Michael Porter’s book, On Competition, is a 500+ page textbook which is widely acknowledged to be the bible on businesses competition and strategy. Bruce Greenwald and Judd Kahn wrote Competition Demystified, a 400 page thesis which simplifies Porter’s five forces of competition to a much more usable model. There’s a 49 page summary of Competition Demystified available on Kindle. I’m now going to attempt to describe my understanding of the process I derive from Greenwald & Kahn’s book by converting it to two page summary. Here goes.
Step 1 – Define Markets
Companies often operate in more than one market. Before analysing we need to chunk a company down to its individual markets. How finely do we need to do this? It depends on barriers to entry that we don’t know yet. Start by writing a list of products and geographies then put that aside until the next step is complete.
Step 2 – Identify Quantitative Indications of Barriers to Entry
Barriers to entry don’t exist in the majority of markets despite the unending amount of hype that companies publish regarding their brands, technology and processes. If barriers exist then the companies that possess them will tend to have two main properties:
- They earn a higher than normal return on capital over the long term.
- Industries where the company competes will tend to have fairly stable market shares between each company.
So first thing to check is the after-tax return on capital (ROC) of any company you are analysing. If the ROC averages more than 15 to 25 percent over a decade or more then that’s a strong indication of barriers to entry. If long-term average ROC is in the range of 6 to 8 percent after tax then there’s no barriers. If it’s between 8 and 15 percent then there’s no clear indication. It could mean irrational price competition has reduced potential returns in a market where barriers exist or it could mean the company is unsheltered by barriers but possesses exceptional management.
Coming back to the statement I made above about individual markets, if the ROC is medium to low it’s worth checking if the company has barriers to entry in some markets but not others. One way to find out is to try and find data which allows the ROC to be calculated for each market (not always easy). The second way is to look at something that you should check for anyway, even if the ROC is high; stable market shares.
Greenwald and Kahn provide a couple of rules of thumb for market share assessment:
- Firstly count the number of main players in each market. If there are more than five then it’s unlikely there are barriers to entry.
- Secondly, if there is more than a five percent absolute market share change over a five to eight year period then there are no barriers to entry. If it’s less than two percent then the barriers are likely to be strong.
Step 3 – Look for Qualitative Reasons for Barriers
If the quantitative checks above suggest that barriers are present then we should be able to find qualitative indicators to triangulate our assessment. These fall into three categories:
- Supply barriers. This includes items such as patents or access to supply of a rare and costly raw material. In practice, real barriers of this type are rare. Patents can often be worked around and when a company can produce a product more cheaply than competitors it is usually due to economies of scale.
- Customer stickiness. This type is more common but I find it harder to be sure about because data on customer churn is not available for many industries. Situations where customers tend not to be able to overcome the cost or inconvenience of changing suppliers abound. Examples include:
- Consumer preferences for Coca-Cola because of habit and the cost/benefit risk of changing to another slightly cheaper brand.
- Dental laboratories preferring to deal with one wholesaler due to volume discounts, credit and convenience.
- The reliance of airlines and the military on manufacturers of aviation equipment for spare parts and service.
- Economies of scale. This one is simpler to quantify. The fixed costs to operate in any particular market should be similar for each competitor and this data is publicly available for listed companies. We can then calculate the market share needed to cover the fixed costs. If the amount of share is large, say more than 15%, then any market entrant is going to need to suffer losses for a significant period in order to reach minimum viable market share.
That’s it for qualitative reasons. If a company claims its brand has customer stickiness then look for habit – the majority of brands don’t create barriers to entry. Same goes for proprietary manufacturing technology creating a cost advantage – economies of scale are more likely the reason.
Step 4 – Check the Market Boundary
The three barriers to entry usually apply only narrowly in terms of geography or market. There are very few worldwide markets where barriers to entry apply. If you find a distributor has barriers to entry in a market because of transport costs in a particular area, don’t assume the same barrier applies in other geographies. The same applies for example with suppliers with a customer stickiness advantage in a particular industry. Just because there are many people with the habit of drinking Coca-Cola doesn’t mean that Coke’s other products enjoy the same advantage.
Once you understand the barriers to entry and market boundaries it may be necessary to go back and change the market definitions in the first step.
Step 5 – Look for Cooperation
Price competition can still erupt, even where barriers to entry exist. Even Charlie Munger admits this aspect of competition is difficult to predict. However, if we’ve made it this far and have confirmed that quantitative and qualitative barriers exist then chances are that the main players in the industry have learnt to get along. Otherwise the resulting depression in ROC would likely hide any barriers to entry which are present. Clues we can look for here to gain comfort are:
- Price signalling. Statements by CEOs about matching competing prices are a good example. Published prices and uniform pricing methods are another sign.
- Most favoured nation pricing clauses in contracts. This means that the supplier promises not to offer customers other than the buyer a cheaper price.
- Avoidance of competing niches. This happens where companies divide up a market into smaller niches then specialise to avoid direct price competition.
Step 6 – Look for Strategic Awareness
Greenwald and Kahn state that high returns on capital are only sustainable in areas where companies are sheltered by barriers to entry. The follow-on to this is that sales growth is only value additive in markets where these barriers provide protection. At this stage of the analysis it is a good idea to see if the company is acting as though it is aware of these implications. Is it expanding only in markets where it will likely obtain a high ROC or is it trying to expand elsewhere? If we know this then we can estimate the ROC of the company in the near future. This will be useful later when we try to value the company in the return space.
Step 7 – Summarise the Implications
You should now be able to write down the following:
- Whether or not the company operates in any markets which have barriers to entry.
- The quantitative evidence for these barriers.
- The qualitative evidence for these barriers.
- The tendency of market participants to avoid competition in order to maximise their profitability.
- The tendency of the company you are analysing to preserve its incumbent advantages.
- What could change that would destroy or deplete the barriers to entry.
- Based on the above – what return on capital is appropriate to use when valuing the growth of the business.
What if I Don’t Find Any Barriers to Entry?
This is what happens in the majority of cases. Luckily this actually simplifies the situation because companies in industries without barriers to entry tend to earn their cost of capital over the long term. However this is provided the management of the company is of average competence. That’s a subject for another time. If you haven’t already, you may want to read the first article in my series on Bruce Greenwald here.
If you have questions or comments please write to Warwick at email@example.com. I answer every email that I receive.
Disclosure: This is not a recommendation to buy or sell any securities. All information presented is believed to be reliable and is for information purposes only. Do your own research before purchasing any security.