Durable competitive advantage: it sounds nice, but what does it mean? And, as an investor, why should I care about it? Sometimes referred to as a "business moat", durable competitive advantage, in its simplest term, means the scale of a business in its field vs. its peers. That is its "competitive advantage."
But what makes it durable?
What make an advantage durable is the cost and time it would take a current or potential competitor to grow large enough in this area (high barrier of entry) to adversely impact our business. A high level of durability allows us a greater degree of accuracy to predict future earnings, and thereby arrive at a price for which we are willing to purchase a piece of the business (share of stock).
How do we recognize and find those businesses that have this (or don't)?
Strict adherence to the "durable" portion of the phrase enables us to do one thing before we even begin to look at possible stocks: eliminate entire sectors of possible investment. This makes our investing easier by shrinking the field of candidates, while reducing the chances of mistakenly investing our money in a good company in a lousy business.
Examples of sectors that lack the "durable" portion:
Investing history is littered with airline bankruptcies. Once high-flyers can sometimes fall victim to either high or low jet fuel prices, or a recession, and go under. After 9/11, were it not for the U.S. government's bailout of the airlines, most of them would have failed, despite only being out of business for less than a week. High union costs, fickle customers and volatile fuel prices make any accurate assumption of future profits by investors impossible. Why would you buy into a company whose future profitability is unknown? Southwest Airlines is a great company, and the best-managed of all the airlines, but investing in it is akin to having the best lounge chair on the Titanic: eventually you'll be sorry.
We have to be careful not to throw the baby out with the bathwater. Not all tech qualifies here, but let's look at it generally and you will have to decide on a case-by-case basis. Warren Buffett of Berkshire Hathaway (BRKA) said it best about tech investing. I will paraphrase: "I cannot invest in something that two teenagers with a PC in a garage can destroy." What?
Simple, Michael Dell started building PC's in his Texas dorm room, Bill Gates started Microsoft (NASDAQ:MSFT) in his garage, Ebay (NASDAQ:EBAY) was launched in a weekend from a living room after a labor day conversation and Google (NASDAQ:GOOG) was a research project by two Stanford University students. All these businesses toppled at-the-time industry leaders and Google is still in the process of doing it to several now. How can you be confident about an investment that an 18-year-old writing code in his family room before he takes out the trash could make obsolete?
This industry must constantly reinvent itself almost yearly in order to survive. The pace of the necessity of this change is accelerating every year. Look at the iPod: its success has exploded over the last three years, and in six months the iPhone comes out. Having both an iPod and a phone, and having to carry both around, will be a thing of the past. Competitors will flood the market with similar products and the stand-alone iPod will be history. It will be relegated to the "remember when" conversations. This is how fast things change in tech; all these companies make missteps along the way, and when they do, investors pay a heavy price. In 2000 investors thought Microsoft (MSFT), Dell (DELL), Amazon (NASDAQ:AMZN) and Yahoo (YHOO) had reinvented the rules of investing; those same companies are still down over 40%. When is the last time you did not buy a bag of M&M's because they "were so yesterday," searched for the "newest version of Arm & Hammer baking soda" or would not be caught dead eating a Hershey's candy bar? Me neither . . .
You have to wade through the tech field carefully (I personally avoid it) and if you do decide to jump in, please do not do what most tech investors do: overpay for shares (see last week's Google post).
Decades ago, these were great investments. However, the advent of generic drugs has turned this into a simple commodity business. They used to enjoy the financial fruits of new drugs for decades, whereas now the exclusive locks up are shorter and increased competition means competitors have similar products in the market almost simultaneously with the generics undercutting profits. This industry is under attack by governments and now in the courts as well by users of their products. The economics of their industry have permanently changed for the worse and it should be avoided as they are spending more and more money to develop drugs with smaller profits potential. Bad equation.
So, now we have a brief idea of what to avoid it would be nice if I gave you some examples of companies that have a competitive advantage that IS durable.
McDonald's (NYSE:MCD): The turn of the century was hard on the golden arches. They had the perfect storm of bad events and the stock was punished over the next two years from almost $50 down as low as $14. Some of the mistakes were theirs, and others were from events beyond their control. The turn of the century began with a heightened interest by consumers of what they put into their bodies. McDonald's was slow to recognize this and their sales began to suffer. Then came mad cow. The whole fast food industry suffered as consumers began to look for options other than meat products to eat and McDonald's was once again slow to react. Then the Jack In The Box chain in the pacific Northwest began serving ecoli burgers and killed several people. These events lead people to fear the drive-thru window.
But, what was really wrong with McDonald's that a menu fixin' wouldn't cure? Nothing! Because of the durable competitive advantage it held over the rest of the industry and the value the McDonald's brand held worldwide, after some menu tampering McDonald's was once again off to the races. It has a worldwide distribution system second to none. It has since survived the premature death of two CEO's and shares are up 214% from their lows. Recent proof of McDonald's advantage has been the introduction of coffee at its locations (good coffee, I should say). It has been a huge success and chains like Dunkin' Donuts and Tim Horton's have noticed sales declines where McDonald's competes. At its low, McDonald's was a value investor's dream...
John Deere (NYSE:DE) / Caterpillar (NYSE:CAT): If you are in either farming or construction, your search for equipment most likely begins and ends at either of these companies. Both basically invented the industries in which they operate and are by far the world leaders in them to this day. Both stocks are up over 125% since 2000.
Walt Disney (NYSE:DIS): When you think of your childhood or amusement parks does anything other than Disney come to mind? After stumbling at the turn of the century the House of Mouse has righted its ship and shares are back on the march. If you are my age, and your folks had bought you Disney shares when you were born, you would be sitting on a 5000% gain.
Hershey (NYSE:HSY): The Hershey Company markets such well-known brands as Hershey's, Reese's, Hershey's Kisses, Kit Kat, Almond Joy, Mounds, Jolly Rancher, Twizzlers, Ice Breakers, and Mauna Loa, as well as innovative new products such as Take 5 candy bar and Hershey's Cookies; it is the largest chocolate manufacturer in N. America.
Coke (NYSE:KO) / Pepsi (NYSE:PEP): The two dominant worldwide soft drink makers. If you really think about it, they are really the only two of any significance. Their products are known worldwide and both stocks have produced. Had your folks bought you share in either when you were born in the early 70's you would be sitting on in excess of 3000% gains.
All of these companies have rewarded loyal shareholders with great gains. The important thing to recognize is all have had their problems and because of their durable competitive advantages, have not only weathered the storms but emerged stronger companies.