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The effects of short-term profit-seeking strategies are rippling through our economy. The damage has been destructive on a global scale. Alas, an era of near-sighted investment horizons has ended.

Every ending has a new beginning
The consequence of years of greedy, quick-profiting investment tactics has been a reminder to focus on longer-term outcomes. Astute investors know that just about any entity can be manipulated to appear profitable in the short term. In reality, however, many companies that seem to exhibit attractive growth actually lack sound financials and sustainable business models.

The recent crisis has spurred a heightened focus on the notion of "longevity." Firms must employ a sense of vision when implementing business decisions. Investors need to identify the companies that do so. Examining industry-wide competitive factors has to be part of investors' due diligence.

The five forces
Finding great companies to hold for the long run requires more than understanding a company's line of business and having the ability to read financial statements. Unlike short-term profitability, where simple supply and demand play a key role in a company's success, determining a firm's long-term profitability requires looking at industry structure and competitive forces that characterize the industry. Specifically, there are five forces that Michael Porter -- a Harvard University professor widely recognized as the father of modern business strategy -- talks about as driving profitability for firms in the long run:

  1. Threat of new entrants in the industry. Companies within industries that have high barriers to entry face weaker threats and greater pricing power. For example, telecommunication services like AT&T (NYSE: T  ) and Verizon (NYSE: VZ  ) have massive fixed infrastructure that cannot be easily created by new firms entering the industry.
  2. Threat of substitutes. Brand names are powerful, but advancing technology continuously creates cheaper substitutes that can erode brand power. Firms build a competitive advantage by employing switching costs and creating customer loyalty. (Nasdaq: AMZN  ) has remained wildly successful in the ultracompetitive e-tailing business -- where switching costs are typically nonexistent -- by creating its Prime membership that draws consumers back again and again.
  3. Bargaining power of suppliers. Firms that heavily depend on particular suppliers may face higher prices that cannot be passed onto the consumer. Microsoft's (Nasdaq: MSFT  ) near-monopoly in operating systems has squeezed profitability for PC manufacturers such as Dell (Nasdaq: DELL  ) that have to include Microsoft software on every computer they sell.
  4. Bargaining power of customers. Consumers are powerful when they have leverage to demand lower prices or higher quality from a firm. Similarly, large companies with very diverse buyers, such as Wal-Mart (NYSE: WMT  ) , are at an advantage since any one buyer is insignificant to overall sales.
  5. Rivalry among existing competitors. When competing firms use tactics such as price discounts, new product introductions, or advertising campaigns to fight each other, they limit the profitability of the overall industry. In particular, aggressive discounting simply benefits customers at the expense of all businesses within the industry.

Growth versus moat
Companies must build a competitive advantage, otherwise known as a moat, in order to create value for shareholders. Using Porter's five forces, analysts can gain a better understanding of a company's level of rivalry within its industry. Further, this big-picture approach reveals just how wide or narrow a firm's moat really is, and thus how profitable it will remain over time.

There is a natural tendency for many investors to gravitate toward fast-growing industries and companies. It is important to remember, however, that high growth does not always translate to long-term profitability.

One of the most recent growth-chasing blunders was Crocs (NYSE: CROX  ) . After rising over five-fold from its IPO price to around $75 in October 2007, the stock now sells for just over $1. In its heyday, the company reported strong growth quarter after quarter. However, Crocs faced intense forces within its industry that prevented it from sustaining attractive returns on investment. Investors who analyzed Crocs with Porter's five forces could have predicted this result.

A necessary shift
I believe that the investment community as a whole must begin to shift from focusing on meeting near-term "street expectations" toward concentrating on factors that create true economic value. Even if this practice doesn't become universal, though, investors who do choose to include industry analysis in their due diligence of a firm's competitive advantage will find truly great companies worth holding onto for a lifetime.

Dell, Wal-Mart, and Microsoft are Inside Value recommendations. is a Stock Advisor pick. Try any service free for 30 days.

Kristin Graham does not own shares of any of the companies mentioned in this article. The Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (15)

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  • Report this Comment On March 30, 2009, at 11:45 AM, madmilker wrote:

    it ain't gonna be the company with tat STAR in the name.....maybe when it had the hyphen but not now with tat STAR.

    People in America need to realize jus what got America in this shape…”cheap” yes so-call cheap items from a foreign land.

    quote*Wal-Mart firmly believes in local procurement. We recognize that by purchasing quality products, we can generate more job opportunities, support local manufacturing and boost economic development. Over 95% of the merchandise in our stores in China is sourced locally. We have established partnerships with nearly 20,000 suppliers in China. *end quote!

    Now! if there be 182 country’s making items for the world to buy and they have only 5% of the pie in China…duh! This company makes the nice people of China support their currency(yuan) by keeping it in their country working for the people there…. but with the “yuan” going up in value and the US dollar going down…all the foreign items that the American consumer buys thinking it is cheap has went up in price.

    People…its all about the currency and to keep a currency strong you got to keep it floating around the country you live in so it can work for you. For the past 12 years all them US dollars are being shipped overseas to a foreign bank and with the American worker not making anything for the foreigner to buy the “we the people” have to turn to the “second” largest employer in America(Uncle Sam) to sell “we the people” debt in order to get all them dollars back!

    50 years ago a foreigner would had given their left nut for a US dollar or a Hershey’s chocolate bar and today the same foreigner has got Uncle Sam and the American consumer by both all the while Hershey is moving the chocolate factory to Mexico. Wake up! America and think “MADE IN AMERICA.”

  • Report this Comment On March 31, 2009, at 8:05 AM, eCompetitors wrote:

    Excellent article, thank you. I agree completely on the use of Michael E. Porter's five forces industry methodology to better understand the environment and long-term prospects that a company faces.

    One added complexity is that a company typically competes in more than one industry.

    In our analysis, Global 1,000 companies competes, on average, in 52 industries (lines of business) at the level suitable for a five forces analysis. Companies like Microsoft and Dell that you mention, and other global IT companies like IBM, HP and EMC each compete in over 100 industries. (For example, a PC, a blade server, and a mainframe - each represent different industries.)


    Alan S. Michaels, president, eCompetitors Inc

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