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How To Identify A Stock With A Competitive Advantage: Cross Your Fingers

When selecting a long-term stock investment, most investors take a page out of Warren Buffett’s playbook and look for companies with strong competitive advantages. History has shown that the odds of identifying such advantages are no better than the flip of a coin. Protecting the Castle A competitive advantage is one of the most sought after characteristics of any long-term investment. Wall Street analysts grade stocks almost exclusively on the strength and sustainability of a company’s competitive advantage. Value investors demand stocks that have track records of fending off competition and sustaining high profit margins. Warren Buffett describes a business with a competitive advantage as a castle with a moat around it. The wider, deeper, and more treacherous the moat, the better the investment. In a 1999 article in Fortune Magazine, Buffett said: “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.” This makes sense. Without some sort of advantage, a profitable business will not be profitable for long. Deterioration Not only are economic moats hard to find, they are hard to maintain. Furthermore, predicting which companies will have strong competitive advantages in the future can be downright impossible. Economic theory shows that once a business obtains an advantage in the marketplace, competitors will attempt to copy and improve upon the successful business model. This will ultimately eat away at the company’s profits and deteriorate its competitive advantage. Here, we’ll look at two case studies which have played out over the last 20 years. In one case, the company possessed all the advantages of an economic moat. In the other case, the company was rapidly losing market share and had a miserably bleak future. Today, one company is out of the business and the other has multiplied hundreds of times over. Blockbuster Video A perfect example of a deteriorating competitive advantage can be found in the case of Blockbuster Video. After opening its first location in 1985, the company became synonymous with movie rentals in the 1990s. By the late 90s Blockbuster had been able to maintain its competitive advantage and fend off its toughest competitor – Hollywood Video. Once the new millennium began, Blockbuster had a whole new set of competitors – Netflix (NASDAQ: NFLX ) and Redbox. Where Blockbuster charged over $5.00 per rental and required customers to pick up movies in person, Redbox charged only $1.00 and Netflix offered unlimited DVD rentals by mail for one flat monthly price. When both companies were in their infancies, Blockbuster could have easily copied their business models or bought them out. In 2000, Netflix offered to sell its operations to Blockbuster for only $50 million. Blockbuster passed on the opportunity to own the company that would eventually be the cause of its demise. Eight years later, as Blockbuster’s business model was teetering on the brink of collapse, management still had its head in the sand. Here’s what Blockbuster CEO said in 2008: “Netflix doesn’t really have or do anything that we can’t or don’t already do ourselves.” It can be argued that Redbox had just as big – if not a bigger – impact on Blockbuster than Netflix. After launching its first video rental kiosks in 2004, Redbox quickly became a cheap and convenient way to rent new release movies on a nightly basis. It wasn’t until 2010 that Blockbuster decided to aggressively pursue this business model with its Blockbuster Express kiosks. By then, it was too late. Apple If Blockbuster is the perfect example of a profitable business losing its competitive advantage, Apple (NASDAQ: AAPL ) is the perfect example of a company regaining its competitive advantage. Less than 15 years after selling its first computer, the company posted its most profitable year in 1990. However, things started to turn south quickly for Apple. While both founders – Steve Jobs and Steve Wozniak – moved on to other ventures, the company started losing market share. By 1996, industry experts and Wall Street analysts had left the company for dead. At the time, no one could foresee the return of Steve Jobs and the innovative products he would bring to the company. Rather than competing head-on with Microsoft (NASDAQ: MSFT ) in the PC market, Jobs decided Apple would gain a competitive advantage by focusing on music-related products. First came the iPod, then iTunes and the rest is history. Today, iPhones and iPads have transformed Apple from a $3 billion company in 1996 to a market cap of $600+ billion in 2016. Identifying a Moat Looking back, it’s easy to say that Apple was the better investment in 1996. A share of Apple has multiplied more than 200 times over in the last 20 years. By contrast, an investment in Blockbuster Video would have gone to zero. But was it possible to have seen this at the time? In investing, the past is history. The future is where profits are made. Let’s put ourselves in the shoes of a stock market investor in 1996 and try to identify which company had the better competitive advantage. According to Pat Dorsey, Equity Research Analyst at Morningstar, there are four types of economic moats: Intangible Assets Customer Switching Costs The Network Effect Cost Advantages Dorsey says, “At Morningstar, thinking about economic moats, or structural competitive advantages, is central to how we do equity research.” He claims that having any or all of the above characteristics, “give superior companies the power to stay on top.” Breaking It Down By breaking down each advantage we should be able to compare Blockbuster with Apple and see what an investor would have thought about the future prospects of each. Intangible Assets: Brand recognition, customer loyalty, patents or trademarks, etc. In 1996, Blockbuster video had strong brand recognition and customer loyalty. The company’s slogan, Make it a Blockbuster night was on everyone’s mind when they wanted a night in. The name familiarity gave customers confidence that the local Blockbuster would have a broad selection of the latest new releases and all the old classics. In order to rent from Blockbuster, customers had to have a membership card. Keeping this card in their wallets reminded customers on a daily basis that Blockbuster was where they went to rent movies. Customer Switching Costs: Time, money, or inconvenience to switch to a competitor. Opening an account with a movie rental company in the mid-1990s was like setting up an IRA. It required multiple forms of ID, proof of residence, a complete family-tree and the family dog for collateral. The Network Effect: Everyone uses it because everyone uses it. Everyone had a Blockbuster card in their wallets, so there was a Blockbuster in every town. The more customers Blockbuster obtained, the more locations they would open. The more locations they opened, the more customers they obtained. It became very convenient to be a Blockbuster customer because the stores were everywhere. Cost Advantages: Scale-based cost advantages allow for huge profit margins on additional sales. Blockbuster received payments dozens, hundreds, or even thousands of times on one VHS or DVD. If one more customer decided to rent a movie on a Friday night, it would not cost the company anything. The additional rental would be pure profit to Blockbuster. The VHS or DVD had already been paid for by Blockbuster. The customer was required to give the movie back to Blockbuster for them to rent again. On The Other Hand By contrast, Apple had none of these competitive advantages in 1996. The OS business was controlled by Microsoft, and Dell controlled the PC market. Apple was a tiny player which the market valued for less than its liquidation value. At the end of 1996, Apple qualified as a Benjamin Graham NCAV stock . It was literally valued more dead than alive. Putting It into Practice Today, there are all kinds of companies which appear to have wide moats protecting their profits. Even more so are the companies which appear to be past their prime and rapidly losing market share. The problem with insisting on investing only where sustainable moats exist, is that strong competitive advantages are impossible to foresee. It’s one thing to identify companies where moats currently exist, it’s another thing to know whether those moats will exist in 5, 10 or 25 years from now. Can you confidently predict which stocks will be the next Blockbuster and which will be the next Apple?

