1. Stock market investing: What is competive advantage? 5 things you must know

Stock market investing: What is competive advantage? 5 things you must know

Competitive Advantage Period (CAP) is the time during which a firm generates returns on investment that exceed its cost of capital.

Published: December 15, 2017 2:20 AM
Competitive Advantage Period, CAP, Inter firm rivalry, Stock market Competitive Advantage Period (CAP) is the time during which a firm generates returns on investment that exceed its cost of capital. (Representative Image: IE)

Competitive Advantage Period (CAP) is the time during which a firm generates returns on investment that exceed its cost of capital. If it earns above-average return on its invested capital, it will attract competitors who will be willing to operate at lower returns, eventually driving down overall industry returns to economic cost of capital, and sometimes even below it. In effect, CAP is a measure of longevity of a firm’s Moat.

Factors determining CAP

There are two major factors which determine CAP—attractiveness of an industry’s structure and effectiveness of a firm’s own strategy. The ‘Five Forces’ framework of Michael Porter is ideal to assess the attractiveness of industry structure.  Porter’s Five Forces

Force #1 – Inter-firm rivalry

Implication: This lies at the core of the industry structure analysis. Higher the rivalry among incumbents, lower the industry attractiveness and vice-versa. Examples: The Indian telecom sector is a huge growth opportunity and currently has just three major players. Yet, the rivalry between them is so intense that the players’ profits are on a declining trend. In contrast, the Indian mortgage sector also is a huge growth opportunity but with a very large number of players. Yet, the benign rivalry between them ensures that sector profit growth remains healthy.

Force #2: Threat of new entrants

Implication: The threat of new entrants compels incumbents to operate at low profitability as a strategy to ward them off. Examples: Realty sector is constantly under threat of new entrants, hurting profits of incumbents. In contrast, distribution-intensive sectors like paints are unlikely to see new entrants, implying steady growth in profits.

Force #3: Threat of substitute products or services

Implication: Like the threat of new entrants, the threat of substitutes also compels incumbents to operate at low profitability. However, this is relatively rare. Examples: Print media and TV sectors are being substituted by the internet. Likewise, within  two-wheelers, scooters are substituting  motorcycles in India.

Force #4: Bargaining power of  customers

Implication: Higher the bargaining power of customers, lower the sector attractiveness. If the customers are large and concentrated, their bargaining power tends to be high, whereas fragmented customers tend to have lower bargaining power. High brand pull and high switching costs also imply lower bargaining power of customers. Examples: Auto ancillaries supply to large OEMs and have low profit margins. In contrast, the auto makers supply branded products to a large number of retail customers, and have superior margins.

Force #5: Bargaining power of suppliers

Implication: Higher the bargaining power of suppliers, lower the sector attractiveness. If suppliers are large and concentrated, their bargaining power tends to be high. Examples: The packaging sector buys its raw materials from large suppliers. Hence, sector profit margins are low. In contrast, cigarette sector buys tobacco from a large number of growers who have low bargaining power. Hence profit margins are high.

Corporate strategy

Corporate strategy is the second determinant of CAP. Strategy is all about maintaining or improving the firm’s competitive advantage vis-à-vis rivals. Companies with a sound strategy are likely to enjoy extended CAP and vice versa. According to Michael Porter, there are three broad strategies—differentiation, low cost, and focus.

Differentiation

A differentiated strategy is all about offering customers a unique value proposition which is not easy to replicate by competition. This leads to customer loyalty, ensuring sales and profits. Most consumer-facing companies follow a strategy of differentiation. Be it products like toothpaste, cola and biscuits, or even services like restaurants, banks and airlines, companies aspire to offer a unique product/service/experience to customers to retain their loyalty.

Low cost

In sectors where customers are unable to differentiate between products/services  offered by the various players, having the lowest cost compared to peers is the only way to sustain competitive advantage. Example: Commodity products like steel, cement and paper are undifferentiated in the eyes of the customer. Hence, companies in these sectors will need to aspire to be the lowest cost  producer in order to maintain or gain  market share.

Extracted from 22nd Annual Wealth  Creation Study by Motilal Oswal

Get latest news and updates on Auto Expo 2018, check breaking news on Budget 2018, like us on Facebook and follow us on Twitter.

  1. No Comments.

Go to Top