Overblown Competitive Advantages

Factors That Should Make a Difference But Often Don’t

Some supposed competitive advantages sound good but somehow never amount to much in practice. Here are two competitive advantages that you’d be better off ignoring unless you’re an expert in the field.

Patents

The pharmaceuticals industry effectively employs patents as a barrier to entry. However, pharmaceuticals are more the exception than the rule. For instance, tech companies file hundreds, if not thousands, of patents annually. Yet new competitors constantly pop up, and it’s hard to think of a tech name that has turned its patents into an effective barrier to entry.

VISX, for example, makes laser systems that enable quick and painless eye surgery to correct vision problems. In 1999, its share price soared from $20 to $100 after its system was approved for use in the U.S. The company and most analysts following VISX thought that it had lock-tight patents on the process. Nevertheless, competitors brought their own systems to market in short order. To stay competitive, VISX was forced to slash prices, killing profits. The last time I checked, VISX was trading at $17.

Few investors have the expertise to judge a patent’s value as a barrier to entry. Even in the pharmaceuticals industry, it’s difficult to assess the value of a particular patent. A new drug may sound miraculous, but there could be an even better treatment on the way from a competitor. Qualcomm, with its proprietary wireless phone technology, and Rambus, owner of a proprietary high-speed memory chip technology, are more examples of patented technologies that somehow failed to produce the expected profits.

Ignore patents as a significant barrier to entry unless you are an

expert in the field

and

a patent attorney.

Proprietary Technology/Production Processes

In theory, a company’s superior production processes or equipment could be an effective barrier to entry. In practice, these advantages often fail to produce the expected results.

For example, again comparing Lexmark to Hewlett Packard, Lexmark enjoys laser printer production cost advantages compared to HP because Lexmark makes its own printer engines (the guts of the printer), while Hewlett Packard buys it engines from Canon. Somehow, that advantage has never meant much. Hewlett Packard still dominates the industry, and Lexmark has failed to gain significant market share. Every CEO, given the opportunity, will tell you why his or her company’s products are technologically superior. That’s their job.

Many market analysts repeat that same dogma as truth. As with patents, unless you’re an expert, you’d be well advised to remain skeptical about touted technological advantages.

Business Plan Score Scorecard

Award one point for each category where a company has a significant advantage, and subtract one point for categories where it is at a disadvantage. Score zero where the category is not relevant.

Summary

Professional money managers routinely evaluate a firm’s business plan before investing, and you should too. Technology candidates will usually score lower than firms in other industries because many do not enjoy strong brand identity that separates them from the field, most offer expensive products with short life cycles, and many depend on acquisitions for growth.