About 18 months ago, I sat down with the CEO of what was a $1 billion company. The company is well-known, and I can almost guarantee that you've heard of it. Here are some of the highlights of the conversation:
"We have to invest year after year to maintain our competitive advantage."
Ouch.
"There's little that we do that no one else can do."
Are you kidding?
"We continually have to adjust for some kind of 'vaporization' effect with respect to our write-offs."
Agghhhh! %$)(@ 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 more than 85% 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, thanks to the financial crises currently unfolding. I considered the exec honorable for his candid truth-telling, and that's a big plus in my book -- but it's not good enough for any investment of mine.
If the person I interviewed sounds anything even remotely like the CEO of a company in your portfolio, dump that stock. Do it now, before you're completely wiped out.
A lasting competitive advantage is a vital element of a great business. Without it, a company's brief edge in sales or technology will disintegrate like a finely built sand castle on the beach.
One excellent example happened just recently with GPS player Garmin (NASDAQ:GRMN). Now, Garmin has and probably always will make a fine product. But when competitors began to witness the company's historically fat margins, they were tempted to enter the business like sharks into bloody water. And Garmin could do nothing to stop them.
These days, Garmin is getting smashed from all sides, by existing competitors such as Tom-Tom and new GPS followers such as Nokia (NYSE:NOK), Research In Motion (NASDAQ:RIMM), and Palm (NASDAQ:PALM). Garmin's stock is down more than 50% in the past two years, after once being a multibagging powerhouse. Worse, the company's future remains even more unclear without any kind of sustainable competitive advantage.
A deadly trap
However good a product or service may be, if it can be replicated by others, it's not worth much. In time, competitors will squeeze margins, batter revenue growth, and produce a bloodied, chum-filled ocean of competition. Companies will need to invest more and more each year, only to receive a smaller piece of the earnings pie in return.
That's precisely why Intuitive Surgical has delivered nearly 500% gains in the past five years, compared to a market that's lost a significant amount of money. No one is even close to replicating the company's technology or its products, the competition remains years behind, and in the meantime, doctors are building familiarity with a system and machine they can use for a variety of procedures. This is a critical advantage in the industry.
By the same token, investing in a company like Yahoo! (NASDAQ:YHOO), which once leveraged excellent advantages atop an immensely popular website, just doesn't make a whole lot of sense. The same customers who flocked to the company in the earlier days for search, email, and a variety of online services have left with similar expediency to patronize newer players such as Google (NASDAQ:GOOG) and Baidu.com (NASDAQ:BIDU). There's no reason why any user can't easily pick up and leave for the next megapowerful search engine once it arrives.
Investing legends will suggest that you look at investments through a similar filter. Warren Buffett has made billions identifying companies that leverage products or brands with an unassailable edge. Coca-Cola and Kraft Foods specifically come to mind here. Buffett's 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 whether the company 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 that sucker.
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, what do you have? Not that much, really.
Instead, focus on the companies that have real moats to keep rivals at bay. 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 our strategy has paid off: We're currently beating the market by nearly 34 percentage points since inception in 2002. Want to take a look? Click here to try the service free for 30 days.
Fool analyst Nick Kapur owns no shares of any company mentioned above, and zero material interest in the company whose CEO he interviewed. Intuitive Surgical, Baidu.com, and Google are Motley Fool Rule Breakers recommendations. Kraft Foods is an Income Investor recommendation. Coca-Cola and Nokia are Inside Value recommendations. The Fool has a disclosure policy.
