Brian Gaudet's  Instablog

This article is part III of a series on evaluating a company's future prospects.

Having found a company with a track record indicative of a strong competitive advantage, we need to convince ourselves that the competitive advantage is sustainable well into the future.  To do so, we must look deeper into the source of a company’s competitive advantage using the five forces that determine industry profitability: supplier bargaining power, buyer bargaining power, the threat of new entrants, the threat of substitutes, and the intensity of rivalry between existing firms. This framework for analyzing industry profitability comes from Michael Porter’s book “Competitive Advantage”, and this article draws heavily from what I learned from this book, which I recommend reading.  What we are looking for is an industry where the incumbents are likely to enjoy a very long period of stable and highly profitable operations. If our company is one of the leaders in such an industry, we gain confidence that the company’s demonstrated competitive advantage will persist far into the future.

As an example of why industry stability is important, let’s look at the retail industry. At one time Sears was considered to be a company with bright future prospects (it was a component of the 1972 “nifty-fifty”), but the company’s competitive position was eroded with the emergence of K-mart, which had a cost advantage over Sears. In time, K-mart’s cost advantage was reduced by Wal-Mart (WMT), which had an even larger cost advantage. If you had invested in either Sears or K-mart on the basis of their demonstrated competitive advantage, you would have been disappointed, as both eventually lost their competitive position within their industry. As for Wal-Mart, it does have an impressive track record – but then so did Sears and K-mart.  In general, a competitive advantage gained by becoming the low cost provider in an industry is often less sustainable than a competitive advantage gained through differentiation.  Whereas multiple companies with differentiated products can often remain highly profitable, having two or more competitors with similar scale that compete on the basis of cost will often lead to a price war, which will result in falling profitability for the industry leaders. 

A competitive advantage in the technology industry is often even shorter lived than in the retail industry.  It was not that long ago when Alta Vista was the dominant company in the on-line advertising industry, but it has recently been supplanted by Google.  For some other examples of technology companies that were once though to have excellent prospects but eventually went the way of the dodo bird, there was Digital Equipment Corporation, Burroughs Corporation, and Polaroid. If you are searching for companies that at one time were expected to have extraordinary future prospects, but where the company’s competitive advantage was not sustainable, the technology sector is a good place to look[1].

Now contrast the retail and technology industries to the disposable diaper industry, where since the 1960’s, the same two companies – Procter & Gamble  (PG) and Kimberly Clark (KMB) – have dominated the market.  The Coca-Cola Company (KO) and Pepsico (PEP) have dominated the soft drink industry even longer.  Another example of a stable industry is the jet engine industry, where General Electric, United Technologies (through their Pratt & Whitney subsidiary), and Rolls Royce have dominated for many decades. With this in mind, given a choice between Abercrombie & Fitch (ANF) – a company with an excellent ten-year operating history – and Coca-Cola, I would choose purchasing shares in Coca-Cola.  The nature of the soft drink industry, and Coca-Cola’s competitive position within that industry, gives me much more confidence that the company’s earnings power will persist far into the future as compared to an excellent company in the retail industry.

We analyze a company’s industry using the five forces of competition. An industry will have favorable dynamics if the following conditions hold:

·      Threat of new entrants is low

·      Intensity of rivalry is low

·      Threat of substitutes is low

·      Supplier bargaining power is low

·      Buyer bargaining power is low

Some Attributes of Stable and Profitable Industries:

High Switching Costs

Switching costs may deter a buyer from switching to a new supplier; this often occurs when switching to a new company would entail a significant loss of revenue. Switching costs can be incurred when switching to a new supplier requires re-tooling, learning new processes, or system downtime.  Switching costs can be high when qualifying a product from a new vendor is both time consuming and costly, as can be the case with aircraft engines, power turbines, and other equipment where the cost of failure to the purchasing company can be extreme. Sometimes switching costs are stipulated in long-term contracts in the form of contract termination feeds.  Switching costs increase buyer bargaining power, reduce the threat of substitutes, and can act as a barrier to entry.

Proprietary Technology

Some industries require extensive manufacturing know-how that can only be gained through years of experience. A case in point is the jet aircraft engine industry. Although the science of jet propulsion is public knowledge, producing jet engines that are competitive with respect to fuel economy, noise, and reliability is another matter. The difficulty of entering this industry is apparent from the fact that there are only three major players worldwide: General Electric, United Technologies, and Rolls Royce. Since it is unlikely that new entrants will be competitive until they gain the expertise of the industry incumbents, the long learning curve will tend to discourage new entrants.

