Video Under Production

Competition: The Battleground of Growth

Course Section 1 - Lesson 5

Business owners always want their companies to grow. Growth, as we learned in the last lesson, is valuable. But if every business is looking to grow, then surely these organizations will eventually collide with one another, right?

Right.

This collision between the interests of two or three or hundreds of businesses is where competition comes in. As investors, it's essential to understand the competitive landscape for the businesses we consider investing in. Seeking this understanding will allow us to better gauge the true potential for growth that our investments hold.

Classifying Competition

The first thing we should try to understand is how much control a company has over the price of its products. Your first thought may be: "A company has absolute control over the price of their products - they can charge whatever they want." But that's not true, at least not if a company wants to make sales. A long time ago, economists came up with a classification structure that simplifies answering that question. Firms are classified based on the number of competitors are in their market and how differentiated their products are from one another.

The four classifications are Pure Competition, Monopolistic Competition, Oligopoly, and Monopoly. You can see each category plotted on the chart below.

Companies classified in the pure competition bucket have no control over the price they sell their products. Farmers fall into this bucket, one farmer's wheat is the same as another farmer's, and thousands of farmers are competing to sell their wheat. They have no choice but to accept whatever the current market price of grain is.

On the other side of the chart are monopolies. An example of a Monopoly is the diamond company De Beers in the 1900s. They owned the only diamond mine in the world. If someone wanted a diamond, they had no choice but to pay whatever De Beers was asking. 

In between the two extremes are Monopolistic Competition and Oligopolies. Monopolisticly competitive companies sell differentiated products into a market with many different but competing products - think Apple's iPhone and the cell phone market. On the other hand, oligopolies are composed of a few companies selling very similar products, much like how just a handful of major corporations control nearly all of the US mass media market.

As investors, we prefer our investments to have as much control as possible over the prices they charge their customers. While monopolies are often viewed with disdain in the media, they can make desirable investments when they exist. By the same token, companies that operate inside of a purely competitive market are subject to market conditions that may threaten to put them out of business.  

Competition Over Time

In addition to understanding how the structure of markets affects competition, it's also important to understand how competition at the industry level evolves through time. The image below depicts an idea commonly referred to as the "Industry Life Cycle."

This image plots the total sales of an industry through time and attempts to label at which stage of its life the industry currently exists. When you're interested in investing in a company, it's helpful to try to identify which stage of the industry life cycle the company is operating in. Doing so will help you to set expectations around how quickly the industry as a whole will grow, how stiff competition will be, and how the company you're evaluating will be engaging with competitors.

Early in the industry life cycle, direct competition tends to be low. Instead of directly confronting one another, it is usually far more profitable for companies to move into new markets as quickly as possible and capture new customers who are not being served.  

As the industry matures and new customers become harder to find, companies will begin to compete more directly. As competition intensifies, individual companies will try to set themselves apart through either the quality of their product (which will increase production costs) or price (which will reduce the income per unit sold). Both of these levers reduce total profit, and we begin to see industry-wide profit margins contract.  

Incorporating Competitive Analysis into your Process

Understanding competition at a high level is a fundamental tool for assessing an industry in the early stages of your analysis. By simply answering two questions:

  • How would my target company's market be classified? (i.e., Pure Competition, Monopolistic Competition, Oligopoly, or Monopoly)

  • In what stage of the industry life is my target company's industry in?

You can gain a reasonably solid grasp of how difficult growth will be to generate and how profitable companies will be inside a given market.

Mark Complete