The Importance of Understanding Competitive Dynamics to Picking Stocks

by: MagicDiligence

Competition is probably the single most important destroyer of shareholder returns. Readers of MagicDiligence, and particularly members, know that a sustainable, favorable competitive position is one of the primary attributes of all Top Buy picks. Without it, a company's return on capital, growth, and cash flows are all vulnerable to competition driving down prices or escalating costs (through advertising, for example). Understanding situations where competition is structurally limited is vital to finding attractive investments, and recognizing working strategies where there is competition is similarly advantageous.

For a long time, the bible on competitive strategy was Michael Porter's aptly named Competitive Strategy. However, Porter's complex analysis juggled five forces of competition, which are not necessarily equal. To simplify this, Bruce Greenwald and Judd Kahn concentrate on what they feel is the single most important factor: barriers to entry. It's this focus that is the underlying theme behind their book, Competition Demystified.

Competition Demystified is a business book, and not an investing one. Greenwald and Kahn identify three basic competitive situations for a market. First, there is the case where there are no barriers to entry, many competitors, and little customer captivity. In this situation, a competitive strategy is a waste of time and participants should be focused on operating as efficiently as possible. An example provided in the book is the remarkable rise of Wal-Mart (NYSE:WMT) to prominence in what is essentially a no-moat business: discount retailing. Wal-Mart focused on saturating small geographic areas, getting the most out of distribution and advertising investments. Eventually, duplicating this strategy across the country allowed the company to gain market share against more spread-out rivals like K-Mart (NASDAQ:SHLD). They present a counter-example where Coors (NYSE:TAP) tried to expand nationwide all at once. It not only failed to increase profits but also lost its competitive advantages in its western state, which was its core market.

The second situation is one where there are a few competitors with the same advantages. This is where competitive strategy can really come into play, as the actions of your primary competitors must be anticipated, and answered. The book goes into the detail of game structure and the prisoner's dilemma, where the cost/benefit of cooperation vs. competition must be weighed to come to a decision. An example given is Home Depot (NYSE:HD) vs. Lowe's (NYSE:LOW). If both have stores in the same market, is it beneficial for one to maintain in-line prices and accept an equal piece of the pie, or lower prices (or increase ad spending) to grab a bigger piece? It depends on what you expect your competitor to do. An all out price war would be a disaster for both firms.

The third situation is when there is a virtual monopoly, with a single competitor dominating a field with huge barriers to entry and high customer captivity. Competition Demystified has a simple prescription here: maintain competitive advantage. However, there are provided several examples where this simple advice was just not heeded. For example, Kodak (EK) dominated film photography for most of the last century. Management decided to enter the "adjacent" businesses of instant photography and copiers in the 1970's, businesses dominated by Polaroid and Xerox (NYSE:XRX). The results were devastating. Aggressive responses by the incumbents prevented profitability, and management's focus on these two new businesses led to erosion in the core film business to overseas competitors such as Fuji.

The book does a good job of providing interesting examples to illustrate the main points. Only one chapter, relating to cooperation between industry players, came off as more theoretical than practical. For Magic Formula Investors, three primary lessons can be taken from this book:

  1. Some businesses have built in competitive advantages and high barriers to entry, while others do not. The ones with structural advantages are more attractive, and likewise, more attractive investments.

  2. Do not invest in situations where players are more interested in fighting each other through price or advertising wars than making a profit.

  3. Be wary when a company with dominant competitive advantages tries to expand into "adjacent" markets. More often than not, this results in a loss of advantage in the core business (Peter Lynch called this phenomenon "di-worsification").

For those interested in business, and especially the dynamics behind competition, I highly recommend Competition Demystified.

Disclosure: Steve owns no position in any stocks discussed in this article.

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