If you’ve ever listened to Warren Buffett talk about investing, you’ve heard him mention the idea of a company trench. A ditch is an easy way to describe a company’s competitive advantages. Companies with a strong competitive advantage have large trenches and thus higher profit margins. And investors should always worry about profit margins.
This article deals with a methodology called Porter’s analysis of five forces. In his book Competitive Strategy, Harvard professor Michael Porter describes five forces that affect a company’s profitability. Here are five forces he noticed:
- Intensity of rivalry among existing competitors
- The threat of entry of new competitors
- Pressure of substitute products
- Bargaining power of customers (customers)
- Vendor bargaining power
These five forces, together, give us an insight into the company’s competitive position and its profitability.
Rivals are competitors in the industry. The rivalry in the industry can be weak, with few competitors not competing very aggressively. Or it can be intense, as many competitors struggle in a cut environment.
Factors that affect the intensity of rivalry are:
- Number of companies – more companies will lead to increased competition.
- Fixed costs – with high fixed costs as a percentage of total costs, companies have to sell more products to cover these costs, increasing market competition.
- Product Differentiation – Products that are relatively the same will compete based on price. Brand identification can reduce rivalry.
One of the defining characteristics of competitive advantage is the entry industry. Industries with high barriers to entry are usually too expensive for new companies to enter. Industries with low entry barriers are relatively cheap for new companies to enter.
The threat of new entrants is growing as the market barrier to entry is reduced. As more companies enter the market, you will see rivalry increase and profitability fall (theoretically) to the point where there is no incentive for new businesses to enter the industry.
Here are some common barriers to entry:
- Patents – Patented technology can be a huge barrier that prevents other companies from joining the market.
- High cost of entry – the more it will cost to start working in the industry, the greater the barrier to entry.
- Brand Loyalty – When brand loyalty is strong within an industry, it can be difficult and expensive to enter the market with a new product.
This is probably the most overlooked and thus the most harmful element of strategic decision making. It is imperative that business owners (we) look not only at what the company’s direct competitors do, but also what other types of products people could buy instead.
When replacement costs (costs incurred by the customer due to switching to a new product) are low, the threat of replacements is high. As is the case when working with new entrants, companies can aggressively set the prices of their products to prevent people from switching. When the threat to substitute products is high, profit margins will tend to be low.
There are two types of purchasing power. The first is related to the sensitivity of the customer to the price. If each brand of product is similar to all the others, then the buyer will base the purchase decision mainly on price. This will increase competitive rivalry, resulting in lower prices and lower profitability.
The second type of customer power refers to bargaining power. Larger customers tend to have more influence with the company and can negotiate lower prices. When there are many small customers of a product and all other things remain the same, the company delivering the product will have higher prices and higher margins. Conversely, if a company sells several large customers, those customers will have a significant impact in negotiating better prices.
Some factors that affect purchasing power are:
- Customer size – larger customers will have more power over suppliers.
- Number of customers – when the number of customers is small, they will have more power over suppliers. The Ministry of Defense is an example of one customer who has a lot of power over suppliers.
- Purchase – When a customer buys a large quantity of a supplier’s product, he will have more power over the supplier.
Customer power looks at the relative strength that a company’s customers have. When multiple suppliers produce a commodified product, the company will make the purchase decision mainly based on a price that tends to reduce costs. On the other hand, if an individual supplier produces something that a company must have, the company will have little leverage to negotiate a better price.
Size plays a factor here too. If a company is much larger than its suppliers and buys in large quantities, then the supplier will have very little negotiating power. Using Wal-Mart as an example, we discover that suppliers have no power because Wal-Mart buys in such large quantities.
Several factors that determine the strength of a supplier include:
- Supplier Concentration – The fewer suppliers for a particular product, the more power it will have over the company.
- Shifting Costs – Vendors are becoming more powerful as the cost of changing another vendor increases.
- Product uniqueness – suppliers who produce products specifically for the company will have more power than suppliers of goods.
It is important to analyze these five forces and their impact on the companies we want to invest in. The Porter Five Forces analysis will give you a good explanation of the profitability of the industry and the companies in it. If you want to know why a company may or may not make decent money, this is the first analysis you should do.