The most important factor to consider before making a long-term stock market investment
isn’t how good the management of the company is, how the company is currently priced, and
it’s certainly not what the stock looks like on a Japanese candlestick chart.
The most important factor to consider before making a long-term stock market investment
is whether the company you are looking at has a sustainable competitive advantage, which
will allow it to be profitable for many years to come.
Companies like Apple, Johnson & Johnson & VISA thrive, while companies like American Airlines,
British Petroleum & Fiat & Chrysler barely scrape by.
But why?
Well, that’s what you will learn in this video, and this is …
A top 5 takeaway summary of Competitive Strategy.
Written by Michael Porter.
And this is the Swedish Investor, bringing you the best tips and tool for reaching financial
freedom, through stock market investing.
Takeaway number 1: Porter’s Five Forces
If you are a business student, you probably recognize this.
Porter’s Five Forces is a model for determining the potential returns of an industry which
is taught at every business university in the world, and for a good reason.
Warren Buffett, the greatest investor of all time, refers to a company that is performing
well consistently as a company that has a sustainable “moat”.
Companies that are performing well are constantly challenged by competitors of all sorts, but
with a deep and wide moat (preferably filled with lots of crocodiles) the companies can
sustain such attacks.
In Warren Buffett’s annual shareholder meeting of 2001 he admits that him and Porter think
alike when it comes to determining this moat.
Quote: “we call it a moat and he turns it all into a book”.
The state of competition within an industry is decided by five forces, and long run returns
on invested capital are decided by these forces: The five forces are:
Threat of entry
Threat of substitution
Bargaining power of suppliers
Bargaining power of buyers; and
Intensity of rivalry
The goal for a particular firm should be to
position itself strategically within the industry so it can best defend itself from these forces,
or, if possible, manipulate them to its favour.
In the coming takeaways, we will do a deep-dive into these forces so you will be able to determine
how well a firm is positioned for yourself.
In fact, this video might as well have been called “a breakdown of Porter’s Five Forces”
instead of “a top 5 takeaways summary of Competitive Strategy”.
But you know … I don’t want to fiddle with a concept that works.
Takeaway number 2: Threat of entry
The first force to consider is how easy it is to enter the industry.
Football is a really competitive sport since it is really easy to enter – all you need
is a ball and it can be practiced all over the world.
Slalom skiing, on the other hand, is less competitive, as it requires expensive equipment
to participate in and can only be practiced in countries with skiing resorts.
You want to invest in companies within industries where the threat of entry is low.
Preferably you’d like to own a monopoly so your company can decide pretty much whatever
prices it wants, but governments usually interrupts here.
An industry is difficult to enter if it posses high barriers of entry, you want entry barriers
as high as the Chinese Wall.
Here are six examples of such barriers:
- Economies of scale
If larger players in
the industry can achieve lower costs, it is difficult for a new firm to enter as it per
definition must be small in the beginning.
Economies of scale can exist in business functions such as production, marketing, distribution,
administration etc.
- Product differentiation
Existing firms have high customer loyalty already, which
may be difficult to replace.
This is why pretty much every company want to create a brand name.
- Capital requirements
If entering the industry is associated with high upfront costs, such
as building a large production plant or spending lots of money on R&D, it will scare competitors off.
- Switching costs
It may not always be so easy to convince a customer to switch from
a product to another, because it may be associated with things such as retraining, new testing,
product redesign etc.
For instance, I don’t want to switch from my IPhone simply because I dread having to
relearn the interface.
- Cost disadvantages
A firm coming in late may face cost disadvantages like being late
in the learnings curve or getting less favourable access to raw materials.
- Governmental policies
Access to an industry can be completely denied by a government.
For example, YouTube is banned in China.
Grrrr …
In addition to this, the threat of entry can
be mitigated by retaliation of the companies within the industry.
A firm will enter the industry if it forecasts that the potential reward for being in it
is greater than the cost of overcoming these barriers of entry and the retaliation that
is likely to happen.
An industry which is almost impossible of entering is that of the railroads.
It takes a ton of capital and it is an enormous risk to build a second railroad network next
to an already existing one, so therefore, it keeps competitors away.
On the other hand, me and my fellow YouTubers have very low barriers of entry, it is relatively
easy for someone to start a channel from scratch without any prior experience.
Therefore, competition on YouTube is very high.
Takeaway number 3: Threat of substitution
Substitute products are those that do not
belong in the same industry but that fulfils a similar need.
For example, A mobile phone is a substitute for a landline phone (and many of the things
by the way).
Social media is a substitute for newspapers.
A train is a substitute for a car.
Yet, these obviously do not belong in the same industry.
Substitutes create price ceilings for industries.
As an investor, you therefore prefer to invest in companies where there is only a low threat
from substitutes.
There are two substitutes that one should especially watch out for:
- Those that are becoming cheaper relative to their performance; and
- Those that earn high returns on capital.
