The Three "Little" Words of Successful Investing

John Price,  Ph.D.

We all know the three little words at the basis of successful marriages. But do you know the three little words at the basis of successful companies, the type of companies that are sort after by long-term investors?

The three words I am thinking of are not so little. Also much more pompous. The words I have in mind are "sustainable competitive advantage".

A bit of a mouthful but vital if you are looking for a company that is going to make excellent profits year after year. Such a company needs a competitive advantage and it needs to be able to maintain this advantage.

Before I get to them, there are another three little words that should be imprinted in the minds of every investor. They are contained in the famous statement by Benjamin Graham, known as the dean of Wall Street: "Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, margin of safety."

Warren Buffett supported this choice in an annual report of Berkshire Hathaway when he wrote, "Forty-two years after reading that, I still think those are the right three words."

These three words are apt for every form of investment. No matter what we are doing in the world of stocks, without a margin of safety, we are treading close to the quicksand of speculation.

Returning to the words "sustainable competitive advantage", a competitive advantage can come from many sources. Products and services, ability of management, sales organization, labor and personnel, brand recognition and location to name some of the main ones.

Something more is needed, however, if an advantage is to be maintained and not washed away by the competition. In simple language, it needs a barrier.

This barrier could be geographical. Consider a shopping mall. Most of its visitors will come from the surrounding region. This makes it unlikely that another mall will be built nearby. Also the shopping mall two towns away is not a competitor because most people will not want to drive that far. At least not on a regular basis.

Careful research is done on the income levels and spending habits of people within different zones surrounding a proposed mall. The same data is also used to determine how much money will be spent on upgrading a mall and the character of the upgrade.

Peter Lynch talks about rock pits as also having a geographical barrier. The cost of hauling sand, gravel and rocks means that you have a virtual monopoly for an hour’s drive around your pit. Someone selling in your "neighborhood" would find their profits eroded by these haulage costs.

Another barrier is an economic one arising in industries where the cost of production decreases sharply with quantity. If the market is dominated by one producer, then it is difficult for a competitor to get a toehold. This is referred to as a natural monopoly. Consider how much it would cost to make a single computer chip to compete with a top-of-the-line chip from Intel. Literally billions of dollars.

Strength of a brand name is another barrier that is difficult for any competitors to breach. "If you gave me $100 billion," declared Warren Buffett, "and said take away the soft drink leadership of Coca Cola in the world, I’d give it back to you and say it can’t be done."

Other brands that distinguish the companies from their competitors range from Walt Disney to Harley Davidson.

Intellectual property locked up in patents and copyrights also acts as a protection for a company.

The most powerful and enduring barrier a company can have is the quality and determination of its people, from the top management down through all the levels. There is no simple way for an investor to judge quality in the area of personnel. One place to start is to keep an eye on newspaper reports about the company. Signs of unrest and excessive labor turnover, whether voluntary or through large scale dismissals, can be an indicator to pass over that company.

One marker for companies with a protective barrier is that they have a level of return on capital that is both stable and high. This is because their competitive advantage allows them to have more control over the prices for their services or products. If there are other companies in the same sector, then it is likely they will have a lower return on capital.

Consider Intel versus Advanced Micro Devices (AMD). Intel has a return on capital of approximately 26 percent whereas AMD is struggling to stay in the black. The average return on capital for the semiconductor industry is around 16 percent.

Another company with a lofty return on capital is Gillette. Over 20 percent for the past ten years. Even though its earnings have recently been under pressure, its ROC is still over this level.

The economist John Kay refers to those aspects of a company that give it a protective barrier as a strategic asset. For long-term value, start with companies that have the sort of strategic assets described above. Within this group of companies look for those with management that understand the value of these assets and have the determination to develop them to their fullest.

Properly managed, these strategic assets provide a sustainable competitive advantage. They allow a company to get a higher return on capital than their competitors and to maintain this over time. If you pay a reasonable price to buy into a company that has strategic assets and that has a management that understands their value, your investment will keep you happy for many years.