SOURCE: Disciplined Growth Investors

Disciplined Growth Investors

July 09, 2013 05:00 ET

Disciplined Growth Investors: Dangerous Competitive Advantage Myths

Benjamin Graham and the Power of Growth Stocks: Part 10 in a Series

MINNEAPOLIS, MN--(Marketwired - Jul 9, 2013) - When analyzing stocks, not everything that looks like a competitive advantage and acts like a competitive advantage actually is a sustainable competitive advantage, according to author Frederick K. Martin of Disciplined Growth Investors.

"The dirty little secret surrounding sustainable competitive advantage is that few companies actually possess one," explains Martin in his book, "Benjamin Graham and the Power of Growth Stocks" (McGraw-Hill). "Many companies talk a good game, but when it comes right down to it, the rhetoric does not stand up to the unrelenting competitive pressures."

Identifying companies with a true competitive advantage is an excellent way to uncover stocks with superior long-term growth potential. But there are many factors, such as a hot new product, a "celebrity" CEO, or efficient execution, that can cause a surge in the company's short term financial metrics but would have little impact on its long-term value.

If you hope to invest in companies with a true sustainable competitive advantage, it helps to recognize the types of unsustainable advantages that investors often mistake for the real deal. In his book, Martin lists several mistakes that sometimes trip up investors in search of companies with a true competitive advantage:

Bad growth. Some companies try to generate growth through expensive new programs and acquisitions. If the company isn't generating its growth primarily through its core products or services, then you need to be suspicious of its ability to sustain that growth. "Bad growth often stems from a 'growth for growth's sake' mentality that results in costly acquired growth or misguided attempts to diversify the business," says Martin. "Investors should be wary of growth initiatives that depend on the integration of sizable acquired businesses or that stray from a company's core mission."

Linear growth. When a company appears to have "linear growth" that means that its earnings or revenue growth seem to be increasing at an even, consistent pace that would be represented on a growth chart by a straight line (rather than a wiggly line). Generally speaking, the growth of most companies tends to ebb and flow as the economy shifts, new products are released and the flow of new business fluctuates. Straight line growth does not necessary reflect a competitive advantage -- in fact some companies use creative accounting to make their growth look linear even when it's not. But what you do want to see in a company is a long-term upward trend in growth, even if it ebbs and flows along the way.

Confusing cyclical growth with secular growth. Companies with cyclical growth may look great when the market cycle is in their favor, but not so good when their industry is out of favor. Companies with secular growth tend to be more consistent over the long term even though they may have some bumps and spurts along the way. For instance, a company's growth may slow when it reaches capacity in a manufacturing plant, but surge after the company adds new capacity and trains in new workers. The secular growth trend remains intact. "Investors must be careful not to confuse cyclical and secular growth when assessing long-term market potential," says Martin. "Secular growth can often appear cyclical at individual companies, and vice versa, so investors must be careful to distinguish between the two by diligently assessing the underlying drivers of the growth."

Precision indecision. Warren Buffett has said "it is better to be approximately right, than precisely wrong." Over-analysis of a company's growth prospects can lead to paralysis and potentially prevent you from investing in promising growth stocks. Martin points out that the emphasis on precision forecasting can have the perverse effect of steering investors away from attractive growth companies and to companies in mature industries that have little room for growth. "Investors must recognize that when companies are poised to benefit from a tidal wave of opportunity, precision is impossible and, dare we say, unnecessary," explains Martin. "Investors need merely to make a reasonable assessment of the market opportunity and the potential for the targeted company to capture share."

The accretion canard. When a company makes an investment in capital, such as an acquisition or share repurchase that gives them a better return on their money (such as cash on the balance sheet) than they were currently earning, that is what is commonly termed "accretion." On the surface, what's not to like about an investment that provides a higher return and an increase in earnings per share? Plenty, according to Martin. "Accretion sounds good on the surface, but it does not tell us whether the investment is a prudent use of shareholders' capital," he explains. "An investment can be nicely accretive to earnings and still earn a subpar return for shareholders." For instance, if the company was earning a 1 percent money market return on its cash and used that money to acquire a company that returned 3 percent, that still isn't a very good return on investment. Martin says shareholders would be better served if the company simply returned the capital to them in the form of a dividend because the shareholders could likely find other investments that would offer a better return for their money than that 3 percent.

Dissipating competitive advantage. Competitive advantages do not last forever. Structural changes in an industry or in regulatory or political regimes, or the emergence of a new disruptive technology can quickly erode a competitive advantage. "Ironically," says Martin, "our experience suggests that the most dangerous enemy of sustainable competitive advantage is not the competition. It is the neglect or strategic distraction on the part of management."

Identifying companies with a true competitive advantage is never easy, but it helps to understand the subtle differences between a sustainable competitive advantage and an unsustainable one if you want to find companies that are poised for long-term growth.

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