In this series we look at some investing lessons from some of the classic investment books out there and apply those lessons to today in order to spot potential investment opportunities. Today we look at Chapter 1 of Michael Porter’s Competitive Strategy: Techniques for Analyzing Industries and Competitors where he evaluates major barriers of entry, and how to identify them.
If you are looking at individual stocks, what are some important factors? In his book, Michael Porter offers some qualities of companies that give it a “Competitive Advantage” over its competitors, and in turn make it a much better potential investment for its investors.
You want to find a company with something unique, making a product no one else can make, being in an industry no one else can get into or maybe just be so efficient that no one else can beat their prices. There is a reason no kid has become a billionaire from his lemonade stand during the summer, for only a few dollars anyone can open a stand and take away business.
One of the factors discussed in Chapter 1 is an industry’s “Barrier to Entry”. That is – how hard is it for competitors to get started into the industry?
First, there are a few things to consider before investing in individual stocks. I want to make sure everyone identifies the risks with investing in individual stocks over broadly diversified index funds. If you have read this before, skip down to the next bold line, which is where the meat of the article really starts. But this is important to know:
When picking individual stocks, there is a long checklist an investor must complete before deciding to invest. When investing significant amounts into one company, the risk within your portfolio jumps significantly. Compare a $10,000 investment into the S&P 500 index fund, where your investment is spread out among 500 companies, to a $10,000 investment into Apple, where the whole sum rests solely on Apple’s stock performance.
Many beginning investors learn the lesson of diversification the hard way. They pile into hot stocks with significant amounts of their portfolio, only to see those stocks (and therefore their portfolio) underperform. For this reason, Begin To Invest has advocated beginning investors pick from some of the thousands of ETFs available to give their portfolio the diversification required (In fact, we have our Fund Spotlight series for just that ).
However, for investors willing to do the work, investing in individual stocks can lead to much higher returns than broad diversification into index funds. Only after investors understand the increased risk and are knowledgeable enough to research companies, should investors start putting significant amounts of money into individual stocks.
This is evidenced by Warren Buffett’s Berkshire Hathaway. At times, Buffett’s top 3 holdings make up more than 70% of his portfolio. By any “traditional” money management philosophy, he has way too much money in only a few stocks! Because these picks have been good ones, he has reaped the benefits greatly. However, imagine the pain if these picks ended up as big losers!
Before Buffett buys, he is researching the company for months, if not years and has very strict valuation criteria the company must meet. It is his full time job to find new investments, a luxury that many investors do not have or desire.
I love his quote:
“Wide diversification is only required when investors do not understand what they are doing.”
Now, if you are new to investing, don’t take that as an insult that you don’t know what you are doing. I think it is pretty obvious from the returns of some of Wall Street’s “best and brightest” that even they, have no idea what they are doing. They just won’t admit it, and its costs them and their clients billions of dollars every year. I think it is much better to admit your weakness and not lose money compared to thinking you are a hot shot when you really are not, and paying the price dearly.
SO, if you are not ready to dive into a company’s balance sheets and annual reports, take some time to learn while investing in diversified index funds first.
Whew…now that all those disclaimers are out of the way, lets get into the actual subject at hand.
One of the factors discussed in Chapter 1 of “Competitive Strategy” is an industry’s “Barrier to Entry”. That is – how hard is it for competitors to get a foothold into the industry.
Back to the lemonade stand example. If word got around that you were making millions of dollars selling lemonade, imagine how quick your friends would start their own lemonade stands. If all it takes to start a lemonade stand is a few dollars worth of lemons, ice and water there is really nothing standing in their way. A competitor could open up a new stand within a day and immediately start taking business away from you.
This is an example of a very low “Barrier to Entry”.
To find good investments we need to find companies with very high barriers of entry, to ensure our investment stays safe and the company can continue to make a profit selling its products.
Michael Porter discusses 6 major barriers to entry. For each one I will do a little explaining on the barrier of entry, and then try to find a couple of examples of real companies today that benefit from that barrier.
1. Economies of Scale
Economy of scale simply means that costs are inversely proportional to volume. As the company makes more products its cost to produce each unit becomes less.
