Different investors use different definitions of competitive advantage. Here’s the one that resonates with us.
Motley Fool Asset Management (MFAM) relies on its “4 Pillars of Quality” when assessing stocks. They are:
- Management, culture, and incentives
- Business economics
- Competitive advantage
- The sustainability of growth.
And MFAM believes paying reasonable prices for the stocks of high-quality businesses increases the odds of generating favorable investing outcomes.
I recently talked about the power of growth. Today, I’d like to discuss the importance of competitive advantage in our process.
Widely sought after
Most CEOs will say their company has a competitive advantage. And many investors look to allocate capital to companies with competitive advantages. The challenge is that businesses with real advantages are rare. What’s even more difficult to do is find businesses that can sustain their advantages over time.
However, history shows that finding and investing in a truly great business for the long term can be very rewarding. That’s why we work hard to identify those types of companies.
Different investors use different definitions of competitive advantage. Here’s the one that really resonates with me: a business has a competitive advantage when it combines a unique position with the right supporting capabilities.
Here’s how that definition works. Coca-Cola is a very successful company that has a very strong set of brands. But Pepsi has a brand. Jones Soda has a brand. Cheerwine has a brand, too. But the aforementioned companies have varying degrees of success.
Having a brand, or a differentiated position, is not enough. Coca-Cola also has excellent marketers in its ranks, an efficient global distribution system, and the ability to create products that encourage consumption.
All of those capabilities work to support Coca-Cola’s position in the beverage industry, which gave it an advantage in the marketplace that we could see in its performance. And for many years, Coca-Cola’s advantage helped the company capture market share, deliver above-average growth, expand margins, and generate incredible returns on invested capital.
An example to further straighten things out
Coca-Cola is a classic example. So, let’s look at a more current one: Align Technology, which is a Top 5 holding in both our Global Opportunities Fund* and our Small-Mid Cap Growth Fund.
As the clear leader in retainer-based orthodontics, Align Technology has a strong position in the industry with its Invisalign brand of products. However, as we said earlier, a strong position isn’t enough. After all, the technology to make a plastic retainer is available to many companies in the industry. In addition, metal braces are still a strong substitute in the marketplace.
That’s why Align Technology’s management has invested heavily in the following capabilities: the science to develop the retainers to correct an expanding variety of ailments, the sales and marketing talent to build relationships with dentists and orthodontists to sell the service, highly efficient and accurate manufacturing capabilities, and extremely reliable logistics at scale.
As I said above, it’s not especially difficult to design and manufacture a simple retainer. But it would take significant time and money to recreate the dental office relationships, the scale of the manufacturing processes, and the wherewithal to deliver thousands upon thousands of retainers to the right customers at the right time. And all of those capabilities are needed to create great experiences for the end user.
Have Align’s positions and capabilities combined to give it an advantage in the marketplace? The evidence suggests yes, as Align Technology continues to grow its market share, deliver strong sales growth, expand margins, and improve its return on invested capital.
The game of business is tough. The competition, no matter the industry, is relentless. Every business leader is trying to make the best decisions to effectively sell her product or service, take more market share than competitors, and deliver good financial performance over time. And the framework above for assessing whether or not a company has an advantage (there’s a separate framework for evaluating the sustainability of that advantage, which I’ll write about in a separate article) helps the MFAM team try to separate the winners from the losers.
Does it mean we always find the best company? No, it doesn’t. But investing is not about getting every decision right. As Peter Lynch says, “In this business, if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.” And investing in companies that we believe have competitive advantages helps put the odds more in our favor for making good investing decisions within our three actively-managed funds: Global Opportunities, Small-Mid Cap Growth, and Emerging Markets.
*Please click here to see holdings for the Global Opportunities Fund. Please click here to see holdings for the Small-Mid Cap Growth Fund.