This is the fourteenth Course in a series of 38 called "Investment Basics" - created by Professor Steven Bauer, a retired university professor and still active asset manager and consultant / mentor.

Course 206 - More on Competitive Positioning

Introduction

In the previous Course, we reviewed the different types of defenses (economic moats) and offered examples of wide-moat firms. Understanding moats, and determining whether or not a firm has a moat is a tricky process. In this Course we'll examine the mental model that underpins our moat framework and explore some of the nuances of wide moats, narrow moats, and deep moats.

Porter's Five Forces

Michael E. Porter's Competitive Strategy, originally published in 1980, is a definitive work on industry competition. In the book, the Harvard professor provides a framework for understanding competitor behavior and a firm's strategic positioning in its industry. Much of Porter's framework should be familiar as it underpins our thinking about economic moats.

In essence, Porter provided a framework of five forces that can be used to understand an industry's structure. Since firms strive for competitive advantage, the first four forces at work help to assess the fifth, an industry's level of rivalry:

• Barriers to Entry. How easy is it for new firms to start competing in a market? Higher barriers are better.

• Buyer (Customer) Power. Similar to switching costs, what keeps customers locked in or causes them to jump ship if prices were to increase? Lower power is better.

• Supplier Power. How well can a company control the costs of its goods and services? Lower power is better.

• Threat of Substitutes. A company may be the best widget maker, but what if widgets will soon become obsolete? Also, are there cheaper or better alternatives?

• Degree of Rivalry. Including the four factors above, just how competitive is a company's industry? Are companies beating one another bloody over every last dollar? How often are moats trying to be breached and profits being stolen away?

Porter's five forces considered together can help you to determine whether a firm has an economic moat. The framework is particularly useful for examining a firm's external competitive environment. After all, if a company's competitors are weak, it may not take much of a moat to keep them at bay. Likewise, if a company is in a cutthroat industry, it may require a much wider moat to defend its profits.

Prof's. Guidance: I spend a lot of time on the "competitive advantage" aspect of investing wisely. With the thousands of companies to choose from - please think - why would you gamble in a gimmick or fad when there are excellent companies to invest your hard earned money - into?

A Five Forces Example: Consumer Products

The five forces concept is perhaps best explained through example. (Porter's work is nothing short of excellent, but it is a heavy read.) Let's briefly examine the household consumer-products industry by considering rival firms Clorox (CLX), Kimberly-Clark (KMB), Colgate-Palmolive (CL), and Procter & Gamble (PG) in terms of Porter's five forces:

Buyer Power. Consumer-products companies face weak buyer power because customers are fragmented and have little influence on price or product. But if we consider the buyers of consumer products to be retailers rather than individuals, then these firms face very strong buyer power. Retailers like Wal-Mart (WMT) are able to negotiate for pricing with companies like Clorox because they purchase and sell so much of Clorox's products. Verdict: Strong buyer power from retailers.

Supplier Power. More than likely, consumer-products companies face some amount of supplier power simply because of the costs they incur when switching suppliers. On the other hand, suppliers that do a large amount of business with these companies -- supplying Kimberly-Clark with raw materials for its diapers, for instance -- also are somewhat beholden to their customers, like Kimberly-Clark. Nevertheless, bargaining power for both the firms and their suppliers is probably limited. Verdict: Limited supplier power.

Threat of New Entrants. Given the amount of capital investment needed to enter certain segments in household consumer products, such as manufacturing deodorants, we suspect the threat of new entrants is fairly low in the industry. In some segments within the household consumer-products industry, this may not be the case since a small manufacturer could develop a superior product, such as a detergent, and compete with Procter & Gamble. The test is whether the small manufacturer can get its products on the shelves of the same retailers as its much larger rivals. Verdict: Low threat of new entrants.

Threat of Substitutes. Within the consumer-products industry, brands succeed in helping to build a competitive advantage, but even the pricing power of brands can be eroded with substitutes such as store-branded private-label offerings. In fact, some of these same store-brand private-label products are manufactured by the large consumer-products firms. The firms believe that if they can manufacture and package a lower-price alternative themselves, they would rather accept the marginal revenue from their lower-priced items than risk completely losing the sale to a private-label competitor. Verdict: High threat of substitutes.

Degree of Rivalry. Consumers in this category enjoy a multitude of choices for everything from cleaning products to bath washes. While many consumers prefer certain brands, switching costs in this industry are quite low. It does not cost anything for a consumer to buy one brand of shampoo instead of another. This, along with a variety of other factors, including the forces we've already examined, makes the industry quite competitive. Verdict: High degree of rivalry.

