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There are forces that drive the greatest companies in the world, forces that make them better than their competitors. Understanding how these forces work can make you a better investor and send you on your way to beating the market.
In 1979, Michael Porter came up with one of the few concepts I still use from business school: Porter's five forces. Below I'll outline what they are and how to spot a business that can stand the test of time.
Power of suppliers can bring you down
The bargaining power of suppliers is one of the places I like to start when looking at a company's competitive position. Suppliers play a key role in any business, but a supplier with too much power can bring your business down and make it less attractive to investors.
Look at the computer business as the PC grew. Companies like Dell, Hewlett-Packard, and IBM were dependent on Intel and Microsoft for chips and software, with few other places to turn. The power of these suppliers kept margins thin and forced PC makers to perfect their supply chains to stay ahead instead of negotiating better pricing with suppliers. That's one of the reasons HP considered exiting the PC business.
A business with many suppliers gives a company more options and room to negotiate, reducing supplier power. So look at whether a company is buying commodities from multiple sources or dependent on one supplier for its products.
Customers that don't want to pay
Bargaining power of customers is the second force that we're going to consider, and it can be the hardest to identify. This can be looked at in multiple ways -- for example, the concentration of sales to one customer, switching cost of the customer relative to the switching cost to a new customer, or buyer price sensitivity.
This force crushed American Superconductor (Nasdaq: AMSC ) in 2011 and nearly brought the company to its knees. The company relied too heavily on one customer, Sinovel, for its sales, and when Sinovel started refusing shipments -- allegedly after using American Superconductor's intellectual property illegally -- American Superconductor found itself in a tough spot.
This is probably the hardest force to analyze because there are many nuances that companies face when dealing with customers. To put it simply, put yourself in the place of a sales person for the company you're analyzing and ask how much power you would have at the negotiating table. If the customer said no to your price, would you drop to your knees and beg for a sale or head for the next place, which will pay what you want?
The threat of substitutes
Companies have to worry about substitutes being used in place of their products. If we go back to our computer example, Apple could be viewed as a substitute for Microsoft on the operating-system front, as well as a computer substitute for Dell and HP products.
Another simple example can be shopping at the grocery store. I may choose to substitute orange juice for my normal milk purchase if the cost of milk goes up.
Companies with strong, sustainable businesses find ways to lower the threats substitutes provide, sometimes by making it costly for customers to switch to new products.
Everyone's worried about the new guy
New entrants are the fourth force that drives business. Some of the world's most successful businesses try to negate this threat by obsoleting their own products so someone else doesn't do it first. Apple created the iPad to preemptively strike against others creating a product that could have replaced Macs.
An easy example is the evolution bookstores have gone through over the past 30 years. I used to go to a small local bookstore for books, but new mega stores by Barnes & Noble (NYSE: BKS ) made those stores nearly irrelevant. Fast-forward to today, and Barnes & Noble is in trouble because Amazon.com (Nasdaq: AMZN ) has threatened its business with a new type of competition. Had Barnes & Noble had the foresight to push the online shopping category before Amazon, it could have eliminated this new threat.
Are rivalries good for business?
Sometimes business rivalries are friendlier than they are fierce. Pepsi (NYSE: PEP ) and Coca-Cola (NYSE: KO ) are rivals, but they hold a virtual duopoly in the sugar-water business, and there's a place for both companies in the huge industry. Companies in similar situations often don't try to undercut each other too much in search of market share. It's more of a wink-wink, nudge-nudge rivalry, as both companies keep prices high enough to enjoy fantastic margins and remain big enough businesses to keep competitors out.
As an example of a fierce rivalry, the solar business is experiencing intense competition right now as too many companies fight for a limited number of sales. Companies have been forces to lower prices in search of sales, leading to lower and lower margins and the bankruptcy of some competitors.
Foolish bottom line
Understanding how a business fits into the overall competitive landscape is important in deciding whether to buy a stock or not. Laying out how these five forces impact a company can be the first step in laying out that landscape. Next time you're considering buying a stock, try doing a five-forces analysis and see how it impacts your thinking.
For three stocks that have the ability to fight off these forces, check out our free report, "3 Stocks That Will Help You Retire Rich."