Large conglomerates mass produce millions of the same product, and can make them much cheaper (on a per item basis) than a small manufacturer. Therefore that large conglomerate can probably afford to sell their product at a lower price and because their price is lower, they will probably sell more.
Think about Coca-Cola Company (Ticker: KO) compared to my lemonade stand. I am making my lemonade by hand, buying a few lemons, a few pounds of sugar and a few plastic bottles at a time giving me higher costs than Coca-Cola who can buy in massive quantities from its suppliers. The cost for me to make 1 bottle of lemonade is probably much, much more expensive than Coca-Cola. Therefore Coca-Cola will be able to sell their bottles in the grocery store for $1, while I will need to sell mine for $2 to make that same profit. Now if my product was so much better, it may still sell (we will get into that later), but more than likely, customers will continue to buy the cheaper Coca-Cola Lemonade (Coca-Cola owns Minute-Maid – the popular lemonade brand).
There are also other cost advantages for large conglomerates. Large companies can afford to “buy their way up the supply chain”.
Consider today’s phone war between Samsung and Apple (Ticker: AAPL). For a few years Apple has dominated the phone market because of their innovation of the iPhone (see barrier of entry #2), but now a new competitor is emerging. Samsung, which owns its own manufacturing facilities, can build it own chips, screens and other parts at a much cheaper price than Apple. This has allowed Samsung to sell phones at a higher margin and bring a wide variety of products to the market, something that Apple has not yet been able to do.
Imagine being able to grow all your own lemons for your lemonade stand. You would be able to get lemons for a much cheaper cost than competitors who have to buy from a middle man. That in turn means either 1) you can sell your product for a lower price, which should hopefully attract more customers. Or 2) you can sell your lemonade for the same price, but have higher margins (make more money) than your competitors.
When looking at individual companies, economy of scale can be a large barrier of entry for new companies in the industry. Is the company you are thinking about investing in able to use the advantage of economy of scale to its advantage?
If not, they need to have other advantages in the industry, such as:
2. Product Differentiation
Product differentiation means 2 things:
1) Having established brands.
2) Having a proprietary product.
First lets look at #1.
Everyone has their favorite brands. For example, my parents and their love for Diet Coke. They will not buy diet Pepsi, ever. Coca-Cola will have them as a customer for life for as long as they live. This is Brand Loyalty at its finest.
People may be like that for car brands, food, restaurants, appliances…you name it.
But as an investor, I want to see a company that has a cult following. I want a company whose customers don’t even consider buying their competitor’s products no matter the cost or convenience. Think Apple computers (Ticker AAPL) fans and their undying hatred for Microsoft, think Budweiser (ticker BUD) and the frat boys who REFUSE to drink anything besides Bud Light (They say it tastes SO different than Coors Light – but I’m not convinced).
All three look like dirty water to me!
Much better! But I’m getting distracted again….
Every year CNBC.com has a “Million Dollar Portfolio Challenge”, where investors use play money to buy and sell stocks and try to make the most money over a period of time. A few years ago, the winner (who was not a professional money manager/Wall Street pro at all) won the whole thing by buying companies she knew, whose products she loved. At a time, her largest holding was WD-40 Company (ticker: WDFC). The other large holding that I can remember off and was Proctor and Gamble (Ticker: PG) – The maker of Tide laundry detergent. Think about it, can you name another brand besides WD-40 that does the same thing? I personally cannot. And when I have needed to fix a squeaking door, WD-40 is on my list. I don’t check out the competing products, I just buy WD-40.
Find a company with a strong long term cult following and I will find you a great long term stock investment.
Companies also differentiate themselves with new, unique products. If a product is “Proprietary” it means it is unique to the market, and it probably means you can sell if for much more than you would be able to if you had a lot of competitors.
Think 5,000 years ago when some genius had the idea to make lemonade for the first time. For a brief period of time, no one else in the world made lemonade. During that time, that genius could have sold lemonade for nearly any price, because if people wanted lemonade, they had to go through them.
But now, any kid on the street can sell lemonade, so the investment potential of lemonade is probably a little lower.
But there are some proprietary products out there today, who have their own unique section of the market.