Prof's. Guidance: Examining an industry through the framework of Porter's five forces helps illustrate the different dynamics at work. It's not always clear-cut, either, so one wouldn't expect all of the firms in this industry to fall into one big bucket labeled wide moat or narrow moat. Instead, there are firms with distinct, long-term advantages and wide moats, like Procter & Gamble and Colgate, while others have advantages that we think may be less sustainable, such as Clorox and Kimberly-Clark.

Getting Back to Moats

Porter's framework makes scouring an industry for great investment ideas much easier. Understanding an industry helps us find the great businesses with economic moats that will withstand the inevitable economic, competitive, and random other challenges that often cripple weaker businesses.

Once we have a collection of great businesses from which to choose, finding those that meet our criteria and deliver above-average returns on invested capital over the long term becomes even easier. (I will discuss returns on invested capital more in Course 305.)

Prof's. Guidance: Generally speaking, we believe investors should steer clear of companies that have no moat because they have very few, if any, competitive advantages and can't keep rivals from eating away at their profits. Some people are shrewd enough to buy no-moat stocks on a dip, hold them for a short term, and make a profit. As long-term investors this isn't a game we like to play. We think the rewards are far better, and the risks much lower, for those who spend a little effort to find strong companies to hold for a long time.

Types of Narrow Moats

There are certainly gradations of moat width, with milder competitive advantages as having "narrow" moats. Far more companies have narrow moats than wide ones. Clearly narrow-moat firms are, on average, of a much higher quality than no-moat companies. Generally, narrow-moat companies generate lower returns on invested capital than wide-moat companies but still have returns slightly above their cost of capital. (I will talk about return on invested capital and cost of capital extensively in coming Courses.) Narrow-moat companies typically come in two varieties:

Firms with Eroding Moats. These companies have competitive advantages, but they are eroding due to a shifting industry landscape. This scenario is faced by some of the consumer-products companies, like those we just examined. For example, we consider both General Mills (GIS) and Kellogg (K) to be narrow-moat firms. The pricing power they once enjoyed is eroding as a result of increased competition and an ever-consolidating retail landscape that is increasing buyer power. The Baby Bells, such as AT&T (T) and Verizon (VZ), are another example; their economic moats are also slowly eroding. In future years, they won't enjoy the monopoly pricing power they once did because of the increased use of wireless phones and, of course, the Internet.

Firms with Structural Industry Challenges. A company in this category dominates its peers, but resides in an industry where wide moats are nearly impossible to create. For example, Waste Management (WMI) has a solid position in the waste services industry. The trash taker is the largest operator of landfills in the country, a position that is nearly impossible to replicate due to political and citizens' group opposition. Such barriers to entry in waste disposal are augmented by regional scale and route density on the collection side of its business, which makes life difficult for local independent haulers. This competitive position allows it to garner real pricing increases, which help to mitigate rising diesel fuel prices and cyclical declines in waste volume.

Wide Moats

All things equal, it is perhaps wiser to choose a wide-moat company over one with a narrow-moat rating for the significant competitive advantages that should enable the wide-moat firm to earn more than its cost of capital for many years to come.

Most wide-moat companies have some sort of structural advantage versus competitors. By "structural," I mean a fundamental advantage in the company's business model that wouldn't go away even if the current management team did. With a structural advantage, a company isn't dependent on having a great management team to remain profitable.

To paraphrase Peter Lynch, these are companies that could turn a profit even with a monkey running them, and it's a good thing, because at some point that may happen.

I hate to sound like a broken record here, but the four types of moats that we identified in the previous lesson are incredibly useful when thinking about structural advantages a company may or may not possess. Keep the four types of moats in mind:

• Low-Cost Producer or Economies of Scale
• High Switching Costs
• Network Effect
• Intangible Assets

Wide Moats Versus Deep Moats

With the concept of a wide moat firmly in place, it's also important to realize that the width of a firm's moat, or how broad and numerous its competitive advantages are, matters more than the moat's depth, or how impressive any individual advantage is. Discerning between width and depth can be difficult, however.

First, it's absolutely critical to understand not only what an economic moat is, but also how it translates to above-average returns on capital. Many investors easily surmise the first point about moats -- that a competitive advantage is required -- but they miss the importance of the second point, above-average returns. If the business doesn't throw off attractive returns, then who cares if it has a competitive advantage? Autos and airlines are two businesses with some barriers to entry, but few new competitors are trying to crash the party in a race for single-digit ROEs (Return on Equity) or bankruptcy.

