Make Sure Your Stocks Have This “Secret Sauce”

When my kids were small, they used to love to go to Toys R Us, roam around… and dream.

Wandering among the toys, board games and bikes stacked stories high, they made lengthy Christmas lists, often starting in July.

That won’t happen for future generations of kids.

Ten days ago, Toys R Us began liquidating its inventory, a move that will close 735 stores, put 33,000 out of work and end a 70-year run for the toy superstore.

Management blamed everything from poor holiday sales to high debt levels to the declining American birth rate.

Those weren’t the real problems, however. The real problem was Toys R Us didn’t have a secret sauce.

And companies that don’t have one often experience an early or unexpected demise.

In 2017 alone, for instance, Aerosoles, Alfred Angelo, Eastern Outfitters, Gander Mountain, Gordmans, Gymboree, hhgregg, The Limited, Payless ShoeSource, Perfumania, RadioShack, rue21, Vanity, Vitamin World and Wet Seal all filed for bankruptcy protection.

At first blush, these retailers don’t seem to have much in common. The Limited sells women’s apparel. Eastern Outfitters sells sporting goods. Hhgregg sells electronics and appliances. Vitamin World sells supplements.

But while their products are very different, their problem is exactly the same. They don’t have a secret sauce… or what Warren Buffett calls a “moat.”

For centuries, royalty and the aristocracy in Europe protected their castles from assault by digging a wide ditch and filling it with water.

Businesses need this kind of protection as well… not physical moats, of course, but legal ones.

Firms with patents, trademarks, copyrights and brand names can prevent competitors from copying their products, stealing their customers or driving down their margins.

If a business you own – either wholly or fractionally (through share ownership) – doesn’t have these protections, trust me, you’re vulnerable.

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After all, enterprising, self-interested people are everywhere. (That’s a good thing, incidentally.) When they see a business doing well – big sales, long lines, rave reviews – they take a closer look to see how they can get in on the action.

They would love to offer similar products – or the same ones – quicker, cheaper or better. (Or all of the above.)

Competition is good. It sparks innovation. It improves efficiencies. It brings down costs.

This ultimately benefits us, the consumers. But it can ruin a business.

The opposite is also true. The biggest stock market gainers of the past few years – not to mention the last couple of decades – have all had a secret sauce.

Apple (Nasdaq: AAPL), for instance, has never licensed its computer or smartphone operating systems to anyone else. Amazon (Nasdaq: AMZN) has a patent on its one-click ordering system. Netflix (Nasdaq: NFLX) – up more than fiftyfold over the last decade alone – has spent billions creating proprietary content that no one else can offer.

Quality products are great. Experienced management is essential. Effective marketing is a must.

But if a business doesn’t have legal protections to keep the conquering hordes at bay, it isn’t a sustainable business model.

If you want to own a stock long term – long enough to generate eye-popping returns – a secret sauce is essential.

Just ask the owners of Toys R Us.

Good investing,

Alex

P.S. I’d like to personally invite you to join me and my esteemed colleagues at our upcoming Private Wealth Seminar this July 23-24 at the Fairmont Chateau Whistler in British Columbia. It’s your chance to be part of an exclusive group of like-minded investors for what should be a spectacular financial retreat.

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