Imagine a stock that offers the combination of high growth, a low P/E ratio, low debt levels and a high return on equity (ROE). It looks like a recipe for an unbeatable investment, and investors would be hard pressed to find a stock with better fundamentals.
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But as compelling as these fundamental features might be, they still do not hold a candle to the best indicator of a company's future success: sustainable competitive advantage. While performance measures like P/E and ROE are certainly important tools for assessing a company, they are not necessarily a complete reflection of future growth and profitability. A company's long-term success is largely driven by its ability to maintain a competitive advantage - and keep it, even in the toughest, most volatile economic times.
In its 2010 Value Creators Report, Boston Consulting Group analysed the total shareholder returns (TSR) of more than 4,000 companies to identify the world's top performers and their underlying drivers of success. A recurring theme in the Boston Consulting Group's research is that firms with competitive advantage are capable of creating value for shareholders. The 2010 report focused on the importance of value creation in a corporation's strategy; the top companies in the report showed strong growth in sales and shareholder returns in the 2005-2009 period.
A good example of a business that outperformed the market in the period examined was Apple Computers (Nasdaq:AAPL), which was ranked third in the report's Large-Cap Companies with sales growth of 37% between 2005 and 2009 and total shareholder returns of 45.6%.
What Does Competitive Advantage Look Like?
The trouble for investors is that, most of the time, sustainable competitive advantage is not easy to spot. For starters, it's awfully hard to measure. Unlike performance measures like return on capital employed (ROCE) and valuation metrics like P/E, competitive advantage cannot be boiled down to a formula or a ratio; furthermore, distinguishing between competitive advantage and operational efficiency is often difficult.
Harvard Business School Professor Michael Porter, in his excellent essay, "What Is Strategy?" (1996), argues that these two concepts must not be confused: operational effectiveness means a company is better than rivals at similar activities while competitive advantage means a company is performing better than rivals by doing different activities or performing similar activities in different ways. Investors should know that few companies are able to compete successfully for long if they are doing the same things as their competitors.
At the same time, gaining a sustainable competitive advantage is not as simple as just being different. When companies do eventually manage to achieve competitive advantage, more often than not the advantage is short lived. Like bees to honey, competitors are drawn to the high profits of competitive advantage; competitors work hard to develop new technologies and business techniques that can quickly upset the competitive status quo. Remember, today's competitive advantage can become tomorrow's albatross.
At the end of the day, it is sustainability that is so critical. Powerful competitive advantage creates a big barrier around a business, allowing it to fend off competitors and enjoy extraordinary growth and profitability. The best long-term investments are those companies whose walls are not only high but also getting higher and thicker over time. Think of Coca Cola's (Nasdaq:COKE) global brand name recognition, Microsoft's (Nasdaq:MSFT) dominance of the PC operating system, or Wal-Mart's (NYSE:WMT) advanced information technology and inventory management systems. Investors need to understand the circumstances in which a company and its business model compete and whether the model puts the company at a competitive advantage or disadvantage.
Spotting Competitive Advantage
A company's future is never certain, so how can an investor pinpoint companies with growth and profits that will be substantially higher in the years to come? In Berkshire and Hathaway's 1996 Chairman's Letter to Shareholders, Warren Buffett, one of the world's greatest investors, says that the trick is to look for firms that already have competitive strengths and that operate in areas that are not susceptible to big changes:
"You will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: We are searching for operations that we believe are virtually certain to possess enormous competitive strength 10 or 20 years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek."
More than anything, Buffett looks for companies that have a sustainable competitive advantage. Here is what he says in the December 1999 issue of Fortune Magazine:
"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."
When it comes to determining a company's competitive advantage, there are a few important questions that investors can ask about a company: Is its strategy different from other companies in the market? Does the company's strategy position deliver superior profits? Is the strategy defensible? If investors can respond yes to these questions, the company may have good future prospects.
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