"Time is the friend of the wonderful business, the enemy of the mediocre."
-- Warren Buffett, 1998 chairman's letter

That's sage guidance from the Oracle of Omaha, but it brings a question to mind. No, it brings two. What, exactly, makes up a wonderful business? And how can we know whether it will perform well over time?

The short answer to both of these questions: a sustainable competitive advantage. If a business does not have strong positioning relative to its peers, it can't be wonderful, and it won't make us rich by compounding investments at above-average rates over time.

Competitive advantage
Competitive advantage revolves around two things: unique positions and the right supporting capabilities to protect those positions.

Analysts love to talk about a business' "moat." That's a good analogy. You put the castle in a safe place and protect it with a moat -- and some men with weapons, of course. No unwelcome guests, please.

It's the same in business.

Positional advantages come in many forms. If you are the de facto standard -- like eBay (NASDAQ:EBAY) is for bringing buyers and sellers together online -- you have a positional advantage. If you have a huge installed base of customers like Microsoft, you have a positional advantage. If you have a recognizable brand name like Nike (NYSE:NKE), you have a positional advantage. But firms can't just seek out those positions without having the right people. That's why they need the right supporting capabilities.

Capabilities come internally. If a firm is good at generating innovative new products, that's a capability. If it's good at miniaturizing things -- Sony (NYSE:SNE) comes to mind -- that's a capability. If a firm is good at integrating acquisitions -- Cisco, for example -- that's a capability.

Positions and capabilities are only the building blocks. A company's true strength is evidenced over time.

To understand whether a firm's moat can protect it from thieves looking to steal returns, we need to understand four things: imitation, substitution, hold-up, and slack. Let me break it down for you.

If a firm's position or capability can easily be imitated, it doesn't have an advantage. Can Coca-Cola's (NYSE:KO) formula for refreshing taste with limited aftertaste be duplicated? Can its marketing prowess be replicated? Many have tried. None have succeeded.

Substitution is where the action is; and substitution, in my opinion, is the toughest criterion to meet. If, for example, a competitor can easily introduce a substitute product, service, or technology into the marketplace, then a firm's competitive advantage may not be sustainable.

For many years, to ward off challenges from Advanced Micro Devices (NYSE:AMD), Intel (NASDAQ:INTC) continuously advanced its microprocessor technology. At the same time, it upgraded its manufacturing capabilities and increased its manufacturing capacity. And as long as Advanced Micro Devices tried to catch up, Intel had an advantage.

Hold-up is kind of like extortion, but much more civilized. It happens when an outside firm prevents your company from capturing value in the form of cash flow. And it goes a little something like this: If someone can hold up your strategy to generate cash flow, then your competitive advantage may not be sustainable.

The best example I can think of outside the business world is professional sports. The reason superstar athletes get paid huge sums of money is because they have the power to hold up the game. Games cannot be played without players. Lucrative TV contracts cannot be signed without games. Therefore, players get paid big bucks.

Slack is essentially internal waste that means less value for the shareholders. It can be thought of as a hold-up problem within the firm rather than outside of it. Compared with Toyota (NYSE:TM), General Motors' cost structure is extremely bloated. A disproportionate amount of the value created by selling cars goes to employees and retirees than to shareholders. As such, General Motors, in my opinion, has lost its advantage and will require draconian measures to get it back.

Putting it to use
So now that you have a mental model to assess competitive advantage, here's how to use it.

The market tends to overweight the most current information. Since competitive analysis has both historical and futuristic points of view, it can help you determine whether the market is overreacting to new information. For example, if a company misses earnings one quarter, see whether its competitive position has changed significantly. If not, the market may be overreacting to the negative news.

You can also use competitive analysis to analyze new companies. New companies are often surrounded by a good story. Competitive analysis help determine if the story is sizzle or steak.

Finally, while analyzing the competitive advantage of one firm, you may come across other strong performers. Use the model to analyze leads and find new ones as well.

Time is on our side if .
To recap, time is the friend of a great business. The analysts at Motley Fool Inside Value do three things to determine if they have found a wonderful business:

  1. Define a company's competitive advantage.
  2. Understand whether it's sustainable.
  3. Understand when the market misinterprets the first two.

Philip's competitive advantage
Inside Value advisor/analyst Philip Durell's advantage is that he's patient, contrarian, a cheapskate, and a lover of any great business. If you'd like to see the buy reports on all the companies Philip believes have competitive advantages, you can be our guest free for 30 days. I promise it will be time well spent.

And for more on value creation, check out:

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