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. Nike is a great example of how important a brand can be in a company's success. Throughout its history, Nike has associated its brand with sports superstars, from Michael Jordan in the 1990s to Tiger Woods this decade. The conspicuous swoosh logo is ubiquitous.

The power of the brand is obvious -- anyone who's chosen to buy Pepsi (NYSE:PEP) 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 Pepsi -- 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.

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

Intel has been successful not simply because of technological superiority but also because of network effects. Almost everyone runs computers based on Intel's processors, so new users are likely to buy similar computers. Typically, developing software for different systems is expensive, so developers prefer to target a single processor -- generally Intel's, since those are the most popular. Finally, because their employees and IT departments already know how to use and manage Intel-based machines, PCs became the standardized platform of choice. All these factors provide a tremendous advantage for Intel.

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. GE is a great success story, proving how important operational competitive advantages can be. GE is one of the largest companies in the world, and this provides it with massive economies of scale. Plus, the company's focus on six-sigma to improve quality and reduce costs has helped to ensure that the company's operations are constantly improving.

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

Regulation may cause Freddie Mac (NYSE:FRE) some pain in the short term, but historically, it has been an advantage. Freddie Mac'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.

As one of the main credit agencies, Equifax (NYSE:EFX), for instance, has such a competitive advantage. The company has a proprietary database containing financial and demographic information about millions of consumers and businesses, a database that is updated millions of times a day. Its business focuses on using this data to assist businesses in making credit and marketing decisions. If you're interested in the proprietary data it has, it's necessary to buy that information from Equifax or one of its competitors.

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 to 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 is beating 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.

This article was originally published on Nov. 14, 2005. It has been updated.

Fool contributor Richard Gibbons is a member of the Inside Value team. He does not have a position in any of the companies discussed in this article.