Last week, fellow Fool Nick Kapur wrote about an undisclosed $1 billion company that looked about as attractive as a week-old Cobb salad left out in the noonday sun. It had little, if any, competitive advantage. Even its CEO admitted, "There's little that we do that no one else can do." Geesh -- talk about creating your own destiny.
Look back at the original S&P 500 index created 50 years ago. Of the 500 original components, 86 have survived. Sure, some of the 414 dropouts still exist after merging with another company, but most of them went to the index graveyard because they couldn't make a name for themselves. Any business with an easily replicated model will face endless competition. And companies that don't distinguish themselves from the crowd probably won't find themselves at the top of their game for very long.
What is it that makes a company's success stand out from the crowd? Why do some companies prosper for decades, even centuries, and others vanish with the passing tides? One explanation is in what Warren Buffett calls a company's "moat." Competitive advantages can take many forms, but in essence they are what a company brings to the table that other companies don't even dream about.
As I see it, three sources give companies moats -- the serious long-term staying power that enables them to succeed in the wake of others' failures. Let's take a look.
The 800-pound gorilla
Being the biggest isn't always a good thing, but towering over competitors certainly doesn't hurt. Think about Wal-Mart (NYSE:WMT). It is so big it can order suppliers to change their production lines and become more efficient. It is so big that many products would die out if manufacturers didn't bend to Wal-Mart's demands. Wal-Mart buys in such large quantities it can pay lower rates than its competitors and then sell the products at lower prices.
Home Depot (NYSE:HD) and Procter & Gamble (NYSE:PG) are also good examples of moats created by size. Think you can start a mom-and-pop hardware store and provide prices competitive with Home Depot? Think you can start a toothpaste company and convince people your product is better than Crest? Think again -- 800 lb. gorillas won't let you put a dent in their marketplace.
Tollbooth companies
Some companies have such a strong, competitive moat their customers cannot survive without them. In the computing world, how many options do you have for document and spreadsheet software? One: Microsoft (NASDAQ:MSFT) Office. Don't like Office? If you want to produce documents and spreadsheets in a format everyone else can open, you don't have much choice. Sure, there are other options out there, such as OpenOffice.org and Google Documents, but the inconveniences that come with these alternatives far outweigh the benefits you get from biting your lip and buying Office. Microsoft has created a tollbooth: Want to cross the bridge into document softwareland? You're gonna have to pass through the Microsoft tollbooth, my friend.
Intellectual property
Some companies sell products; others sell memories. Think about it: Companies like Coca-Cola (NYSE:KO), Disney (NYSE:DIS), and Nike (NYSE:NKE) instantly bring happy thoughts into your head. Coke makes you think about a bubbly, cold beverage on a summer day. Disney makes you a kid again, watching Bambi or Cinderella. The Nike swoosh conjures up Michael Jordan soaring through the air.
Compare those images to your responses when you hear the names Building Materials Holdings or Titanium Metals. My guess is you don't even blink an eye -- and that's why the former have such an edge over the latter. As Warren Buffett puts it, "Forget share of market; I'm talking about share of mind." Companies that take control over part of your mind can hold you for decades -- creating a kind of moat Henry V would envy.
When valuing a business, it's the discounted amount of its future cash flows over time that matters. So having a long horizon for success is essential. Always make sure your investments have the ability to show as much oomph in 5-10 years as they do today. The wider the moat, the less you worry about losing that coveted edge.
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