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:
- 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.
- 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. Amazon.com (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.
- 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.
- 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.
- 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.