Amazon Goes Head-To-Head With Netflix In Streaming Video

After amassing a portfolio of critically acclaimed original TV series, Amazon.com ( AMZN ) has decided the time is right for its subscription streaming video service to go head-to-head with industry leader Netflix ( NFLX ). The Seattle-based e-commerce giant late Sunday revealed that it will offer its Amazon Prime Video as a stand-alone service for $8.99 a month, a dollar less than Netflix’s standard streaming plan. Amazon Prime Video was launched five years ago as an extra for subscribers of Amazon Prime, a program that offers free two-day shipping on millions of items. Amazon Prime costs $99 a year. In addition to the stand-alone video service, Amazon also is offering full Prime membership on a monthly basis. Customers can pay $10.99 a month with no annual commitment or save 25% by paying for the full-year plan. Like Netflix, Amazon has been investing in original content as well as signing exclusive licensing deals for cable and broadcast shows. Amazon original series include “Transparent,” “Mozart in the Jungle,” “Catastrophe,” “Bosch,” “The Man in the High Castle” and “Red Oaks.” Other competitors in the Internet video sector include Hulu and Time Warner ‘s ( TWX ) HBO. Hulu is co-owned by Comcast ( CMCSA ), Disney ( DIS ) and Fox ( FOXA ). Amazon’s move comes as many long-time Netflix customers will see the price of their service jump from $7.99 to $9.99 a month starting next month. Netflix boosted its pricing starting two years ago, but it provided grace periods for existing customers. Netflix stock was down about 3% to near 108 in afternoon trading on the stock market today . The Los Gatos, Calif.-based company is scheduled to report first-quarter earnings after the market close today. Amazon stock was up almost 1% to about 631. Amazon gets an IBD Composite Rating of 84 out of a possible 99, and Netflix a 51. For when to buy, hold or sell off Amazon and other top stocks, sign up for a free trial of IBD Leaderboard Amazon is offering the stand-alone video service only in the U.S. for now, but it is likely to take it to international markets soon, CCS Insight analyst Paolo Pescatore said in a research note Monday. Amazon’s new video offer will limit Netflix’s ability to grow its domestic subscriber base, Wedbush analyst Michael Pachter said in a research note Sunday. “The monthly video offering reflects Amazon’s determination to capture an increased share of Netflix’s addressable market,” he said. “While we don’t expect a significant number of current Netflix customers to defect to Amazon Instant Video, it is likely that Amazon and Netflix will divide the remaining uncommitted market on a roughly equal basis, severely impacting Netflix’s continued domestic growth.” Subscriber Fees Hiked Pachter believes Amazon timed the offer to take advantage of the impending price increase at Netflix. An estimated 30 million domestic Netflix subscribers will see their monthly subscription fees go up starting May 9, he said. Pachter rates Amazon stock as outperform with a price target of 700 and Netflix as underperform with a price target of 45. RBC Capital Markets analyst Mark Mahaney said Monday that the Amazon offer “creates a negative headwind for Netflix.” However, Mahaney reiterated his outperform rating on Netflix with a price target of 140. “We view this move by Amazon as a significant negative development for Netflix,” he said in a report. “Amazon certainly has the brand name, the customer relationships and the focus on high-quality consumer experiences to impact the growth in Netflix’s U.S. subscriber base, and perhaps eventually its global subscriber base.” Netflix is facing growth challenges in the U.S. market. In the fourth quarter last year, it missed its own target for new domestic subscribers. But its international growth easily beat expectations and offset U.S. weakness. Netflix Original Shows Rank Tops In a survey released last week, consumers ranked Netflix as No. 1 for original programming. It topped HBO for the first time in the six years that Morgan Stanley has tracked consumer preferences in premium video services. Some 29% of survey respondents said Netflix was best in original programming, up from 23% last year, while HBO came in second place at 18% (compared with 31% last year), Morgan Stanley said. Amazon.com, Hulu and CBS (CBS)-owned Showtime were each near 5%. Netflix original shows include “House of Cards,” “Orange Is the New Black,” “Unbreakable Kimmy Schmidt,” “Narcos” and Marvel comic-book hero shows “Daredevil” and “Jessica Jones.”

