The best investors say they look for businesses with a competitive advantage, referring to them as moats. Last I checked, every CEO thinks his business has a sustainable competitive advantage and that his stock is undervalued, too. Unfortunately, I think that competitive advantage is like Benjamin Graham's famous book Security Analysis; everyone has a copy, but few have read the whole thing. I think people use the phrase without really understanding what it means.

I have come across many definitions for competitive advantage (which to me means it's hard to define). But the one that makes the most sense to me is this: A firm creates a competitive advantage when it seeks a unique position and has the right supporting capabilities. The word "and" is extremely important in this definition. It implies that a business cannot rely entirely on a unique position in its industry nor merely hire a bunch of functional experts to be successful. Some combination of both must be present.

Positional advantages
Firms create a positional advantage by seeking out unique areas to compete within an industry. Coca-Cola (NYSE:KO) has a unique position in the drink business. It has created soft-drink flavors that promote consumption by having very little aftertaste while being extremely refreshing. But Coca-Cola could not have generated its amazing success by neglecting to develop the marketing, brand management, and distribution capabilities needed to supports its position.

As Fools, we know that having a brand can create a positional advantage. But there are other ways to create positional advantages. Fannie Mae and Freddie Mac have positional advantages based on their relationship with the U.S. government. Microsoft (NASDAQ:MSFT) has a positional advantage because it owns the de facto standard for computer operating systems. There are other ones, but I think you get the gist.

Capability advantages
Capability advantages are all about people, how well they are organized, and how well they serve the position. I cannot think of a better example of a firm with capability advantages than Berkshire Hathaway (NYSE:BRKa).

Its main business is selling insurance. Yes, it has decided to sell auto insurance, catastrophe insurance, and reinsurance. These are its positions. But because insurance is essentially a commodity, there are no significant positional advantages to pursue. Sure, GEICO originally refined its position further by serving only government employees in an attempt to reduce risk, similar to USAA serving military families. But at the end of the day, success in the insurance business depends on people. You have to be disciplined in the policies you write, the prices you charge, how well you service the policies, and how you invest the proceeds. People, not position, create the value of Berkshire.

Sustainability creates value
I think the reason that business leaders tout their competitive advantages is that, using the framework above, it's easy. All businesses develop strategies to serve unique positions with unique products and services, using organizations specifically designed to do so. But having a strategy that creates a competitive advantage does not necessarily create value. To create value, the competitive advantage has to be sustainable, and this is where I think many people get tripped up. I know I find myself gushing about a company because there is a competitive advantage only to learn that it's probably not sustainable.

To see whether a company's strategy has is robust and has staying power, you need to start by asking four questions about imitation, substitution, holdup, and slack.

Can a competitor easily imitate/duplicate your competitive advantage?
The best example is Wal-Mart (NYSE:WMT). Wal-Mart's distribution system is probably the ninth wonder of the world and is largely responsible for its low-cost advantage. Fortunately, it is almost impossible to duplicate.

Can a competitor substitute a better strategy?
Dell (NASDAQ:DELL) turned the PC industry upside down by selling made-to-order computers directly to consumers. IBM and Compaq used to have positional advantages through their relationships with retailers. By using just-in-time inventory, bypassing the retailer, and offering lower prices, Dell turned its competitors' strategic assets into strategic liabilities and created a ton of value. Compaq merged with Hewlett-Packard and IBM has since changed it business model. When you think of substitute strategies, Rule Breakers should come to mind.

Can another company prevent you from executing your strategy and disrupt your cash flows?
Have you ever wondered why oil companies such as Exxon and Shell are vertically integrated? The reason is that they use so much capital to find, extract, refine, distribute, and sell their oil-based products. They cannot afford to have outside firms "hold up" or prevent sales from flowing into their businesses. Their fixed costs would kill them quickly if sales were not continuously coming in.

Does someone have excess resources, people and financial, to explore new positions and capabilities?
Having excess resources to pursue new positions and capabilities is known as slack. Microsoft has lots of money and people to explore new ideas for taking computing to the next level. That plays a significant role in making their competitive advantage sustainable. I think Google (NASDAQ:GOOG) has organized its entire business to create slack. Google devotes its time and resources to finding new positions for search technology in today's networked economy.

You must understand competitive advantage first
In "Start Your Streak Today", I commented that great investors such as Bill Miller strive to understand a business's competitive advantage before calculating its intrinsic value. That's an important part of his amazing market-beating streak, which apparently is still alive at 14 years in a row.

The reason you have to understand competitive advantage first is that you have to decide how much margin of safety you need when purchasing your investment. Sustainability creates value. Value is derived from future cash flows. If there is uncertainty about the amount of value created because sustainability is low, then you need additional margin of safety for your investment. That made my head hurt thinking it through, so let me give you an example.

Select Comfort
The stock price of Select Comfort (NASDAQ:SCSS), a Motley Fool Hidden Gems recommendation, is just under 50% off its 52-week high because of two recentissues. That sparked my interest to do my own analysis. Below is a summary of the framework discussed above.

  • What's the business: Selling a good night's sleep.

  • Position: Adjustable firmness mattress to try to "customize" sleep.

  • Capabilities: Sales, marketing (which could be stronger), distribution.

  • Imitation: There are other air mattress designs, but Select Comfort's construction technologies are good and it has created brand awareness via the Sleep Number.

  • Substitution: Spring and foam mattresses are substitutes. Heck, the floor is a substitute. Using its Sleep Number as a marketing tool to sell the value proposition is key to making sure its product is differentiated on performance rather than on price.

  • Holdup: Bypassed retailers by setting up small stores and its own distribution system to sell directly to customers. Allows Select Comfort to sell its value proposition and takes power away from retailers to lower prices and hold up cash flows.

  • Slack: Not much here, but Select Comfort and others still spend some money on R&D to keep products fresh.

I calculated the intrinsic value to be about $22 per share. But given the significant threat of substitute products, I do not think there is enough margin of safety to warrant a purchase at a current price just under $18. If it dropped back into the $13 range again, I think there would be adequate margin of safety to take a position. I tend to be a pretty conservative investor, and your estimate could be different than mine.

Well, I hope that illustration was helpful, and I hope you will use the framework in your decision making. I can't say it enough that it is crucial to understand how a business competes in order to determine the margin of safety you feel you need to make a purchase decision. Best of luck in 2005.

Margin of safety is at the heart of value investing. Check out Philip Durell's Inside Value to see how much margin of safety his recommendations have.

Fool contributor David Meier does not own shares of any of the companies mentioned. The Motley Fool has a disclosure policy.