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Your Edge
by WealthEffect Staff

 
 

Competitive advantage is the investor's edge
 
  Two types of advantage are cost and quality  
  The key question: Is this competitive advantage sustainable?  
 
1.

As an investor in stocks, and not just a speculator, you are making a choice. You are making a commitment to ignore the seemingly easy money of the "hot" stock (which might not be so hot), in some business you kinda, sorta understand but that didn't seem to matter much anyway because you were just in it for a quick profit. Once you're out of the speculating game, once you insist that your future wealth shouldn't be part of a game, you're halfway home.

Now, you're in the business of finding great businesses. And great businesses have one thing in common: they each maintain an advantage over their competitors. This advantage is the source of their success; it is what separates great companies from the host of pretenders. Competitive advantage is the investor's edge.

 
 
2.

One type of competitive advantage is a cost advantage — namely, a company which operates more efficiently than its competitors. This company might sell a product that is no different or better, but which it is able to produce more cheaply. This cost advantage will put the company on the "virtuous cycle": It can sell its products at a lower price, customers buy more, and its average costs drop (since fixed costs per unit will decline), allowing the company to cut prices further, and so on.

A lower cost structure is usually the result of a superior management's ability to do all the little things right. Witness the success of Wal-Mart in retailing and Sysco in food distribution, two companies whose customers and shareholders have benefited from this competitive advantage.

The other major category of competitive advantage is a quality advantage. If a product is truly "better", or thought to be superior, consumers will pay more for it.

The theme parks of Disney World draw families worldwide to Orlando for a pilgrimage that is anything but inexpensive. Here, the quality of the product and the "positive awareness" of the product create a powerful advantage — an advantage which is reinforced by the Disney Studios and the ABC Television Network.

Harley-Davidson manufactures motorcycles that don't match some of its competitors in price-performance, but it is the only multi-billion dollar company that can't meet demand. Its product is more than a means of transportation — it's a life-style. This intangible quality is deeply ingrained in our collective consciousness, in the United States and internationally, from the hardcore biker to the white-collar weekend rider. Here, the perception is reality. As someone pointed out, if customers tattoo your logo on their chests, they probably won't change brands.

 
 
3.

Finding a company with a competitive advantage is not enough, however. You must also determine that its advantage is sustainable. If the company has a lower cost structure, is there a way that its competitors catch up? Is the company's management willing and able to do all the little things necessary to keep costs lower?

If the company has a superior product, can the product be duplicated? If the product's superiority is more perceived than real, is there anything that can damage or destroy that perception?

These are tough questions to answer, which is often more art than science. But this is what makes true investing such an interesting challenge. Once you have found a company with a sustainable competitive advantage, you are on your way to finding an excellent investment.

Suggestion: Go to The Importance of Management