A bit more than six months ago, I sat down with the CEO of what used to be a $1 billion company. The company is well-known, and I can almost guarantee that you've heard of it. Here are some highlights of the conversation:
"We have to invest year after year to maintain our competitive advantage."
Ouch.
"There's little that we do that no one else can do."
Are you kidding?
"We continually have to adjust for some kind of 'vaporization' effect with respect to our write-offs."
Agghhhh! %$)(@No.
Out of journalistic considerations, I can't tell you the name of the stock. But the simple truth is that since the interview, shares have dropped 40% anyway -- so people are definitely getting the picture.
Dime a dozen
You might be able to find the stock if you looked hard enough. Actually, you could probably find dozens more in a similar predicament. While I thought the exec honorable for his candid truth-telling -- and that's a big plus in my book -- it's not good enough for any investment of mine. The point here is universal: If the person I interviewed sounds even remotely like the CEO of a company in your portfolio, dump that stock. Now.
A lasting competitive advantage is a vital element of a great business. Without it, a company's brief edge in sales or technology or whatever will disintegrate like a finely built sand castle on the beach.
Remember when IBM was the only company on the block mass-producing individual computers? That kind of situation would be analogous to Pepsi (NYSE:PEP) having exclusive reign over the soft drink industry. IBM was making money hand over fist -- and yet it couldn't keep it going. Eventually, competitors like Dell and then Hewlett-Packard (NYSE:HPQ) started taking tastes, then nibbles, then gigantic bites. Only recently did IBM refocus and realign, but most companies aren't so lucky.
A deadly trap
No matter how good a product or a service is, if it can be replicated by others, it's not worth much. In time, competitors will squeeze margins, batter revenue growth, and produce a red ocean of competition. More and more will need to be invested each year, only to receive a smaller piece of the earnings pie in return. As an example, think about what's happened to Cisco's (NASDAQ:CSCO) return on capital over the past few years.
And that's precisely why Intuitive Surgical has delivered more than 2,000% returns in the past five years. No one is even close to replicating the company's da Vinci technology. And it helps explain why Pfizer and Eli Lilly (NYSE:LLY) have stagnated for years. The two are fighting in shared space and eating each others' lunches.
Now compare that to a company breaking ground in previously untouched space like BioMarin (NASDAQ:BMRN), a pharmaceutical business focusing its R&D on markets that are just too small for the bigger pharma companies. That's where the real payoffs are -- in green spaces.
Investing legends will tell you the same thing. Among others, Warren Buffett has made billions identifying companies that leverage products or brands whose edge was not in danger. CarMax (NYSE:KMX) and Burlington Northern (NYSE:BNI) come specifically to mind. His track record confirms that looking for these types of businesses is a fundamental characteristic of a successful long-term investment.
Back to the horror story
I knew going into the CEO interview that I didn't really like the company's position in the industry. So when I got a sense that he was willing to talk, I pushed harder. I asked him if they had any kind of ringer in the pipeline; perhaps a blockbuster project in one important segment that investors could look forward to. His response?
"There's no killer application."
Man. Sell this stock.
The Foolish bottom line
If you own shares of a company that has no real barriers to hungry competition, and it doesn't have anything in the works for the future, then what do you have? Not that much, really.
Instead, focus on the companies that do. Every single one of the recommendations in Motley Fool Stock Advisor leverages some kind of competitive advantage -- it's a crucial aspect of our selection process. And the strategy has paid off: We're currently beating the market by 43 percentage points since inception in 2002. Want to take a look? Try the service free for 30 days.
This article was first published Oct. 15, 2007. It has been updated.
Stock Advisor analyst Nick Kapur owns no shares of any company mentioned above and has zero material interest in the company whose CEO he interviewed. Intuitive Surgical is a Motley Fool Rule Breakers recommendation. Pfizer is an Inside Value recommendation. Pfizer and Eli Lilly are Income Investor recommendations. The Fool has a disclosure policy.