A company’s product can also be protected from direct competition by patents. A good example of this is a pharmaceutical company, where new drugs are covered for a limited time by patents. In this case, while a competitor can attempt to come up with their own drug to meet the same medical need, they cannot copy the company’s exact molecular compound. When it is difficult for a competitor to develop a substitute, a patent gives the company many years of a virtual monopoly on that particular drug, with the lack of competition enabling the company to charge a high price per unit without losing market share. 

Restricted Access to Distribution Channels

Distribution channels can act as a barrier to entry. One example is the soft drink industry’s sales to supermarkets and convenience stores, where there is typically intense competition for shelf space.  Consequently, a new entrant might find it hard to persuade a retail chain to allocate space for its product, as if it does poorly, the retail chain will suffer.  The automobile industry is another example where distribution channels create a barrier to entry; not only must a new entrant be able to manufacture a quality product in large volume, but it must also have a dealer network in place in order to reach potential customers.

Strong Brands

New companies are less likely to gain market share in an industry when buyers associate the brands of industry incumbents with exceptional quality, taste, or other sources of value. With consumer goods companies, this brand loyalty is the result of the development of innovative products supported by high advertising expenditures, which enhance a consumer’s preference for the product.  Manufacturers on the other hand might have a brand supported by a large installed base with a low failure rate.

When each of the industry leaders has a strong brand, the intensity of rivalry is lessened.. For example, Coke has little incentive to cut costs to gain market share, as some people just happen to prefer Pepsi, and the cost of the product is low enough where they are unlikely to be swayed by price differences.  Here the market share gains (if any) would unlikely be sufficient to offset the reduced cost per unit.

Undifferentiated Inputs

When a supplier has a product that is differentiated from other suppliers this enhances the bargaining power of the supplier, and thereby reduces a company’s profitability. In this case, during price negotiations the company cannot make a credible threat to replace the supplier’s product.

Low Supplier Concentration

A company’s bargaining power with a company’s suppliers increases when each supplier provides a small fraction of the company’s purchases, and the company accounts for a large percentage of each supplier’s sales. Here a company can play off the suppliers against each other by offering to increase the volume purchased in return for a reduction in price; of course the company would be careful to insure that any one supplier does not gain a large share of the company’s business.  This is easy to do; once the price reduction occurs, other suppliers will follow suit, and next year the company can make a deal with another supplier, and the process repeats.

Low Price Sensitivity

It seems intuitive that a buyer will spend more time investigating the extent of a product’s value if the total amount spent on a product becomes a significant fraction of total expenditures.  One example of this can be found in the automobile industry. Even if you have been happy with the performance and reliability of a certain make of automobile, you might not necessarily be willing to pay a large premium for the same make when it comes time to purchase a new car. Instead, you would likely spend a considerable amount of time researching other makes in Consumer Reports, and then carefully analyze whether any price premium is worth the likely benefits.

We can contrast this with the purchase of razor blades, which in any given year represent a much smaller fraction of a consumer’s expenditures than automobiles. Here, if you have been happy with a particular brand, you are unlikely to invest a lot of time and effort in researching which brands actually offer the best shaving performance for your money. The likely cost savings would just not be worth the effort.  This creates a certain amount of market share stickiness, where an incumbent can charge a premium for their product and still not experience significant loss in demand.

High Product Differentiation

A company’s bargaining power with buyers increases when the company’s product is differentiated from that of competitors.  In the absence of differentiation, a buyer can make a more credible threat to switch to buying its product from a competitor.  If the product has a large effect on the buyer’s profits, then the company’s bargaining power is increased even more.

Buyer Concentration

A buyer’s bargaining power increases when it accounts for a significant fraction of a company’s sales, particularly when the company’s sales are a small fraction of the buyer’s total purchases.  This is just the flip side of the scenario described under Supplier Bargaining Power. 

Low Threat of Substitutes

Companies can lose their competitive advantage if a new product or service is created that better meets the needs of the customers served by the industry’s incumbents.  An example of this is when cellular networks and Internet telephony created a substitute for fixed line telephone service. This resulted in rapidly declining revenues from what used to be the telecom industry’s cash cow. Although the incumbents in the telecom industry survived (although most were acquired during a wave of acquisitions), they only did so by rapidly embracing these substitutes and turning them into new sources of revenue.  The threat of substitutes cannot always be avoided by embracing the substitute, as the company’s competitive advantages may not be applicable to the new product or service, and sometimes (as with the case of digital photography replacing film-based photography) the new industry may not be as profitable as the old.

For more on evaluating a company's future prospects, as well as an in-depth treatment of company analysis, you can check out my book:

web.me.com/briangaudet/ThePatientInvestor/Home.html

And for an inexpensive company analysis software package that help in quantifying a company's demonstrated competitive advantage, check out:

web.me.com/briangaudet/InvestingToolBox/Investing_Tool_Box.html