Such substitute industries are likely to have more new entries in the future, which will
drive prices down within that industry, and have a spill over effect in the industry that
you are considering to invest in yourself.
Companies within the industry of power grids face pretty much no substitute at all.
We need electricity and nothing is likely to change that in the coming future in my
opinion.
No matter how that electricity is produced, someone must transport it.
On the other side of the spectrum we have the newspapers.
For the longest of times, they had monopoly-like situations for the service of delivering news
to their hometowns.
These days however, they face competition from online papers & social media, which has
pretty much killed the industry and the companies within it.
Takeaway number 4: Bargaining power of suppliers/buyers
These two forces can be included in the same
takeaway as they mirror each other.
If industry A is the supplier, industry B is the customer, and it’s in this relationship
that a kind of power struggle can occur.
A supplier can stop delivering the product, raise prices or lower quality.
Similarly, a buyer can stop buying the product, demand lower prices or demand higher quality.
You want to invest in companies within industries which are winning this power struggle, both
against their suppliers and customers.
Here are six factors that help an industry to mitigate the power of its suppliers:
- Large portion of suppliers’ sales.
If the industry represents most of the suppliers’ sales, they live and die together, and it’s
in the suppliers’ interest to remain friendly.
- Large portion of buyers’ budget.
Similarly, if the cost is a large one for the industry, it typically commands more power
in the bargaining as it has a very serious incentive to keep prices low.
- Undifferentiated purchases.
If the purchased products are commodities, the industry can get lower prices than otherwise.
- Low switching costs.
If it is simple and relatively cheap to switch from one supplier to another, suppliers will
be in less of a position to command premium prices.
- Threat of backward integration.
Backward integration is when a company decides to compete directly with its suppliers in
their industry, in other words, take over their operations.
For example, an auto-manufacturer may decide that it wants to create all of the components
of the cars itself, and that it also wants to mine the ores necessary for creating such
components (now this is not very likely).
Nonetheless, the simpler it would be for an industry to take over the operations of the
supplying industry, the better.
- Unimportant for buyers’ quality.
If the product that is purchased is unimportant for the quality of industry’s product, high
prices are never accepted.
It should be noted that workers for the industry counts as suppliers as well.
If you mirror this, you’ll get six factors that helps an industry to mitigate the power
of its buyers.
An example of an industry that has been good at mitigating the power of its suppliers is
that of the supermarkets.
Suppliers of goods to these firms (at least most of them) must accept the supermarkets
as powerful players of distributing their products if they want to be represented on
the product shelves.
The airline industry is in a different situation.
With only two main suppliers of airplanes in Airbus & Boeing, it was a tough industry
to be in, even before the current COVID-19 situation.
Takeaway number 5: Intensity of rivalry
The final force to consider is how tough the competition among existing firms in the industry is.
Price cutting, advertising battles, new product introductions and increased customer service
are common weapons of choice here, and they lead to lower profitability for companies
within the industry.
Therefore, you prefer to invest in a company within an industry where the intensity of
rivalry is low.
Here are a few factors which typically lead to low competition:
- Concentrated and/or few companies.
You prefer to see that the industry is dominated by a few players only.
Companies are then familiar with the hierarchy of the industry and larger companies can often
discipline smaller ones that tries to do something stupid.
- High industry growth.
With a growing industry, most companies can fulfil their promises of expansion to their
shareholders without waging price wars.
- Low fixed costs.
High fixed costs often lead to overcapacity and incentives for firms to sell products
at lower prices just to cover the fixed costs.
For example, an industrial company may just have built a new production plant that can
produce 1000 units of product X per day.
The price difference of producing 1000 or, say, 700 units a day could be quite small.
If the demand of the product is only 700 units a day at the current price, the company may
decide to cut prices to sell at the full capacity of 1000 units, as this doesn’t cost much
extra.
The car manufacturing industry face this problem, for example.
Generally, you don’t want to see such behaviour in industries you invest in.
- High differentiation.
If customers perceive the products of the companies within the industry as somewhat
different, price sensitivity will be much lower.
Commodity products such as oil & gas producers and mining companies have very low product
differentiation and therefore have problems with this.
An example of an industry which has been able to mitigate the force of rivalry is soft drinks.
The major players here have such strong brands that their products are perceived as different.
Therefore, they have commanded high returns on capital for many decades now.
Hairdressers exists on the other side of the spectrum, they haven’t been able to handle
this force very well.
Again, in the long run, the returns of an industry is pretty much determined by these
forces.
At times, it’s a single force that is responsible for the excessive or depressive returns of
an industry, but at other times, it is a combination of the five.
For the investor, it is important to notice that a specific company within an industry
may handle the forces much better than the rest of the competitors.
While a sustainable competitive advantage is the most important factor to consider
before investing in a stock market company for the long run, there are many other important
factors to consider too.
If you want to learn more about advanced stock market concepts, check out the playlist that
I’ve compiled on other interesting stock market books.
Cheers guys!