Think about Corning Company (Ticker: GLW) who makes Gorilla Glass, which is common on many smart phones and touch sensitive glass products. Think about many of the large Pharmaceutical companies who own patents for unique specific drugs.
To identify how proprietary a product is, you can look at a company’s margins. Generally, a higher margin means that the company has a more proprietary product because they are able to sell the product for much more than it costs them to make it. If they had a lot of competitors, their margins would most likely be squeezed as they would be in a price war with the competing companies.
There are many ways to determine a company’s margins, there is Gross Margins, Net Margins, etc. For these examples we are going to be looking at the company’s net margin or “Net Operating Margin” which is:
All of this information can be found on a company’s most recent Income Statement.
Lets compare margins of a couple companies:
Corning: (click to enlarge)
393 million ÷ 2018 million = 17.9% Net Operating Margin
This information is also on finance sites such as Yahoo Finance under the “Key Statistics” section:
(The slight difference in our 17.9% and Yahoo’s 18.32% is due to Yahoo using the last 4 quarters of data [or ttm- Trailing Twelve Months of data] compared to our data which just looked at the last quarter)
Compare this to Amazon.com’s margins. Amazon really doesn’t do anything proprietary as far as their online store. They just sell a lot of products at very cheap prices.
Generally, looking at a company’s margins can help you in identifying a company with a proprietary product, and hopefully a good investment.
If a company owns the patents for a product, it almost ensures that competition will stay at bay for a while.
3. Capital Requirements
The next barrier of entry to consider is the capital requirements required to enter or compete in the industry. A lemonade stand takes a table and a glass pitcher, so it can easily be copied by competing children in the neighborhood. Your neighborhood might look something like this:
Which would not be good for business!
If an industry required a huge sum of money to get started, competitors may think twice before starting up, because of the tremendous risks of losing a lot of money.
Think Boeing (Ticker: BA). New competitors to a company like Boeing don’t come up very often. Just to get started, you need tremendous sums of capital to build buildings large enough to build airplanes in, buy all the equipment, train employees, test the product, etc. No one is just going to decide to start an airplane manufacturing business over a quick weeknight beverage.
The strength of this” barrier of entry” is evident today in Tesla motor’s (Ticker: TSLA) struggles to gain share in the auto industry. It turns out that building a car company from scratch is pretty hard. And as a result Tesla has had trouble financing their operations and building a high quality product. Ford and GM already have the plants, the assembly line, the access to suppliers and a century of experience…Tesla had nothing but a bare patch of land.
By finding companies with large startup capital requirements, you can ensure that want-to-be competitors will not pose a problem for a while down the road.
4. Switching Costs
The “switching costs” barrier to entry refers to customers being locked in in some way to buying the company’s products.
Cell phone companies are notorious for this practice. In exchange for a few hundred dollars off of a cell phone, you sign a 2 year contract with the provider.
Companies like Verizon (Ticker: VZ) and AT&T (Ticker: T) lock in their customers to contracts, making it very expensive for them to switch. I haven’t looked at what it costs to break a contract with one of these companies these days, it used to be several hundred dollars! Companies like Verizon and AT&T can count on a fairly constant revenue stream coming in as most of their customers are locked in for a couple years at a time.
Or consider a company like Microsoft (Ticker: MSFT) which dominates the computer productivity software industry, especially for corporate customers. If a corporation with 100,000 employees all have been using Windows and Microsoft Office for 10 years, imagine the costs in training (and software and hardware) to get everyone up to speed in using Apple’s computers and its operating system! For this reason, many companies continue to buy Dell and HP computers, with Microsoft windows on them year after year, because it is not worth it to have to train every employee on how to use a Mac. Even if Apple provided a slightly better product, the costs of upgrading are hard to overcome.
Locking in customers guarantees sales for years to come, and guarantees profits for the shareholders for years to come as well.
5. Access to Distribution Channels
In order to survive in the retail market, a company has to get their product in front of customers. And with millions of companies all struggling get to get your attention, it can be hard for them to stand out.
When space on the shelves is limited, access to the distribution channels is everything. A company could have the best product in the world, but no one would know it because their competitors own all the shelf space.
