Imagine a stock that offers the combination of high growth, a low P/E ratio, low debt levels and a high return on equity (ROE). It looks like a recipe for an unbeatable investment, and investors would be hard pressed to find a stock with better fundamentals.

Tutorial: How To Analyze Earnings

But as compelling as these fundamental features might be, they still do not hold a candle to the best indicator of a company's future success: sustainable competitive advantage. While performance measures like P/E and ROE are certainly important tools for assessing a company, they are not necessarily a complete reflection of future growth and profitability. A company's long-term success is largely driven by its ability to maintain a competitive advantage - and keep it, even in the toughest, most volatile economic times. (For background reading, see Economic Moats Keep Competitors At Bay.)

The Survivors
In its 2010 Value Creators Report, Boston Consulting Group analyzed the total shareholder returns (TSR) of more than 4,000 companies to identify the world's top performers and their underlying drivers of success. A recurring theme in the Boston Consulting Group's research is that firms with competitive advantage are capable of creating value for shareholders. The 2010 report focused on the importance of value creation in a corporation's strategy; the top companies in the report showed strong growth in sales and shareholder returns in the 2005-2009 period.

A good example of a business that outperformed the market in the period examined was Apple Computers (Nasdaq:AAPL), which was ranked third in the report's Large-Cap Companies with sales growth of 37% between 2005 and 2009 and total shareholder returns of 45.6%. (To learn more about what it takes for a company to be successful, see 3 Secrets Of Successful Companies and The Characteristics Of A Successful Company.)

What Does Competitive Advantage Look Like?
The trouble for investors is that, most of the time, sustainable competitive advantage is not easy to spot. For starters, it's awfully hard to measure. Unlike performance measures like return on capital employed (ROCE) and valuation metrics like P/E, competitive advantage cannot be boiled down to a formula or a ratio; furthermore, distinguishing between competitive advantage and operational efficiency is often difficult.

Harvard Business School Professor Michael Porter, in his excellent essay, "What Is Strategy?" (1996), argues that these two concepts must not be confused: operational effectiveness means a company is better than rivals at similar activities while competitive advantage means a company is performing better than rivals by doing different activities or performing similar activities in different ways. Investors should know that few companies are able to compete successfully for long if they are doing the same things as their competitors.

At the same time, gaining a sustainable competitive advantage is not as simple as just being different. When companies do eventually manage to achieve competitive advantage, more often than not the advantage is short lived. Like bees to honey, competitors are drawn to the high profits of competitive advantage; competitors work hard to develop new technologies and business techniques that can quickly upset the competitive status quo. Remember, today's competitive advantage can become tomorrow's albatross.

At the end of the day, it is sustainability that is so critical. Powerful competitive advantage creates a big barrier around a business, allowing it to fend off competitors and enjoy extraordinary growth and profitability. The best long-term investments are those companies whose walls are not only high but also getting higher and thicker over time. Think of Coca Cola's (Nasdaq:COKE) global brand name recognition, Microsoft's (Nasdaq:MSFT) dominance of the PC operating system, or Wal-Mart's (NYSE:WMT) advanced information technology and inventory management systems. Investors need to understand the circumstances in which a company and its business model compete and whether the model puts the company at a competitive advantage or disadvantage.

Spotting Competitive Advantage

A company's future is never certain, so how can an investor pinpoint companies with growth and profits that will be substantially higher in the years to come? In Berkshire and Hathaway's 1996 Chairman's Letter to Shareholders, Warren Buffett, one of the world's greatest investors, says that the trick is to look for firms that already have competitive strengths and that operate in areas that are not susceptible to big changes:

"You will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: We are searching for operations that we believe are virtually certain to possess enormous competitive strength 10 or 20 years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek."

More than anything, Buffett looks for companies that have a sustainable competitive advantage. Here is what he says in the December 1999 issue of Fortune Magazine:

"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." (To read more about Buffett\'s strategies and theory, see Think Like Warren Buffett and Warren Buffett\'s Best Buys.)

When it comes to determining a company's competitive advantage, there are a few important questions that investors can ask about a company: Is its strategy different from other companies in the market? Does the company's strategy position deliver superior profits? Is the strategy defensible? If investors can respond yes to these questions, the company may have good future prospects.

Related Articles
  1. Mutual Funds & ETFs

    The 5 Biggest ETF Companies

    Review a list of the five largest and most influential ETF providers in the world: BlackRock, Vanguard, State Street, Deutsche Bank AWM and Invesco.
  2. Professionals

    Advertising, Crocodiles And Moats

    Memorable advertising is a brick in the fortress that keeps competitors at bay.
  3. Active Trading

    Economic Moats: A Successful Company's Best Defense

    Find out why some companies thrive while others flounder.
  4. Investing

    3 Secrets Of Successful Companies

    Make smart investments by spotting up-and-coming success stories early.
  5. Investing

    Warren Buffett and the Media Industry

    While most people believe traditional media is dead, Warren Buffett sees an opportunity.
  6. Stock Analysis

    This is What Bill Gates's Portfolio Looks Like

    Find out about the stocks Bill Gates has in his portfolio. Learn about the close personal and business relationship Gates has with Warren Buffett.
  7. Term

    Public Goods & Free Riders

    A public good is an item whose consumption is determined by society, not individual consumers.
  8. Mutual Funds & ETFs

    4 Mutual Funds Warren Buffet Would Buy

    Learn about four mutual funds Warren Buffett would invest and recommend to his trustee, and discover detailed analysis of these mutual funds.
  9. Stock Analysis

    Markets Are Tanking: Time to Buy Like Buffett

    Learn about three value stocks Warren Buffett holds in his portfolio. See how Buffett uses market declines to find good deals on stocks.
  10. Investing

    Procter & Gamble Restructures, Sheds 100 Brands

    All businesses face adversity, and Procter & Gamble is no exception. We take a look at recent developments affecting this global giant.
  1. What factors are the primary drivers of share prices in the retail sector?

    The retail sector includes companies selling every consumer product imaginable and spans both traditional brick-and-mortar ... Read Full Answer >>
  2. What are the benefits of research and development for a company?

    Some advantages of research and development are clear, such as the possibility for increased productivity or new product ... Read Full Answer >>
  3. How does financial accounting differ from managerial accounting?

    Financial and managerial accounting are two of the four largest branches of the accounting discipline, with the others being ... Read Full Answer >>
  4. What is the most important type of data used in business analytics?

    The usefulness of any data type or data source depends on the type of analytics being performed. For some businesses, data ... Read Full Answer >>
  5. How has the Internet impacted Value-Added Network (VAN) providers?

    The advent and proliferation of Internet-based service providers and cloud technology has created an easier, cheaper and ... Read Full Answer >>
  6. What is an economic moat?

    The term economic moat, coined and popularized by Warren Buffett, refers to a business' ability to maintain competitive advantages ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Ex Works (EXW)

    An international trade term requiring the seller to make goods ready for pickup at his or her own place of business. All ...
  2. Letter of Intent - LOI

    A document outlining the terms of an agreement before it is finalized. LOIs are usually not legally binding in their entirety. ...
  3. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  4. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  5. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  6. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!