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My Short-term Plan VIII:

This is a continuation of my 10 part series on the core concepts I am focusing on in this difficult market environment. (Part I, II, III, IV, V, VI, VII)

Number 8:

One valuable quality that any investor can benefit from over the long-term is foresight. I’ve said before that you don’t need a business degree to understand investing in stocks. What you do need is an understanding of what makes certain businesses successful and that should lead to better investments over the long-term.

A competitive advantage, or moat, is something that Warren Buffett has often highlighted as imperative and a requirement in order for him to invest in a business. While many investors like to use this buzz word in their analysis of stocks the harsh reality is that competitive advantages are rare, fiercely protected and usually not sustainable. The competitive advantages that are sustainable provide their respective companies with significant long-term benefits that can last years or decades.

A sustainable competitive advantage (SCA) acts as a moat to protect a business from competition attempting to overtake its operations. The larger the moat, the further away the attack must come from and the greater the resources needed in order to penetrate this protective barrier. A SCA comes in more than one form and often exists due to a company’s ability to secure an advantage that no one else can duplicate or acquire without significant financial resources. These can include strategically owned global real estate as with McDonald’s, supply chain management in the case of Walmart or owning a patent or process that allows a company to manufacture a product at a much cheaper cost than competitors.

A SCA doesn’t allow a company to sell a product or service cheaper than their competition, but it allows them to enjoy a much higher profit margin. This relates full circle back to my earlier post on why a company never competes on price.

Take Company ABC: they can manufacture a product for $7/unit because of their specific patented process. But their global competitor Company XYZ can only make the same product for $10/unit. The patent won’t expire for another 30 years, but the products are in high perpetual demand over the coming decades. Company XYZ sells their products for $12/unit, but so does Company ABC. Why? Because they can.

The profit margins for Company XYZ are 20% while the same margins for Company ABC are 43%. In an industry with competition rules (no monopolies) why would Company ABC ever sell their product at a 20% margin when they can get double because of their SCA? Even if they dropped their price by $1, why sacrifice the margins unless you want to put your competition out of business?

A SCA in this current environment allows a company to enjoy higher margins than their respective competition and places a company in a much better financial & operational position for the future. This is why cutting margins right now is suicide in my view for a business.

A company can use higher margins to build cash, continue growing their international presence, grow their market share through innovative marketing initiatives or re-invest back into the business for future business cycles. This is where a focus on margins comes into my current investment strategy.

Bottom Line: focus on companies that have a SCA or competitive advantage that will sustain them through this difficult economic period. If a company is properly managed they will be in a much better position when the economy emerges on the other side of this downturn. In comparison their competition will continue to struggle to grow profits, expand their operations and only hope to sustain their market share.

Suggested Stocks I Own: Walmart (WMT) & Exelon (EXC)

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{ 4 comments… add one }
  • Anonymous October 15, 2008, 2:45 pm

    Just nitpicking, but how can a company’s patent expire in 30 years? Patent protection is always 20 years, unless you know a trick?

  • Nurse B, 911 October 15, 2008, 4:55 pm

    Its not nitpicking Anon – I should have explained it better.

    There are cases within the last 5 years where patents (on financial products) have been obtained for 30 year periods.

    Frequently in industry a company will seek to protect a patent further by applying for secondary or accessory patents on a product/process after 10 years so that the process/product is extended.

    While unethical many businesses continue to pursue this type of patent protection by bringing into question the authenticity of the original patent. PFE attempted this some years ago with Lipitor as they sought to extend their patent period.

  • Anonymous October 16, 2008, 2:04 pm

    Ah, I gotcha. It’s called “Evergreening,” I believe? Though technically the protection is on another invention, and also its not possible to predict whether the “extension” will be passed.

    However, I like your thinking – is there any particular competitive advantage that a public company has that you are focusing on?

  • Brad October 16, 2008, 5:41 pm

    I generally like patents, but they are increasingly rare and often challenged with a company at the mercy of a court.

    I really like supply chain management and the advantages it provides a company who can execute on a large scale those efficiencies.

    A sustainable competitive advantage is very rare as a competitive advantage often moves in a cyclical pattern. If you read my stock analyses or this series (http://www.nurseb911.com/2007/09/diamond-in-rough-part-i.html) I think you’ll find some of your answers there.

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