Being a beer snob as I am, I hate walking into a grocery store and seeing a mile long aisle of only Budweiser and MillerCoors (Ticker: TAP) products. Have you ever noticed how many of the beers on store shelves are really just Budweiser or Miller in disguise? Look at this: (if you don’t care about beer like I do, feel free to scroll down and skip my rant)
Coors Light, Molson Canadian, Molson Export, Molson Canadian 67, Molson Dry, Molson M, Rickard’s Red, Rickard’s Blonde and other Rickard’s brands, Carling, Carling Black Label, Pilsner, Keystone, Creemore Springs, Granville Island brands, Caffrey’s, and Cobra; and various regional brands. The company also brews or distributes products under license under the Heineken, Amstel Light, Murphy’s, Asahi, Asahi Select, Miller Lite, Miller Genuine Draft, Miller Chill, Milwaukee’s Best, Milwaukee’s Best Dry, and Foster’s brands. In addition, it distributes the Corona, Coronita, Negra Modelo, and Pacifico brands, through a joint venture agreement with Grupo Modelo S.A.B. de C.V., as well as Singha brand. Further, the company sells various brands in the United States comprising Coors Light, Miller Lite, Coors Banquet, Miller Genuine Draft, Miller 64, Miller Chill, Sparks, Miller High Life, Keystone, Icehouse, Mickey’s, Milwaukee’s Best, Hamm’s, Old English 800, Blue Moon, Henry Weinhard’s, George Killian’s Irish Red, Leinenkugel’s, Peroni Nastro Azzurro, Pilsner Urquell, Grolsch, Coors Non-Alcoholic, and Sharp’s.
Budweiser, Stella Artois, and Becks; multi-country brands consist of Leffe and Hoegaarden; and local brands comprise Bud Light, Michelob, Skol, Brahma, Antarctica, Quilmes, Jupiler, Hasseroder, Klinskoye, Sibirskaya Korona, Chernigivske, Harbin, and Sedrin.
And Budweiser just put in a bid to buy Corona.
How is anyone supposed to compete with that?
All these beers combined are about 70% of the beer market, and take up most of the space on store shelves. If I was to start a brewery today, I have no idea how I would be able to get on store shelves over companies like Budweiser.
This is a huge barrier of entry, competitors don’t stand a chance! And this will be a major reason that sales at Budweiser, and Miller continue strong (as much as I hate to say it!).
The same may happen in many other industries that I am just not as up to speed on. For example, many TV brands are really the same parent company. The different brands take up space on the shelves and ensure the parent company gets the customer one way or another.
Look at the shelves of the stores you shop at, does one company dominate the shelf space?
6. Government Policy
Lastly, you have to consider the largest spender of them all – The Government. Get on the right side of Uncle Sam and you are almost guaranteed to make it.
The large defense contractors come to mind. The likes of Lockheed Martin (Ticker: LMT), Boeing and Northrop Grumman (Ticker: NOC), who dominate in getting government contracts.
The concept holds true for smaller companies with state and local governments as well. Find companies that have ins with your local government for some ideas.
I live in the Hampton Roads area of Virginia, an economy dominated by military and federal spending. Apartments rent for absurd prices because of the per diem that military members are given, and they are always in short supply. I keep an eye on stocks that own a lot of rental property in the area (REITs – Real Estate investment Trusts) because I think that those companies will always do well in the area, no matter the economy. Sailors will always need a place to live. Small local banks do very well here, and are under the radar or Wall Street, as young military members are quick to take out loans for new cars, homes or other personal reasons. Towne Bank (Ticker: TOWN) and Monarch Financial Holdings (Ticker: MNRK) are just a couple of examples.
Don’t invest in those just because they are mentioned on here, find companies that benefit from your own local economy that you are more knowledgeable about for some ideas. Maybe you live in a rural farming community and can spot some new companies offering better agricultural products subsidized by the government. Maybe you know some key suppliers for your local government offices. Keep an open eye for where your government’s money is flowing to, and you may be able to spot some good investments.
Lots of information to digest! Hopefully this discussion got your mind churning on some potential investment opportunities.
These 6 steps are a great start in getting you started in your search for your next great investment.
Our series continues with chapter 2 discussed in this post here. Chapter 2 deals with identifying strategies companies can use to outperform their competitors.