At Delaware Investments, fundamental research is our calling card. But what does that entail exactly? In an effort to better educate our investors about various aspects of the fundamental research process, we present the first in a series of articles concerning Porter's Five Forces. An explanation of Porter's Five Forces and how they may be used to analyze industries or companies for potential investment, are set forth in Michael Porter's groundbreaking book, Competitive Strategy: Techniques for Analyzing Industries and Competitors (The Free Press, 1980).
Created by Harvard professor Michael Porter, "Porter's Five Forces" is considered a framework for analyzing an industry's structure as well as its relative attractiveness for investment in relation to other industries. The five forces — barriers to entry, supplier power, buyer power, threat of substitutes, and rivalry among existing firms — shape every industry and every market. They determine the intensity of competition, and hence the potential profitability and attractiveness of an industry. This article focuses on the first of the Five Forces: barriers to entry.
Identifying barriers to entry can help investors determine a company's competitive position within an industry, its ability to withstand economic turbulence, and, to a large extent, its profitability. Of course, barriers to entry are only one perspective on a company's competitive landscape. Professional investors often rely on all elements of Porter's Five Forces to develop a comprehensive understanding of a given industry.
At Delaware Investments, our investment teams either use the Five Forces as part of their fundamental research or employ its general concepts in analyzing the market landscape and identifying companies with a competitive advantage.
Barriers to entry are circumstances particular to an industry that create disadvantages for new competitors attempting to enter the market. Some of these barriers include capital requirements, market share, economy of scale, strategic alliances, and intellectual-property protection. In essence, anything deterring competitors from entering the market is considered a barrier to entry.
Not surprisingly, barriers to exit can also prevent companies from entering an industry. These are obstacles, such as supplier contracts with high termination penalties, which may impose excessive costs for leaving a market and may prohibit a firm from doing so.
Barriers to entry benefit existing companies in an industry by protecting their revenue stream and profits from being whittled away by new competitors. In other words, the higher the barriers to entry, the more power incumbents wield, and the more prone an industry is to monopolistic or oligopolistic conditions. The reverse is also true. The lower the barriers the more likely a market is to achieve "perfect competition" (that is, become a market in which there are many small firms, all producing the same type of product or service).
The auto industry is an example of an industry with high barriers to entry. Large capital investment in manufacturing equipment, compliance with safety and emission rules and regulations, access to parts suppliers, and development of a network of car dealerships are just a few barriers that make it extremely difficult for a new competitor to enter the auto manufacturing industry.
E-retailing is an example of an industry with low barriers to entry. Sellers on eBay, for instance, operate in a market where anyone can sell a product (provided they have some knowledge of computers and the internet) and many products are homogenous.
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