Unstoppable Stocks, Phenomenal Returns

The really huge money is made in the stock market by buying and holding superior companies over the long term. Consider the performance of the following companies since 1990:

Of course, it's easy to point to the incredible stocks of the past 15 years, but it's much harder to find the huge performers of the next 15 years. But history can still help, because what all these businesses have in common is that they really aren't run-of-the-mill companies. All of them are fantastic businesses that obliterate weaker competitors.

So when value investors go looking for companies set to outperform, that's where we start. We look for fantastic businesses that have what investors call "competitive advantages." There are many different types of competitive advantages, but they all have one similarity -- they help businesses survive, grow, and demolish their competition. A solid understanding of the various competitive advantages a company can possess will help investors in their quest for these massive performers.

Killer brands
A killer brand can be a powerful competitive advantage, particularly in consumer markets. Harley Davidson is one of the best examples of how far a brand can take a company. Its brand is so strong that some of Harley's customers are willing to permanently tattoo the corporate logo on their bodies. With that sort of loyalty, it's unlikely that these customers will purchase any other type of motorcycle.

The power of the brand is obvious -- anyone who's chosen to buy Coca-Cola (NYSE:KO) over a cheaper generic cola recognizes that brand is a significant factor in many purchasing decisions. But a strong brand has more subtle benefits, too. Retailers have limited shelf space, so they need to make decisions about which soft drinks to sell. Clearly, they're required to stock Coke -- their customers demand the product. But that means that there's less shelf space for competitors' products. And if competing soft drinks aren't on the shelf, there's no way for consumers to even think about buying them.

Coke's brand is also an advantage when selling new products. Since retailers already deal with Coke, know its processes, and have developed relationships with its sales team, they're likely to be significantly more receptive to Coke's new products than those from other companies.

Network effects
A second type of competitive advantage arises from "network effects." Network effects occur when the value of a product increases with the number of customers. For instance, instant messaging has a strong network effect, because if all your friends are using a particular messaging system, you'll want to be on the same system, too. As a result, these products often become natural monopolies.

Microsoft has been extremely successful in exploiting networking effects. Windows is the operating system that everyone uses, so new users are likely to choose Windows, too. Hardware manufacturers want to sell to the biggest market, so they make sure their components run on Windows. Finally, since their employees and IT departments already know the operating system, companies standardize upon Windows as their PC operating system. All of these factors combine in a virtuous cycle that has been a huge competitive advantage for Microsoft. When you consider that Office software has similarly strong networking effects, it's not surprising that Microsoft has been the most successful software company ever.

Operational superiorities
With most products, the more you manufacture, the cheaper the unit cost of manufacturing. Thus, economies of scale can be a huge competitive advantage for large companies. And economies of scale are even more important in the global economy. After all, companies need to have reasonable sales volumes before outsourcing manufacturing halfway around the world makes sense.

Many companies have other operational competitive advantages, such as superior distribution systems, manufacturing capabilities, or inventory management. Dell is one of the great success stories, proving how important operational competitive advantages can be. At this point, Dell is able use its position as the largest PC manufacturer to demand lower prices from its suppliers. But Dell was able to achieve that position in a relatively commoditized market by focusing superb inventory management and other operational efficiencies.

Regulation
Many companies have a competitive advantage based on regulation. For instance, the patent system gives Merck (NYSE:MRK) a temporary monopoly on all new drugs it develops, allowing it to charge unusually high prices for a period of time. Plus, it's an arduous process to get a new drug approved by the FDA, a process that Merck, with experience and resources, can successfully navigate.

Regulation may cause Fannie Mae some pain in the short term, but historically, it has been an advantage. Fannie Mae's special status with the government has allowed it to both borrow money at extremely low rates and use an extraordinary degree of leverage.

Proprietary data
Some companies have access to proprietary data -- information that they have that other companies do not. Such information can be difficult or prohibitively expensive to acquire and can therefore be a competitive advantage.

Dun & Bradstreet, for instance, has such a competitive advantage. The company has a proprietary database containing information about 92 million businesses, a database that is updated roughly 1.5 million times a day. Its entire business consists of obtaining, aggregating, linking, and analyzing this data, and then selling the results. So, if you're interested in the proprietary data it has, it's prohibitively expensive to get that information any other way.

The upshot
I've listed only a few of the competitive advantages that superior companies exploit to ensure that they grow and prosper over the long term. As an investor, you'll want to pay close attention to these factors, since businesses with strong competitive advantages have a head start on huge returns. A good way to begin is by analyzing each company in your own portfolio and trying to understand its competitive advantages. Then, for future investments, focus your investment dollars on the companies with the most significant competitive advantages.

An even better way achieve extraordinary returns is to look for the companies with massive competitive advantages, and then purchase them for much less than they're worth. That's what we do at Inside Value, and it's one reason that our portfolio has handily beat the market. Each company we've recommended not only has a superior competitive position but also was trading at an average of 72% of fair value when we recommended it. Intrigued? Check out a free 30-day, no-obligation trial. You'll be able to see all our recommendations, including our two most recent selections.

Fool contributor Richard Gibbons is a member of the Inside Value team. He owns shares of Merck as a component of his pharmaceutical HOLDRs and shares of Dun & Bradstreet but none of the other companies discussed in this article. Microsoft, Fannie Mae, and Coca-Cola are Inside Value picks; Merck is an Income Investor pick; Dell is a Motley Fool Stock Advisor selection.