Education: Growth & Income Investing

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Finding a Sustainable Competitive Advantage

Growth and income investors are frequently referred to as buy-and-hold investors. These investors seek solid companies that are expected to outperform the market over the long term. Needless to say, companies that fit this mold must possess some form of sustainable competitive advantage.

All Advantages Are Not Created Equal

When one company can rightfully boast that it holds some type of advantage over its competitors, it has to feel pretty good about itself and its future prospects. However, it is important to distinguish between advantages that are simply competitive advantages from those that are sustainable. Those that have one or more sustainable competitive advantages find themselves leading the race more often than not.

A competitive advantage is present when a company posts profits that exceed the industry average. This is usually the direct result from either delivering the same benefits of its rivals at a lower cost or from delivering benefits that exceed those of competing products.

In December 1999 issue of Fortune Magazine, Warren Buffett stated:

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

A competitive advantage that is sustainable differs from one that is strictly competitive in that it provides the company with a long-term advantage that is not easily duplicated. Or, more likely, competitors have thrown in the towel trying to replicate this advantage. It is just not possible.

Building a Sustainable Competitive Advantage

One of the world's leading experts on strategy and competitive advantage, Harvard Business School Professor Michael Porter, has helped people identify companies with competitive advantages that are likely to endure, which is obviously no easy task. Mr. Porter’s article, “What Is Strategy?" (Harvard Business Review, November/December 1996) clarifies the distinction between strategic positioning and operational effectiveness—both imperative to superior performance. However, both work in different ways. Porter defines the two as follows:

Operational effectiveness: performing similar activities better than rivals perform them.

Strategic positioning: performing different activities from rivals’ or performing similar activities in different ways.

Porter goes on to mention that constant improvement in operational effectiveness is necessary to achieve superior profitability, and that few companies have competed successfully on the basis of operational effectiveness over an extended period of time.

When All Else Fails…

If you are like me, I sometimes have some trouble digesting research papers written by well-respected academics—including Mr. Porter. When I read through the article for a second time, it became clearer. Lucky for you, we can save you the time, headache and money (you thought Harvard Business Reviews were free?) from trying to get to the bottom of Mr. Porter’s research. How, you ask? With the Zacks Rank, of course!

The Zacks Rank is a quantitative model that can be used to help determine whether to buy, sell or hold a particular stock. Trends in earnings estimate revisions and earnings per share surprises are used to categorize companies. Long-term investors are encouraged to buy or add to existing positions in stock with a Zacks Rank of 1 or 2 and to reduce holdings of stocks ranked 4 or 5. Mr. Porter mentions “superior profitability” and the Zacks Rank is a perfect mechanism to sniff out these high-quality companies. (Learn more about the Zacks Rank).