This article was written by Whitney Tilson in 2001, a time when understanding a company's competitive advantage was crucial to investing in any dot-com. With IPOs once again on the rise -- especially popular and hyped-up names like Google (NYSE:GOOG), Baidu.com (NASDAQ:BIDU), Warner Music Group (NYSE:WMG), and Chipotle Mexican Grill (NYSE:CMG) -- the concept of competitive advantage has renewed relevance.
If you could ask only one question about a company before deciding whether to invest in it, what would it be? How rapidly is it growing? How good is management? How attractive is its industry? What is its return on equity, or return on invested capital? What is its P/E ratio? Are its shares at a 52-week low (or high)?
All of those -- except the last one -- are good questions, but they should be superseded by the following: "How strong is the company's competitive advantage, and how sustainable is it?"
Warren Buffett agrees, noting in a 1999 Fortune article: "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."
Powerful competitive advantages -- obvious examples are Apple's (NASDAQ:AAPL) brand and large following, or Intel's (NASDAQ:INTC) control of the operating components necessary for personal computing -- create moats around businesses, allowing them to keep competitors at bay and reap extraordinary growth and profits. The best long-term investments, assuming one pays attention to valuation and doesn't overpay for the stock, tend to be the rare companies that not only have wide, deep moats, but also moats that widen and deepen over time. Few companies succeed in this endeavor.
Moats are rarely enduring for many reasons: High profits attract competitors, and new technologies, customer preferences, and ways of doing business emerge. Numerous studies confirm that there is a very powerful trend of regression toward the mean for high-return-on-capital companies. In short, the fierce competitiveness of our capitalist system is generally wonderful for consumers and the country as a whole, but bad news for companies that seek to make extraordinary profits over long periods of time.
So how does one identify companies with powerful, sustainable competitive advantages? Look for companies with sensible, consistent, well-defined strategies, because strategy is the root of competitive advantage for most companies.
Michael Porter on strategy
For further thoughts on this topic, let's turn to one of the world's leading experts on strategy and competitive advantage, Harvard Business School Professor and strategy expert Michael Porter. Here are some extensive excerpts from a 2001 interview with Fast Company.
"Only strategy can create sustainable advantage. And strategy must start with a different value proposition. A strategy delineates a territory in which a company seeks to be unique. Strategy 101 is about choices: You can't be all things to all people."
"Many [companies] have abandoned strategy almost completely. Executives won't say that, of course. ... Typically, their 'strategy' is to produce the highest-quality products at the lowest cost or to consolidate their industry. They're just trying to improve on best practices. That's not a strategy."
"There's a fundamental distinction between strategy and operational effectiveness. Strategy is about making choices, trade-offs; it's about deliberately choosing to be different. Operational effectiveness is about things that you really shouldn't have to make choices on; it's about what's good for everybody and about what every business should be doing. Lately, leaders have tended to dwell on operational effectiveness."
"If all you're trying to do is essentially the same thing as your rivals, then it's unlikely that you'll be very successful. It's incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals do and actually do better for very long. That's especially true today, when the flow of information and capital is incredibly fast. It's extremely dangerous to bet on the incompetence of your competitors -- and that's what you're doing when you're competing on operational effectiveness."
"The underlying principles of strategy are enduring, regardless of technology or the pace of change. Consider the Internet. Whether you're on the Net or not, your profitability is still determined by the structure of your industry. If there are no barriers to entry, if customers have all the power, and if rivalry is based on price, then the Net doesn't matter -- you won't be very profitable."
"In great companies, strategy becomes a cause. That's because a strategy is about being different. So if you have a really great strategy, people are fired up."
Conclusion
When you're analyzing a company as a potential investment, you can apply Porter's thinking by asking a few key questions: What is this company's strategy? Is it sensible and distinct? Does it -- or will it -- lead to superior profitability? And, most importantly: Is it defensible?
In a market where many IPOs are priced high and many more even pop, it's worth learning the lessons from 2002 and investigating whether or not companies actually have a competitive advantage for the long run.
Intel is a Motley Fool Inside Value recommendation. Need help finding a great company with sustainable competitive advantage? Take a page out of Philip Durell's book with a free guest pass to Motley Fool Inside Value. He can help you separate the good from the greats and invest at bargain prices.
Shruti Basavaraj, who updated this article, owns no shares in any company mentioned above. The Fool has a sustainable disclosure policy.