Over the years, Warren Buffett has frequently referred to his desire to widen the moats of his companies, but it's rare to see him refer to a moat's depth. Buffett's frequent talk of moat width -- and silence on moat depth -- speaks volumes. Michael E. Porter has said, "Positions built on systems of activities are far more sustainable than those built on individual activities."

Unfortunately, no company is going to tell you if it has a moat, much less whether that moat is of the wide or deep variety. If a firm has a competitive advantage, it behooves it to not tell you how its moat has been built. After all, you just might emulate it.

Still, it can be worth investors' time to ponder whether the stocks they're invested in have one really fantastic competitive advantage that, while deep, may lack width, or if they're invested in firms with a series of advantages that can sustain above-average returns on capital over the long haul.

Consider well-run (lately - not so well run) giant conglomerates like General Electric (GE) or Citigroup ©. Finance theory tells us that these decades-old firms should have seen their returns on capital dribble down to their cost of capital ages ago due to rivals competing away the excess returns. (We'll talk much more about returns on capital and cost of capital in coming lessons.) Yet, Citigroup's ROEs are still in the upper teens even in a bad year.

Why haven't competitors captured these profits? Quite simply, these firms are pretty good at an awful lot of things. If Citigroup is hobbled by problems in its private banking unit or regulatory scandals on its trading desks, it can rely on its impressive credit card operations and retail banking business to carry the day. At GE, if new competition from cable hurts the NBC network or its insurance division posts lackluster returns, it can rely on a cadre of numerous other good businesses to pick up the slack. Like stacked plywood, each of these businesses is strong in its own right, but virtually indestructible together.

The Bottom Line

This and the preceding Course have covered a lot of material about moats and the qualitative aspects of a company's positioning. Though this step in identifying attractive companies for investment is an important one, it is only the first step. In coming Courses, I will show you how to quantitatively confirm that a company has a moat, as well as show you how to value stocks so that you don't blindly pay too much for a quality company.

Thanks for attending class this week - and - don't put off doing some extra homework (using Google - for information and answers to your questions) and perhaps sharing with the Prof. your questions and concerns.

Investment Basics (a 38 Week - Comprehensive Course)
By: Professor Steven Bauer

Text: Google has the answers to most all of your questions, after exploring Google if you still have thoughts or questions my Email is open 24/7.

Each week you will receive your Course Materials. There will be two kinds of highlights: a) Prof's Guidance, and b) Italic within the text material. You should consider printing the Course Materials and making notes of those areas of questions and perhaps the highlights and go to Google to see what is available to supplement those highlights. I'm here to help.

Freshman Year

Course 101 - Stock Versus Other Investments
Course 102 - The Magic of Compounding
Course 103 - Investing for the Long Run
Course 104 - What Matters & What Doesn't
Course 105 - The Purpose of a Company
Course 106 - Gathering Information
Course 107 - Introduction to Financial Statements
Course 108 - Learn the Lingo & Some Basic Ratios

Sophomore Year

Course 201 - Stocks & Taxes
Course 202 - Using Financial Services Wisely
Course 203 - Understanding the News
Course 204 - Start Thinking Like an Analyst
Course 205 - Economic Moats
Course 206 - More on Competitive Positioning
Course 207 - Weighting Management Quality

Junor Year

Course 301 - The Income Statement
Course 302 - The Balance Sheet
Course 303 - The Statement of Cash Flows
Course 304 - Interpreting the Numbers
Course 305 - Quantifying Competitive Advantages

Senor Year

Course 401 - Understanding Value
Course 402 - Using Ratios and Multiples
Course 403 - Introduction to Discounted Cash Flow
Course 404 - Putting OCF into Action
Course 405 - The Fat-Pitch Strategy
Course 406 - Using Morningstar as a Reference
Course 407 - Psychology and Investing
Course 408 - The Case for Dividends
Course 409 - The Dividend Drill

Graduate School

Course 501 - Constructing a Portfolio
Course 502 - Introduction to Options
Course 503 - Unconventional Equities
Course 504 - Wise Analysts: Benjamin Graham
Course 505 - Wise Analysts: Philip Fisher
Course 506 - Wise Analysts: Warren Buffett
Course 507 - Wise Analysts: Peter Lynch
Course 508 - Wise Analysts: Others
Course 509 - 20 Stock & Investing Tips

This Completes the List of Courses.

Wishing you a wonderful learning experience and the continued desire to grow your knowledge. Education is an essential part of living wisely and the experiences of life, I hope you make it fun.

Learning how to consistently profit in the Stock Market, in good times and in not so good times requires time and unfortunately mistakes which are called losses. Why not be profitable while you are learning? Let me know if I can help.