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Client Questions

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Income Investing
Competitive Advantage


Daniel E. Hutner, Sr.

"I see in the news that Blackberry is on the ropes and I wonder whether it is a classic example of why it is risky to invest in tech stocks. I don’t know much about Blackberry’s history, except that Al Gore had one and was a big proponent. So at that time it seemed to me that it was the leader in the “smart phone” industry. But now Blackberry seems finished, undone by other competitors in a relatively short number of years. Is this, then, a classic example of how a product can be so useful and so valuable that it stimulates intense competition and therefore is not a wise investment because profit margins are likely to be low? And is it also perhaps a great illustration of how in the tech industry things are changing so fast that it is easy to fall behind quickly to the point where you go out of business?"

That's exactly the right analysis.  A successful tech product like the Blackberry will temporarily produce high profits, but those profits will draw competitors, which results in lower margins if the competitors are successful.  Worse, innovation in the industry means that competitors may leapfrog a product by coming out with a replacement that meets the same needs but offers far more features and functionality - like the iPhone.  So you not only have to worry about someone copying your product and selling it at a lower price - you have to worry about someone making your product obsolete.  The tech landscape is littered with once great companies like Digital Equipment and Wang Computer that lost out to competitors and disappeared.

All this business carnage is great for consumers, since we get a constant stream of exciting new products, but terrible for investors.  Of course, speculators like hedge funds like to buy these stocks when they shoot up on excitement about new products and then short them when they collapse.  So they get a lot of coverage in the financial press, and brokers will push them because all the trading generates a lot of commissions.

In contrast to tech companies, the candy industry has barely changed in decades.  It's hard for a new company to compete with the established brand names, and every day that goes by means that more people have had additional favorable experiences with the product, or have heard the company's advertisements, so it gets harder and harder for a new entrant to catch up.  Also, if you do the same thing over and over again, you get better and better, which also gives you a huge advantage over someone new.  In addition, you can build up scale over time, which gives you cost advantages.

Ultimately, the degree and durability of a company's competitive advantage determines the degree and durability of its profits - which determines income and capital gains from a stock.

I suppose some contrarian might say, “Oh, I know all that. I’ll just invest in something like Blackberry for a while and ride it up and then sell it before too long.” So the next phase in the discussion would be the drawbacks of that approach – presumably not being able to time the buy and sell right, transaction fees, taxes, etc.

In terms of riding the stock up for a while and then selling it, that’s speculation rather than investing – and basically what most “investors” are doing today. The biggest problem with speculation is that you can end up with a permanent loss of capital. That ruins the compounding process where your capital gets bigger and bigger over time. You’re also dependent on someone else deciding that the asset you buy is worth more – also known as “the greater fool.”

With an investment, your focus is on earnings yield (earnings in relation to the current price), not a forecast of a future (often short-term) price move. The best way to think of this is in terms of owning a private business, which doesn’t have a public stock price. If you owned the local McDonald’s, you would judge your investment by the price you paid to become an owner and the earnings each quarter. You would also have a value in mind for the whole business based on those earnings and other factors, such as recent sales of other McDonald’s franchises.

Over long periods of time, stock prices tend to track this “economic,” or earnings-based, value. That’s why Buffett says:

I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.

Or consider this Buffett quote, which reflects the same idea:

[The] stock market serves as a relocation center at which money is moved from the active to the patient.

True investing was actually more common back in the 1950s and 1960s, but it is exceedingly rare today. John Bogle, the legendary founder of Vanguard funds, listed several “radical and far reaching” changes in the financial services industry at the 2010 Chartered Financial Analysts Conference during a panel discussion that also included Chris Davis. (Note: Davis is a third-generation old-school investor whose grandfather, Shelby Davis, was a well-known investor specializing in insurance companies and a good friend of my father’s.) Here are some of the changes Bogle has observed:

  1. Sixty years ago, investment principles emphasized long-term investing in businesses. Today, the strategy is short-term speculation in stocks.

  2. Sixty years ago, portfolio turnover averaged 20%. Today, mutual funds average 100% portfolio turnover with ETF’s even worse with some averaging 50% turnover in a day.

  3. Sixty years ago, the focus was on stock picking. Today, the focus is on asset allocation, a form of speculation.