Ask the Rational Investor: Assessing Stocks' Competitive Strategy
Perhaps you’ve undergone strategic planning at your workplace, company, or a local non-profit board and experienced a SWOT, or Strengths, Weaknesses, Opportunities, and Threats analysis. Often participants in these meetings debate the long-term vision of their organization and how they will achieve their goals. An alternative to the SWOT that we prefer is from famed management consultant and Harvard Business School professor Michael Porter.
Porter’s Five Forces of Competitive Position Analysis were developed in the late 1970s. The concept is simple to understand and has gained great credibility over the resulting decades. The five forces can be summarized as follows:
Competition in the industry,
Potential of new entrants into the industry,
Power of Suppliers,
Power of Customers, and
Threat of substitutes.
As stock investors, assessing a company’s strategic plan and priorities are important to understanding how management and the board of directors will allocate free cash flow. Management can allocate cash flow in five ways: reinvestment in the business (such as research and development), building new facilities and general strategic capital expenditures, paying a dividend, repurchasing stock, paying down debt, or mergers and acquisitions.
Value-conscious investors generally focus on more predictable forms of capital allocation, such as a growing dividend, high return reinvestment opportunities, and share repurchases.
Astute investors can work through the five forces of a company after thorough research and quickly assess what risks and opportunities exist.
Let’s walk through an example, such as Mastercard Incorporated. Mastercard, over many decades, has built a network of banks and merchants globally that accept Mastercard as payment. All parties must have full faith in the Mastercard network and that transactions will be processed quickly, accurately, and widely across multiple merchants and countries, without fraud.
Given these rigid criteria, the industry naturally consolidated over decades to Visa and Mastercard. Discover and American Express now offer their own networks and are mostly accepted everywhere, but do you remember 10-15 years ago when they weren’t?
Mastercard’s competitive advantage is clear. Their global network is unique, widely accepted, and reliable. These factors have resulted in outstanding net profitability of almost 46% of revenue versus 12% for the S&P 500 in 2021.
In Economics 101 we learn that if an industry is highly profitable it will attract competition. With the emergence of bitcoin and other decentralized finance applications, many investors wondered if Visa and Mastercard would be disrupted in 2020 and 2021.
One of the risks to a highly profitable company, and number 2 on Porter’s Five Forces, is industry disruptors. Concerns relating to industry disruption by cryptocurrencies and lingering headwinds from Covid on international cross-border transactions presented a great opportunity to purchase shares of Mastercard in 2020-2021 if you felt these threats and concerns were exaggerated.
Sources: Company reports, FactSet, Harvard Business School
Beese Fulmer Private Wealth Management was founded in 1980 and is one of Stark County’s oldest and largest investment management firms. The company serves high-net-worth individuals, families, and non-profits, and has been ranked as one of the largest money managers in Northeast Ohio.