Alphabet Seen Riding Strong Mobile Ad Sales To ‘Stellar’ Q1

When Google parent firm Alphabet ( GOOGL ) reports Q1 earnings on Thursday, analysts are expecting the search giant to deliver what one of them terms “stellar” top-line results, riding strong mobile advertising sales. But Wall Street also wants to see that the sultan of search is serious about monetizing its various so-called “moonshot” initiatives. The diverse group that Alphabet calls its “Other Bets” range from self-driving cars to smart home device maker Nest to a life sciences division that developed a glucose-monitoring contact lens for diabetics. Capital expenditures for the “Other Bets” segment are expected to increase this year, although no details have been offered yet. When Alphabet released Q4 earnings in February , the tech giant revealed that it logged an operating loss of $3.6 billion on such moonshot projects in 2015. The company broke out its spending on its search core and “Other Bets” for the first time in Q4 2015. Far-out innovations aside, “it will be interesting to see if they can continue growing their business-oriented solutions, such as Google Drive and Google Docs, which also have correlation with their monetization capabilities,” Hannu Verkasalo, CEO of Verto Analytics, told IBD via email. For Q1, analysts polled by Thomson Reuters expect Alphabet to see total sales — including TAC (“traffic acquisition costs” or fees paid to bring traffic to its site) — rise 18% year over year to $20.36 billion. They are modeling EPS ex items of $7.97, compared with EPS ex items of $6.47 in Q1 2015. Subtracting out TAC, revenue will rise to $16.54 billion, up nearly 19% year over year, according to FactSet. Alphabet subsidiary Google saw a double-digit increase in ad spending on its site last year, led by mobile gains and new offerings that let shoppers buy directly by clicking ads, according to a research report from Cowen analyst John Blackledge in January. “Overall, Google’s core search business appears strong, with room for further innovation,” Blackledge wrote. Google, which dominates the global digital ad market, will see its net ad revenue rise 9% this year, while No. 2 Facebook ‘s ( FB ) net ad revenue will jump 31%, says eMarketer’s latest ad spending forecast , released in March. Google CEO Sundar Pichai said in February that seven of the company’s products, including YouTube and Gmail, each have more than 1 billion monthly active users around the globe. In March, 243.1 million users accessed one of Google’s online services in the U.S. at least once, which puts Google’s net reach in the U.S. at 98.2%, Verto Analytics said. The company is looking to make headway into the $27.4 billion cloud computing market with Google’s Cloud Platform, which now trails Amazon.com ( AMZN ) unit Amazon Web Services, with approximately 37% market share, and Microsoft ‘s ( MSFT ) Azure. But Google’s cloud service may get a boost from Apple ( AAPL ), which in March signed a deal worth between $400 million and $600 million to use Google’s Cloud Platform for its iCloud service. The Google unit of Alphabet also sells high-speed Internet and TV services in four markets and has trumpeted expansion plans. Google Fiber bundles video and gigabit-per-second broadband service for $130 monthly and also sells stand-alone Internet for $70 monthly. “Foreign-exchange headwinds should continue to damper the company’s otherwise stellar top-line results, but to a lesser degree than in recent quarters,” said Pivotal Research analyst Brian Wieser in a pre-earnings research note on April 11. “Current-quarter results for Alphabet and core Google business trends should be positive overall.” Wieser said he estimates the company will show 16% revenue growth and 18% revenue ex-TAC growth year-over-year. “The company’s hegemonic position in digital advertising alongside Facebook is fundamentally unchanged, and we continue to expect Google to sustain double digit growth rates in advertising on an ongoing basis,” said Wieser. “The factors which were cited as supporting growth last quarter — including YouTube and programmatic display-related revenues associated with Google Display Network (collection of Google-run websites) will undoubtedly continue.” Alphabet stock was up 1% in afternoon trading in the stock market today , near 787. Alphabet stock has risen 45% compared to this time last year. The company’s stock is trading 3% below its all-time high of 810.35, brushed on Feb. 2.