We've spent a lot of time talking about competitive advantages in the Rule Maker Portfolio lately.
In fact, it's the focus of this year's Rule Maker seminar, which we're about halfway through. Successful investors such as Warren Buffett and investment thinkers such as Harvard's Michael Porter focus on identifying businesses with lasting competitive advantages, not spotting the fastest-growing company or slickest technology. This makes sense to us.
Actually, while we love to find fast-growth companies, growth can be a siren's song. Growth puts tremendous strain on an organization and needs to be managed carefully. It attracts competitors, spurs innovation, and creates high expectations leading to high stock prices. Fast growth is a rocky shoreline.
In the early to mid-1990s, for example, Dell Computer (Nasdaq: DELL) put the brakes on its go-for-growth strategy and focused on growth in its most profitable areas. This is why the company, famous for its direct-sales model, stopped selling any products in retail outlets around 1994. Retail sales were growing quickly but unprofitably.
As a rule of thumb, investors can expect growth in most industries to follow a path that moves from an early, pioneering phase, characterized by slow sales growth; to a fast-growth phase with super-high returns; to a maturing growth phase with the entrance of new competitors; to a stabilizing phase, where sales slow dramatically and returns on capital shrink; to a declining phase, where sales drop and the company focuses on efficiencies.
What this lifecycle tells us is that the fastest-growing companies aren't always the best investments, not when the rains come. We saw it in the Internet sector recently. eBay (Nasdaq: EBAY), which has its customer base locked in and a reasonably secure revenue stream, is one of the few that hasn't been washed away in the flood. We look for companies that can sustain growth as a result of competitive advantages that slow competitors, and lock in above-average profits for several years. It takes a lot of work to find these companies.
This brings us to Southwest Airlines (NYSE: LUV), the poster child for competitive advantages. Southwest's chief executive and founder, Herb Kelleher, announced his succession plan yesterday. Investors have anxiously awaited this news since Kelleher's prostate cancer diagnosis two years ago. On the conference call yesterday, Kelleher said he had struck a deal with the board of directors under which he had promised to name a successor on his 70th birthday or when he started drooling uncontrollably. His 70th birthday came March 12.
James Parker, 54, will become vice chairman of the Southwest board of directors and chief executive, and Colleen Barrett, 56, will become president and chief operating officer. Parker is the company's current VP-general counsel, and Barrett is executive vice president of customers and corporate secretary. Kelleher has a contract to remain chairman of the board until 2003.
Why are we talking about Southwest Airlines in a Rule Maker column? The airline industry -- with its high costs, low margins, overcapacity, and commodity services -- isn't classic fishing grounds for the Rule Maker Portfolio, but, oh my, how this company shines.
Market values don't tell investors everything they need to know about a company, but check out the difference between Southwest and a few of its competitors:
Company Market Value (billions) Southwest $13.6 Delta (NYSE: DAL) $4.8 United (NYSE: UAL) $1.9 American (NYSE: AMR) $5.1 Alaska Air (NYSE: ALK) $0.7Southwest, the short-haul, low-cost carrier, has gone from being a maverick upstart 30 years ago, to the most highly valued company in the passenger airlines industry. In fact, it's worth more than twice as much as its highest-valued rival, AMR, the parent company of number-two U.S. air carrier American Airlines. There are lessons to be learned in understanding why the market would give this company such a premium valuation, especially in an industry with shabby economic characteristics.
In his book On Competition, Michael Porter spends a lot of time helping investors spot companies with competitive advantages, which he boils down to strategic positioning. This means "performing different activities or performing similar activities in different ways." The essence here is that the best companies won't ape competitors. They will focus on what they do best and deliver value others can't achieve.
Southwest is focused on being the best short-haul carrier in the industry, which means it doesn't pretend to offer everything to everyone. This is its niche. Porter points out that Southwest doesn't serve meals. It doesn't offer premium-class services, or coordinate passengers' travel schedules. It focuses on getting planes turned around quickly at gates, which means they spend more time in the air generating revenue and less time messing with baggage and on-loading meals. By focusing on a specific strategy and executing aggressively, Southwest has become a world-beater.
Interestingly, many airlines want to dominate long-haul routes since these are often the most lucrative. Southwest became a leader by avoiding this super-competitive profit zone and creating a new one through its cost advantages and efficiencies. Now it flies in the lead.
That's what Rule Making is all about.
Have a great day.
Richard McCaffery, who helps manage the Rule Maker Portfolio, owns shares of Dell, not Southwest, but he'd be willing to meet with the companies and talk about the possibilities of a merger. The Motley Fool is investors writing for investors.