The six stocks I'm talking about today have -- at various points -- rewarded shareholders with outstanding returns. They have demonstrated institutional excellence at times, and will likely continue to be in existence for years -- if not decades to come. I even owned three of them in the past.
But today -- thanks both to their current prices and my own evolution as an investor -- I wouldn't touch them. That's because none of them have what I consider to be a sustainable competitive advantage, or moat.
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A moat? What's a moat?
Before delving further, it's important to define what a moat actually is. At its most basic, a moat is a semi-enduring structural advantage that keeps a company prevalent while holding off competition. In my book, there are four types of moats:
- High switching costs: If leaving a company would involve high costs for a customer, that company benefits from this moat. Think of tax-preparation cloud services that have decades of your information stored to use.
- Network effects: As each additional user joins a network, the overall value of the network increases. This is true of just about any social media company.
- Low-cost production: If one company can consistently offer a product -- or service -- for less than the competition, that's a huge advantage.
- Intangibles: This includes things like patents, regulatory protection, and the power of brands.
It's not necessary to have one of these moats to be a successful company or investment. In fact, many of the companies I'm pointing out today have enjoyed huge success.
The problem is that this success often breeds competition. And when the competition arrives, if there's no moat present, chances are they will encroach significantly on business.
Hardware makers that are leading the field...for now
In the field of technology hardware, commoditization should be a four-letter word for investors. Because there's almost no brand loyalty, and a "good enough" product for a cheaper price will almost always win the day, this field is ripe for disruption.
Three companies currently flying high in this subsector are NVIDIA (NASDAQ: NVDA), Arista Networks (NYSE: ANET), and Cognex (NASDAQ: CGNX). On average, these three have returned an astounding 395% since February 2016. That's because they are all providing something -- graphics chips used for AI and cryptocurrencies, switches to improve server speeds, and machine-vision technology, respectively -- that is in high demand, and they currently have the best solutions.
But do they really have a moat protecting them? Based on the four moats that I presented above, I would say no. While it's possible that they will continue to outstrip the competition by a wide margin, that's really a bet against a legion of competitors that we think will be challenging for years to come. I'm not comfortable making that bet, especially with these stocks trading for such high valuations.
It's important to point out that I wouldn't short -- or even give an underperform CAPS call -- to any of these companies, either. As long as they remain ahead of the competition, they'll likely continue to excel. But since I understand there's more that I don't know about what the future holds than what I do, I prefer to invest in companies that have wide moats.
Brands that aren't as valuable as I thought
The second group of stocks that I'm tackling at least have a moat. That comes in the form of brand value that has proven -- at times -- to be powerful. But given shifting patterns within their respective industries, I believe all three have brands that are on the downswing. When that's combined with price tags that are expensive, it's enough to convince me give them all underperform ratings.
Those three companies are Chipotle (NYSE: CMG), Hain Celestial (NASDAQ: HAIN), and Under Armour (NYSE: UA) (NYSE: UAA). As you can see, they are all fairly expensive as well.
Chipotle's woes have been well-documented. While everyone is focused on how food-borne illnesses have forever damaged the brand, it's worth pointing out that the competition has essentially caught up with the company.
Hain owns a bevy of natural and organic brands that it has acquired over the past two decades. The problem is three-fold: it hasn't done a good job of nurturing those brands, the organic industry is still relatively young, no brand has shown outstanding pricing power, and with Amazon entering the business via its Whole Foods acquisition, a commoditization of such goods seems unavoidable.
And Under Armour, which enjoyed an incredible string of quarters showing 20%-plus growth, has shot itself in the foot. Investments in wearable technologies haven't panned out, but it was the company's decision to sell its goods at discount stores that really burned the brand value.
While I think a solid argument could be made for investing in the three technology companies above -- if you have industry-specific knowledge and believe you'll see the competition coming before others -- I don't think any of these latter three are worthy of your time. You'll have better luck looking elsewhere.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Brian Stoffel owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon, Arista Networks, Chipotle Mexican Grill, Cognex, Hain Celestial, Nvidia, Under Armour (A Shares), and Under Armour (C Shares). The Motley Fool has a disclosure policy.