Five threats to a company's profits

Investing isn't just about numbers. More than 30 years ago, Harvard professor Michael E Porter devised the following 'five forces' framework of industry profitability. Combined, they signal the size of what Warren Buffett once called a firm's "economic moat". The deeper the moat, the stronger the firm and the more likely it is that profits can be sustained. Here are the five forces that influence the strength of a firm's moat.

1. Barriers to entry

High profits attract competition. If it is difficult for competitors to enter a market, then profits can stay high for incumbents. These companies have a competitive advantage. But how are barriers to entry created? Here are five examples:

Economies of scale. Being big gives incumbents a cost advantage in production, purchasing, distribution and advertising. For example, Tesco's scale gives it immense buying power, which means that it can offer prices that could be unprofitable for new entrants.

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High capital requirements. Does it cost a lot of money to enter the industry?

Unique licences. TV broadcast rights or train franchises give some companies a monopoly for a period of time.

Patents. In pharmaceuticals, for example, patents make life difficult for competitors.

Captive customers. Branded cigarettes or soft drinks attract loyal customers. For software firms, retraining costs and the threat of business disruption can be high. In engineering firms, the makers of original equipment may sell at cost or less as they often have a captive customer base in spare parts and servicing, where they can make very high profits.

If you find a firm or industry with these characteristics, ask yourself whether such advantages are sustainable and what is being done to preserve or enhance them. You only have to look at once dominant firms, such as Kodak, Xerox or IBM, to see how the competitive edge can be lost.

2. Strong suppliers

Does the company/industry have powerful suppliers that increase costs and depress profits? A classic example of a powerful supplier is labour. Just look at the damage inflicted by unionised labour on the airline and car industries. Another example is the leverage that, say, iron-ore suppliers have over their steel customers, or the power that Microsoft has over PC makers. Companies with powerful suppliers rarely make good investments.

3. Strong buyers

Try to avoid investing in companies that sell to powerful buyers. These buyers may be able to use their scale to limit the profitability of their suppliers. Asking for regular price reductions or threatening to change suppliers are common indicators. Suppliers to supermarkets and car makers, for example, usually suffer limited pricing power and low levels of profitability.

4. Product competition

A substitute product or service that performs the same or similar function as a company's existing product can hurt sales. Generic drugs can destroy the market for branded ones, for example, and mobile phones can damage fixed-line services. Identifying substitutes isn't always easy, but if it doesn't cost the consumer too much money or time to switch, they may have a very rapid affect on a firm's profitability.

5. Price wars

Where the degree of industry rivalry is high, profitability tends to be low. A price war, for example, can decimate profits as has been seen in sectors such as airlines and retailing. So the onus is on industry participants not to break rank and start a price war in which all participants tend to suffer. However, if firms can differentiate themselves on the basis of quality and service, then the consequences of rivalry can be more benign for investors.

Six quick tests for the size of a firm's moat

Investors can use the following six pieces of information from a set of accounts to test the size of a firm's economic moat, based on Michael Porter's 'five forces' framework (see above).

1. Management commentaries often give useful insights into changes in industry conditions (such as new entrants or altered market share). Also read the annual reports of competitors.

2. Look for companies with high return on capital employed over five to ten years. This is a good indicator of competitive strength, and is usually based on high barriers to entry.

3. Rising research and development costs, or advertising costs (as a percentage of sales), may also be a sign of increasing barriers to rising competition.

4. Check labour costs as a proportion of total costs. A high number may be a sign of potential supplier power particularly if the labour force is unionised.

5. Creditor days tell you how quickly a firm pays suppliers. If the days are increasing, it may reflect a firm's increasing buying power. A decrease suggests the reverse.

6. Debtor days how quickly does a company get paid? A rise can suggest customers have the upper hand.

This article was originally published in MoneyWeek magazine issue number 532 on 8 April 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.