In this series we look at 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 2 of Michael Porter’s book: Competitive Strategy: Techniques for Analyzing Industries and Competitors, where he evaluates the 3 generic strategies companies use to outperform in an industry.
If you are looking at investing in individual stocks, what are some important factors to look for? In his book Competitive Strategy, Michael Porter offers some strategies companies can use to give them a “Competitive Advantage” over their competitors, and in turn make it a much better potential nvestment for its investors.
New to this series? Check out our post on Chapter 1 here.
Michael Porter gives 3 generic strategies:
1. Overall Cost Leadership
Cost leadership means becoming the low cost provider in order to gain market share. Low prices attract customers. So the goal of a company looking to establish cost leadership is to be able to create a product cheaper than its competitors and therefore be able to offer it for a lower price.
Cost leadership requires a high market share, as more than likely the company’s margins are reduced relative to competitors.
Cost leadership is achieved by:
– Efficient-scale facilities,
– Inventory or overhead control,
– Minimization of R&D costs, Salesforce costs, advertising costs and
– Maintaining a wide variety of products to spread costs.
Large conglomerate companies have an advantage here, as they typically own the supply chain for products they offer.
You can notice cost leadership by walking down the beer isle of your local grocery store. Although thousands of breweries exist, the big guys (Budweiser, MillerCoors) own 70% of the beer market share, why? Usually nothing is cheaper than a case of Bud Light. So budget conscious consumers have a hard time justifying paying for $20 12 pack of a microbrewery (even if it is much better) compared to the $10 for Bud Light. This is why InBev (The company that owns Budweiser and many other large beer brands – Ticker symbol; BUD) is poised to sell nearly $40 billion in beer this year. Of all its brands – Budweiser is still its fastest growing.
Think about how InBev achieves its cost advantage using Porter’s list above:
– Little R&D costs. Budweiser’s recipe doesn’t change. Sure there are costs associated with new recipes and research new technology in the brewing process. But the largest portions of InBev’s income come from well established brands that need no tinkering.
– Wide variety of products. And most importantly, these products can all be brewed using the same equipment and similar ingredients as other brews. This means Budweiser can produce more products, for less average cost.
– Efficient facilities. InBev’s large, efficient facilities operate nearly 100% on computer controls. Take a tour through a Budweiser brewery one day (in fact, this is where the picture in Begin to Invest’s About Page was taken), it is incredibly interesting!
How can you determine whether a company has cost advantage? You want to look at 2 numbers:
- Market Share
Cost leadership means low margins, meaning the company makes less money on a single purchase. But with being the low cost provider also comes more volume of business. So although InBev may only make 30 cents on that 6 pack compared to a local brewery’s $1, InBev will sell millions of 6 packs of beer to make up for it.
Other companies that benefit from cost leadership that come to my mind (Have more? Leave a comment below!):
-Amazon.com (ticker symbol: AMZN) – Certainly known for their low prices and wide variety of products available. Amazon sells over $65 billion in products every year, but with a profit margin typically around 0.2% or so.
-GEICO insurance – If you haven’t received a quote for your car insurance from GEICO, give it a try as it may be much less than what you are paying now. Geico (owned by Berkshire Hathaway, ticker symbol BRK.A and BRK.B) is able to offer low prices by tightly controlling costs of its business.
Differentiation means being unique. It may be selling a product no one else has, it may mean superior products or a unique selling position.
Apple (ticker symbol: AAPL) certainly had this when it released its first iPhone. At the time, the “smartphone” was a truly unique idea, and it lead Apple to becoming one of the largest companies in the world.
Some characteristics of companies who are able to get a competitive advantage using a differentiation strategy:
– A feel of exclusiveness.
– High margins.
– Brand loyalty.
– High R&D costs.
Here, a company is giving up hopes for high market share and instead aiming to make a cutting edge product or service. This means high margins and low market share.
Think of Apple. Whether it is their computers (iMacs) or early iPhones, Apple produces a product that is more expensive than many other similar products, but has still generated a strong fan base.
Consider the cost of a new iMac vs. a new Dell computer, or an iPhones against other smartphones. Apple has dominated the market by making its product feel different than everyone else.
Other companies that come to mind:
Caterpillar (Ticker symbol: CAT) – Michael Porter uses Caterpillar as an example in the book. Although more expensive than other “cheap” construction equipment companies, many choose Caterpillar over others because of their reputation of high quality parts.
Cummins (Ticker symbol: CMI) – The maker of diesel engines for trucks. If you know someone with a Dodge Ram, they might be one of those who swear by Cummins engines.
Focus means serving a narrow segment of the market very well. It may mean specializing in a certain small industry, focusing on an age group, specific product line or specific geographical area.
In my area, there is a significant number of military personnel. Many companies focus on serving military members exclusively, whether it be a daycare or relator.
Nationally, I think of clothing lines who target a specific age group or specific style of person. Consider a retailer like Urban Outfitters, who is obviously not worried about attracting the aging baby boomer generation over the younger generation. Or a company like FUBU, which targets a specific urban market.
Or consider Bank of New York Mellon (Ticker symbol: BK), who focuses specifically on high net worth individuals for their investment management business.
This is a strategy that small investors can spot well before Wall Street, and can mean getting in ahead of the pack in a particular stock. What brands does your kid/brother/mother like and why? What companies service you in your industry? What companies give up market share in one segment of an industry to focus specifically on another?
All of the strategies above have risks, so monitor your investments carefully. A company that was once the low cost provider may struggle to keep that advantage with new technology, or a company with product differentiation may lose their edge and their following.
When you invest in a stock, you need a compelling reason. If the company you are investing in has no competitive advantage of its competitors it is doomed for average results at best. A company who masters one of the 3 strategies above can give it an edge over its competitors, and make your investment flourish.