The Most Important Factor for Long Term Returns

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

What is the single most important driver of long term returns for companies and their investors? If I had to choose one thing above all others when it comes to buying the best stocks, that would definitely be management quality.

Building competitive advantages

"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."

Warren Buffett

I couldn´t agree more with Buffett; competitive advantages are absolutely central to long term investing success. However, management quality comes first, because the management team can actually create or destroy competitive advantages. Investing in the right management means investing in the business leaders which will grow and protect those competitive advantages.

Howard Schultz created some unbelievably strong competitive advantages for Starbucks (NASDAQ: SBUX) over the last years much to the benefit of shareholders. Starbucks is not like any other coffee company, in fact, it doesn't just sell coffee, but an integral and unique customer experience supported by a differentiated brand and strong cultural identity.

Schultz decided early on that Starbucks was to be a “third place” between home and work, providing a comfortable and pleasant environment, free wifi connection and a very attentive staff. There is a reason why customers pay extra for a Starbucks coffee, and that's the brand image that Schultz has built for the company.

Microsoft (NASDAQ: MSFT) and Steve Ballmer´s lack of vision show how even the strongest competitive advantages can be eroded under the wrong corporate leadership. Microsoft was the king of the tech world a decade ago, benefiting from a near monopolistic position provided by Windows and Office. This meant not only big fat profit margins for the company, but also an invaluable strategic asset in terms of competitive strength.

While Steve Jobs was innovating to a whole new level and pushing his engineering team to achieve the unthinkable, Ballmer was downplaying the mobile revolution that Apple was creating. “Apple is a cute, little, tiny niche guy” said Ballmer in February of 2007. “No chance that the iPhone is going to get any significant market share” he added later.

Microsoft´s CEO also said that the iPad was “just another PC” back in 2010 and he didn't expect any problems for Microsoft because of the iPad. As things turned out, the iPad and other tablets are now stealing market share away from PCs at a considerable speed, and Microsoft seems to be doing too little and too late to adapt to adapt to the mobile computing parading.

Being in the right business

A horse that can count to ten is a remarkable horse—not a remarkable mathematician.” Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company—but not a remarkable business-”

Buffett

Again, being in the right industry, or at least avoiding the declining ones, can be absolutely central. If the industry as a whole is going down, chances are that even the best run companies will suffer the consequences sooner or later.

That is, of course, unless the management team is really smart and capable, in which case they will change directions and drive the business towards greener pastures.

Louis V. Gerstner was the chairman and CEO of IBM (NYSE: IBM) from April 1993 until March 2002. Back when he took charge of the company, IBM was in serious trouble. Not only was the company executing poorly, the hardware business was being commoditized and profitability was scarce on an industry wide basis.

Gerstner didn’t just implement a turnaround plan by improving execution and efficiency; he transformed IBM into a different company and changed the focus from hardware to software and services.  This set the stage for a spectacular recovery which made IBM the rock solid industry leader it is today, with big fat profit margins and generating tons of free cash flows on a regular basis.

Hewlett-Packard (NYSE: HPQ) on the other hand, has been trying to survive in the savagely competitive hardware business for a long time. The company then decided to make some acquisitions in software and other business, but they were mostly done out of desperation and delivered some really lackluster results.

The evolution of earnings per share for IBM versus Hewlett-Packard since 1993 couldn't have been more dissimilar, and the biggest factor explaining this difference is the strategic direction of each company as decided by their respective management teams.

 

The human factor

Competitive advantages, industry dynamics and many other factors can be very important for long term investors returns. But one thing comes above all other, because it determines most other aspects, and it’s the quality of the management team.

 


acardenal owns shares of Apple and IBM. The Motley Fool recommends Apple and Starbucks. The Motley Fool owns shares of Apple, International Business Machines., Microsoft, and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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