The Olympic motto "Faster, Higher, Stronger" is as applicable to investing as it is to sports. Investors want to find strong companies that are constantly growing and improving themselves. But avoiding poor investments is as important as identifying good ones. Your portfolio returns are a product of both your winners and your losers, and if you lose half your investment, you need a 100% gain just to break even.
The issue is particularly relevant to value investors who look to buy top companies when they're on sale, battered down by some temporary bad news. The problem is that competitive advantages fade, and temporary bad news is sometimes not so temporary. It's critical that you recognize the signs of a weakening competitive position, so that you don't buy a stock just as it starts its descent.
So before buying that beaten-down company, check to see if it's becoming slower, lower, and weaker. If so, you may be dealing with a company with a tenuous competitive position, and it may not be as good an investment as it initially appears.
One of the most noticeable signs of a weakening company is slower growth, which can be an indication that competition is starting to heat up. Of course, things are never so simple -- not all slowdowns in growth are a result of competition. Slower growth is a characteristic of both mature markets and larger companies. Your challenge as an investor is to distinguish between a slowdown caused by competition and one caused by other factors.
For example, Microsoft's
Often, a faltering competitive position is evident when you look at the financial ratios. Lower margins, return on investment, and return on equity are often signs that a company's competitive position is faltering. After all, a company generally achieves extraordinarily high margins and returns on investment because it has barriers to competition. If those barriers weaken, extraordinarily good ratios can become mediocre. Of course, such numbers always fluctuate, so you should be looking for trends that last for several quarters at least.
Consider Albertson's position in the supermarket wars. In the last half of the 1990s, Albertson's
One of the biggest signs that a company is weakening is when its customers start buying from competitors. You may see the competitors' press releases touting new contracts, or you may simply notice that the company's market share is declining.
For instance, consider Intel
A more subtle weakening can be caused by disruptive technology. Such technologies may not even be considered direct competition, but may simply make a competitive advantage less relevant.
Netscape's browser, in its time, was this sort of threat to Microsoft. If users spend much of their computing time using a browser, and web applications become the norm, the browser effectively becomes the "operating system" upon which applications run. Since the browser could potentially run on any platform, Microsoft's Windows operating system becomes far less relevant -- and less of a competitive advantage for Microsoft. To deal with this threat, Microsoft expended significant effort and risked antitrust actions to make Internet Explorer the standard browser. In time, Google's search platform may pose a similar threat.
To sum up
Value investors who pick up cheap companies that are experiencing temporary trouble should be particularly aware of these issues. If you're looking for help distinguishing between companies that are unjustifiably cheap and those that deserve a low price, we can help. Our Motley Fool Inside Value newsletter specializes in identifying cheap companies with major competitive advantages. Every recommendation includes a discussion of the company's competitive position and potential risks to that position. And, for a limited time, we're offering new subscribers a discount of 25% off the regular price, plus two free books -- Stocks 2006 and Benjamin Graham's classic The Intelligent Investor. Click here to learn more.
Microsoft and Dell are Motley Fool Inside Value recommendations. Whole Foods is a Stock Advisor pick.
Regrettably, over the last couple of years, Fool contributor Richard Gibbons has embodied the anti-Olympic ideal of "Slower, Lower, Weaker." He does not have a position in any of the stocks mentioned in this article.