How to analyze competitive strengths of a business

We will briefly uncover competitive analysis in this article. One of the basic and the most important way of understanding competitive strength of a business is follow porter’s 5 forces. Porter’s 5 forces play significant role in understanding a company’s competitive advantage. Porter’s 5 forces include:

1. Threat from substitutes
2. Bargaining power of suppliers
3. Bargaining power of buyers
4. Rivalry amongst competitors
5. Barriers to entry

Companies with low threat from substitutes, low bargaining power of suppliers, low bargaining power of buyers, low rivalry amongst competitors and higher barriers to entry are signs of strong competitive strength of a company.

Single most advantage a company can have is to conduct business in an industry with high barriers to entry. For those companies that operate in an industry with no barriers to entry, generate zero economic profits in the long run. The only way to differentiate themselves is through efficiency and effectivity. Newer technology and less expensive labor can only be temporary for new entrants. The ones powerful American industries like machine tools, textiles and even automobile seem to support my above view of decreasing profits or companies disappearing. For companies with no competitive advantage, life is all work and where profits, except for the exceptionally managed companies, are average at best. Efficiency, efficiency and efficiency are most suited words for such companies.

Commodity business are to be avoided. Any operation in which sellers offer essentially identical products to price-sensitive customers faces an intense struggle for economic survival and must accept a lower than average level of profitability.Do not allow yourself to be trapped in a commodity business. Profitability can shrink even though product may be differentiated.Let’s look at an example: Branding is a tactic used for product differentiation by Mercedes Benz. Cadillac and Lincoln once had the same stature in America. Both these companies made exceptional profits post world war but profits shrunk as new entrants ate away their share of profits. These brands in the long run, although differentiated themselves, earned no exceptional profits distinguishable from those mundane commodity businesses everyone alludes to avoid.

Profits in American market were eaten by the European entrants – Mercedes Benz, Jaguar and BMW - Soon followed by the Japanese Acura, Lexus and Infinit. Due to competition, overall profit margin per car dropped and fixed costs of differentiation strategy – product development, advertising, maintaining dealer networks rose. This concludes that by product differentiation for strong brands like Mercedes Benz doesn’t guarantee exceptional profits. Companies cannot eliminate competition.

In copper, steel, textiles, it is clear that if a company cannot produce at a cost at or below the price established in the market, it will fail and ultimately disappear. The price of a commodity is determined in the long run by the cost levels of the most efficient producers, competitors who cannot match this level of efficiency will not survive.

The work of an investor is to find companies that generate sufficient returns on invested capital and continue to do so in foreseeable future. Companies that generate returns on invested capital greater than cost of capital add value to investment.

There are only a few ways company can enjoy competitive advantage:

1. Supply advantage – access to superior production technology/privileged access to resources (weakest barrier to entry)
2. Demand advantages - due to customer preference
3. Interaction of supply and demand advantages -Economies of scale with some level of customer preference (strongest barrier to entry)

Other advantages include, patents, tariffs, direct subsidies, uotas, licenses and authorized monopolies and various kinds of regulation

Three ways to entice customers to products are:

1. Habit – Coca cola
2. Switching costs – Software
3. Search costs – Insurance

However, products could still be vulnerable like Pepsi did to Coca cola. Companies must continue to fight barriers and protect its competitive edge.

The truly durable competitive advantage arises from the linkage of economies of scale with customer captivity. Two companies could have same technology, but the company with higher market share can produce more for lower costs. As the scale of the enterprise grows, the fixed cost is spread over more units, the variable cost per unit stays the same, and the average cost per unit declines. As each company has same access to customers, customer captivity is a must to maintain dominant market share. Combination of customer aptivity with economies of scale is a powerful competitive advantage.

To know if a company has competitive advantage, one must develop an industry map that shows the structure of competition in the relevant markets. A company is said to have competitive advantage if it can maintain stable or growing market share in the niche geography it operates. If there is lots of shuffling at top and many firms fighting for share, there is no competitive advantage.

A return on capital invested above 15% and consistently maintaining this level for a decade are signs of competitive advantage. Above is the test to assess competitive advantage

Being a first mover does not always guarantee above average profits in the long run. Benefits do come from decline in variable costs with cumulative production volume. However, plants built latter are more efficient and cheaper for competitors to enter business. It is certain that success of a business would attract competition that results in diminishing returns to shrinking first mover advantage. An example of such is Philips that first entered the CD market but it’s profitability shrank as new participants entered. For Philips to have continued to make profits, it would be wiser to operate in a niche market in which it would have had the field to itself for five to seven years. During this phase, it would have earned enough returns to compensate for its initial development expense.

Defensible competitive advantages matter the most in markets which can be undermined by size and growth. Size without competitive advantage is of no use nor is differentiation a competitive advantage. Toasters are highly differentiated but no barriers to entry and many market participants erode exceptional returns. Below is the list of question to assess competitive strength of the company:

1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
3. How effective are the company’s research and development efforts in relation to its size?
4. Does the company have an above-average sales organization?
5. Does the company have a worthwhile profit margin?
6. What is the company doing to maintain or improve profit margins?
7. Does the company have outstanding executive relations?
8. How good are the company’s cost analysis and accounting controls?
9. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
10. Does the company have a short-range or long-range outlook in regard to profits?