drug makers (or bioinformatics companies), or that, because of the brand problem, that we can really say that our biotechs are true Rule Breakers. We need to think more about sustainable advantage on the biotech side.
By the way, our almost obsessive focus on sustainable advantage is essential for our strategy, but not necessarily for other strategies. Very good companies throughout history have succeeded without the initial push of sustainable advantage. Collins and Porras, in their book Built to Last, identify many visionary companies that began with lousy ideas and often bombed out for years before finding their way. 3M (NYSE: MMM) is a notable example. That's fine. We don't quibble with their ingredients for success. We stress that while Collins and Porras' companies and shareholders apparently could muddle through sometimes for decades before providing returns to investors, the nature of the RB strategy means that RB investors cannot.
Brian: There's no question that there's lots of money in technology. I'll note, though, that a few of our portfolio's worst investments -- 3dfx (Nasdaq: TDFX), 3Com (Nasdaq: COMS), and the later years of Iomega (NYSE: IOM) -- were purchases based on a technological advantage that didn't hold up. Sustainability has to come from vision and marketing, perhaps in concert with technology. That's what's done it for AOL Time Warner (NYSE: AOL), Intel (Nasdaq: INTC), et. al. That's what creates long-term brand, and with it sustainable advantage.
Jeff: Sustainable advantage means that a company's sales literally are largely protected from competitors' attack. Something keeps competitors at bay -- a moat, as Buffett calls it. For Amgen, that means patents on its two blockbuster drugs and on the drugs it develops next. For Starbucks (Nasdaq: SBUX), it largely means the brand -- the brand protects the sales base. For eBay (Nasdaq: EBAY), the community protects -- in fact, IS -- its sales. The community is eBay's sustainable advantage.
Tom: As long as its brand remains unsullied.
Jeff: I don't like to buy companies that do not have a definable sustainable advantage. I imagine if eBay's brand went downhill, the community MIGHT start to leave -- but where would they go? And how would they know where to meet?
Brian: Exactly.
Jeff: So, in my opinion, either a company has a defendable sustainable advantage that you can write down on a sheet of paper at home, or it doesn't. Fools around the world should be thinking about what they own, and write down, in a list, what the sustainable advantage at each company they own is. In other words, what protects a company's sales, and what protects the idea that it will continue to make more sales?
Tom: Excellent advice.
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.
