This post was originally made on August 1, 2006 on a former blog of mine.
A couple of recent experiences have made me want to write a bit more about barriers to entry into an industry and the effect that that has on investing. I read an article yesterday, Profitless Prosperity is Tech’s Achilles Heel, which reminded me of some of my own reasons for shying away from many technology stocks. I have also spent the better part of the last month trying to get my own financial planning company set up. For those of you who have tried to jump through all the hoops necessary to get that done you know what I mean by “barrier to entry”.
I went into greater detail about my idea of a good company to invest in from a top-down perspective in Picture of the Perfect Investment. The notion of barriers to entry is a key component of that and I wanted to discuss it a bit more thoroughly.
Those of us who are long term investors and are not gaming short term trades must absolutely evaluate the competitiveness of the industry our investments play in. Quality long term investments always have a sustainable competitive advantage that they can leverage. This advantage is protected by any barriers to entry into the market. Barriers to entry prevent other companies from trying to enter the industry and take market share from the existing players. This is a crucial element in the long term success of any company.
Prior to my foray into investment management, I worked in the technology field for over 15 years. I worked for a software development company prior to starting an internet marketing business. I have seen all the latest technology fads come and go and they all have one thing in common. This is something Fleckenstein mentioned in his article. The technology companies are always competing with themselves, obsolescing their own products by creating new ones that are improved over older models. They are forced to do this because there are very few barriers to entry into the field of technology. Reverse engineering tech gear is relatively easy and consumers are very open to change and innovation in the field so they don’t really have brand attachment. My own personal experience with internet websites is a perfect example of a lack of barrier to entry. Anyone can setup a website and compete with any of my own with very little money and very little knowledge. More and more companies are making it easy for anyone to setup an online store and sell products and services. There are NO barriers to entry in this field. Any mom and pop bookstore can compete with Amazon.com if they wish. One of them may not cut into Amazon’s profit but thousands of them certainly do.
Contrast that to the field of investment advice. There are tests, and education requirements, and state registrations, and SEC/NASD registrations, and insurance requirements, and compliance issues numbering in the 100s, and many other things that would dissuade someone from simply setting up shop and beginning to compete with the other advisors. These are barriers to entry. Granted, they are not quite as thick as some industries have but they are pretty strong in the area of professional services.
My own personal investment style involves really analyzing various industries to determine just how hard it is to get into and compete with the existing players. After I have determined that the space suits my needs then and only then do I go looking for companies (or ETFs if the entire industry seems protected, i.e. medical devices) within them to invest. If you are picking your own stocks or are a serious long term investor I would advise you to really ask yourself how hard it would be to get into business and compete with a company you are interested in.
Here are some examples of industries I like and don’t like from this perspective. This is not a recommendation to buy these companies. It’s simply a reference point to let you know what types of companies I am interested in.
High Barriers to Entry:
- Transportation Services
- Waste Management Companies
- Heavy industrial Companies
- Telecom, Cable Providers
- Utilities
Low Barriers to Entry
- Anything on the Internet.
- Any other type of technology with very little branding (components, chips, etc.)
- Service businesses with very little in the way of regulation (landscaping, construction, etc.)
There are many other members of both groups. These are just some examples to give you an idea of what types of things to look for. Notice how most all of the high barrier group requires significant capital expenditure (a very large deterrent to potential competitors) while most of the low barrier group requires little, if any, capital expenditure. Money is a huge barrier for many industries. Pay close attention to that.
Good luck finding that perfect investment!
“An organization’s ability to learn, and translate that learning into action rapidly, is the ultimate competitive advantage.” -Jack Welch
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