A few weeks back, Fool Co-Founder David Gardner discussed the six signs of a Rule Breaking company . Over the next few weeks, our analysts will be examining each of these signs in greater depth. After the series has run its course, you should be able to identify Rule Breakers for yourself. Today, we'll look at sign No. 2: Sustainable advantage gained through business momentum, patent protection, or visionary leadership.
We all know the story of the three little pigs. One pig builds his house out of straw, another builds one out of wood, and the last makes his house out of brick. For two of the pigs, the story has an unhappy ending -- the mean ole' wolf comes along and trashes the place. The last pig, however, is safe and sound in a strong, sturdy structure. No amount of huffing and puffing from that wolf is gonna bring the brick house down.
There is a moral here, and it's actually relevant to investing. The house is the business that we, as shareholders, own. The wolf is the competition that wants to eat us for lunch. If we want our business to last, it had better be a stout enterprise that is able to withstand attacks.
Earlier this week, my colleague Rick Munarriz wrote a fine article about the importance of being the first mover in important and emerging industries. Well, it's all fine and dandy to be first, but you also need to be the best -- and be able to stay that way. It's not sufficient to break the rules and turn an industry upside down with a new way of doing things if any other company can immediately rip off your ideas and copy your business. This is why companies that we want to invest in for the long haul need to have competitive advantages that are lasting and not easily overcome. They need to have built a brick house.
And this is why true Rule Breakers must have characteristics that keep the competition at bay. The brick house can come in a number of different forms; patent-protected intellectual property or a critical mass of customers that gives the business momentum that cannot be matched by a newcomer are two examples.
Robust intellectual property
Nothing shuts out the competition like laws that say they can't rip you off. Want to make your own Pentium computer chips? Good luck with that. Intel (NASDAQ:INTC) would cream you with lawsuits the minute you tried to copy its products protected by patents. Want to build your own digital music player that can play songs from Apple's (NASDAQ:AAPL) iTunes Music Store? You'd better get yourself a good lawyer.
If a strong brand -- think Apple -- gives a business a protective moat, then intellectual property is the impenetrable stone wall keeping invaders from overrunning the place.
Intellectual property can take the form of patents, copyrights, and trademarks. Patents in particular are quite important because they prevent competitors from making, using, and selling the product a company has invented. Patents in and of themselves aren't worth anything; they are only important when they are protecting something of value.
Patent protection of valuable products is one reason I like biotech companies. When a biotech creates a new drug from its R&D, it is the only company in the world that can make and sell that drug until the patent expires. That's a huge competitive advantage, and it is not easily surmounted. This intellectual property position is a virtual guarantee that a company will make money selling its drugs. Because a competitor cannot make an identical drug, it has to spend the time and money to develop its own unique drug. That's a costly proposition, and makes for very high entry barriers in the biotech industry.
The competitive advantage gained from drug patents leads to long periods of sales growth. With that revenue comes fat profit margins -- these drugs are highly profitable, after all. This is the big reason that biotech companies are great to own once a legitimate product has been developed. Genentech (NYSE:DNA), for example, has increased in value 1,700% over the past two decades, stomping the S&P 500's 400% upswing.
Business momentum
Being the first mover in an industry creates business momentum. Once a company has momentum in its niche, it is very difficult for competitors to catch up. Dell (NASDAQ:DELL), for instance, rocketed ahead of the other PC makers because of its lean and mean business model. Once it got out front it was there to stay.
Netflix (NASDAQ:NFLX) is another great example. Over the past few years Netflix has emerged as a true Rule Breaker by changing the way people rent DVDs. For years movie aficionados had to hop in their cars and drive to the local movie rental place, which was likely a Blockbuster (NYSE:BBI) store. Driving to rent a movie is now passe. Millions of Netflix subscribers now simply hop online and set up rental queues. In a day or two, the DVDs show up in the mail.
Because Netflix was first to act, it acquired a critical mass of customers that now totals more than 3 million subscribers. For the most part, these are loyal customers who played an important role in growing the company -- via word-of-mouth "buzz." I should know -- I've been a happy customer for several years.
This customer base has given Netflix incredible momentum. Anyone with enough money can buy an inventory of DVDs and ship them through the mail. There are no barriers. What a competitor cannot easily do is capture the buzz surrounding the Netflix service and grow a subscriber base to the point where the business will be viable for the long run. Just ask Wal-Mart (NYSE:WMT) and Blockbuster, who have both had a heck of a time trying to catch Netflix, despite being much larger companies. Wal-Mart, the king of retailers, even gave up trying this past May.
So whether you call it a moat or a brick house or just sustainable advantage, your company needs to be protected from the young whippersnapper that thinks it has a better idea. We insist on this principle for all of our Motley Fool Rule Breakers selections. If you'd like to learn more about our thinking, Fool Co-Founder David Gardner is offering a free 30-day trial to the service. You'll receive access to all of our past picks, as well as this month's recommendations, hot off the presses. And if you end up thinking the service is not for you, that's fine too. Just cancel. Our customer service team actually understands the word no. Click here for more information.
And for related Foolishness:
- Rick Munarriz examines sign No. 1 in Be First, Be Great.
Charly Travers is a movie buff and a Netflix fan but does not own shares of any company mentioned in this article. Dell and Netflix are Motley Fool Stock Advisor recommendations. The Motley Fool has adisclosure policy.
