We received a lot of feedback after our discussion about sustainable advantage last week, much of which asked us some follow-up questions. Fellow Fool C. E. Thurmon sent us the following four thoughtful, intriguing ones that well represent the sorts of inquiries we've received. The questions apply to sustainable advantage and to Rule Breaker investing in general, so we decided to put our answers in a column.
1) How can a lay investor be readily apprised of all the necessary facts about a company required for proper decision?
Brian Lund: I don't think that a lay investor can be readily apprised of all the necessary facts. First, an investor will not be apprised of anything; she has to apprise on her own. And there won't be anything "readily" about it. Investing takes a lot of digging and a lot of time.
We've been criticized before for not acting quickly enough on our ideas, but we think that it's necessary to take a good, long look at a company before buying into it. Watch how the management handles the company. Does it set targets and meet them? Does it allocate its capital well? Is it signing up good partners and/or customers? Have its marketing efforts paid off? Is it expanding its profit margins? The past is no guarantee of the future, but an excellent track record suggests that management has a clear vision and is pursuing it successfully.
Even after lots of research and observation, it's possible to come to the wrong conclusion. That applies not only to lay investors, but also to people on the inside. Even the Warren Commission dropped the ball. That shouldn't prevent us from investigating as closely as we can and coming to our best, objective conclusion.
2) From a practical investing standpoint, i.e. to keep risk at a reasonable cost/benefit level, wouldn't an investor need to see some profit generated by the candidate company before investing?
Tom Jacobs: We approach this question from a different direction. We focus first on risk versus reward, not a company's profits. One person's "reasonable cost/benefit level" could be one person's safe night's sleep -- not much cost or benefit -- while to someone else it could be reckless, like riding a motorcycle without a helmet.
For example, you could invest in Coca-Cola (NYSE: KO), a profitable company, knowing that people will swig Coke and other company products for a very long time. Coca-Cola offers fairly low risk, but also low reward. But you could also buy shares of currently unprofitable Human Genome Sciences (Nasdaq: HGSI), knowing that you are banking on the company's drug target discovery and drug candidate development platform to produce FDA-approvable therapeutic protein and antibody drugs that blow away the marketplace. Risky? Ohmigod yes! But if HGS succeeds, the potential rewards will likely blow away Coke's. Why else take on the risk?
So each investor must first define reasonable risk. That dictates the choice of investing strategies -- and the importance of profits. Most people prefer a majority of Cokes, and fewer, if any, HGSs.
3) Wouldn't an investor be better off trying to find sustainable advantage in a "niche" player (pardon the MBA School clichï¿½) which should require less capital than an oversize giant? The disadvantages of the giants would include anti-trust action and lack of agility. While it is true that the niche player would be vulnerable to a "buy out" by the Giant, shouldn't the investor nevertheless be ahead economically?
Paul Commins: I think it's a question of whether you want to buy an existing advantage or buy the potential for a future advantage. In the former case, you're taking on less risk, but your odds for a big win are smaller and based more heavily on market pricing considerations. In the latter case, your guess is more about how the "niche" product market will unfold and expand. Of course, spotting the potential for advantage is more difficult than recognizing one that exists, and so these bets offer both a greater upside and a greater chance that you'll lose all of your money. Such is the nature of an individual Rule Breaker investment.
As for "agility," this can certainly be a competitive advantage. As technology evolves, the place to be is at the interface with consumers. Companies weighed down with heavy production assets will have a harder time jogging left and right to keep up with the pace of change, especially in emerging industries. Also, these asset-heavy businesses are more often caught holding the dead-inventory bag, when the economy takes a sudden shift downward (see the fourth quarter of 2000).
On the other hand, without a strong connection to consumers -- either via brand, great service, the ability to anticipate their needs, network effects, or switching costs -- it's tough for such light business models to survive. They have little to fall back on, and competition is cutthroat for these high-margins spots near the consumer. Among these light-business advantages, brand, network effects, and switching costs appear to be the most sustainable (toughest for competitors to duplicate).
Given this perspective, it's not a sure thing that "niche" players will be more nimble. Giants like Coca-Cola, Microsoft (Nasdaq: MSFT) and, more recently, Cisco (Nasdaq: CSCO) have respectively exploited brand, network effects, and a strong rapport with customers to stay a step ahead of their competition. Certainly size has been a factor in the success of these giants, but nimble business models have ultimately set them apart.
4) Like the real estate warning, "Location, location, location," shouldn't the idea of sustainable advantage be finalized, even after investment, with "be vigilant, vigilant, vigilant," meaning that investors must be vigilant for signs of negative change in sustainable advantage and have a readiness to sell when it shows?
Jeff Fischer: This is true. Investors should always be tuned in to the status of the sustainable advantage at each company that they own. In the second part of our chat about sustainable advantage, we stated that you should consider selling when sustainable advantages begin to wear thin because -- when you're buying Rule Breakers -- that serves as a large indicator that the young business isn't progressing as hoped.
Rule Breakers must have sustainable advantages if they are going to succeed and become, as we always hope, large, earth-rattling Rule Makers. Without lasting advantages in a new, emerging industry, a company will always be undermined by revenue- and margin-stealing competitors.
How do you recognize waning sustainable advantages? Each company is inevitably different. If a young, emerging biotech like HGS starts to fail in getting drugs through human trails, or at finding new drug candidates, this is an indicator that its drug discovery platform -- its sustainable advantage! -- is flawed, and an investor would need to rethink the position. Or if eBay (Nasdaq: EBAY) hadn't bought Half.com, and Half.com had become the third-most visited e-commerce site and second-most popular trading platform (as it is now), we'd be forced to reassess eBay's sustainable advantage in light of Half's fast-growing, simple trading service.
So, as we said last time: Write down your companies' sustainable advantages, and then watch to make sure that they remain intact. Without sustainable advantages, a company isn't a Rule Breaker.
The Breaker Team is available to lead cheers for the Final Four, if the NCAA is interested. They own various stocks mentioned above. Check the profiles for Tom, Brian, Paul, and Jeff to view their holdings. The Motley Fool is investors writing for investors.