QUALIPORT
Great Barriers To Entry

By Maynard Paton (TMFMayn)
January 29, 2004

Long-term investors must always seek companies with sustainable competitive advantages. In his book Competitive Strategy, Michael Porter outlines the 'five forces' that drive industry competition: rivalry among existing firms, the threat of new entrants, the bargaining power of suppliers, the bargaining power of buyers and the threat of substitute products or services.

Of the five, the 'threat of new entrants' is probably the most important, since it's the radical newcomer that so often upsets an industry status quo. Today's Qualiport scrutinises this particular 'force' with help of the portfolio's watch list.

Barriers to entry

Porter lists seven 'barriers to entry' that keep new entrants at bay:

1. Economies of Scale: Economies of scale refer to declines in unit costs of a product as the absolute volume per period increases. Economies of scale deter entry by forcing the entrant to come in at large scale and risk strong reaction from existing firms, or come in at small scale and accept a cost disadvantage, both undesirable operations.

This is probably the weakest of Porter's barriers, with economies of scale of use mainly to companies whose weapon is low pricing. Indeed, history has often shown smaller, leaner businesses overcoming this particular hurdle by purposely accepting 'cost disadvantages' in the hope of gaining market share. One good example is Wal-Mart (NYSE: WMT).

Within the watch list fifteen, only Carpetright (LSE: CPR) and perhaps DFS Furniture (LSE: DFS) rely heavily on price and economies of scale. Both can flex their buying power muscles in the hope of squeezing margins at rival firms.

Yet 'scale' can also provide a very useful 'network' advantage. On the London Stock Exchange (LSE: LSE) for instance, traders demand liquidity. So even though transactions may be cheaper and more efficient elsewhere, there's little point in switching exchanges if nobody's there to complete your proposed trade. A Catch-22 situation can thus develop, whereby everybody waits for everybody else to migrate to the new exchange first. There's a similar 'network' relationship between the readers and classified advertisers of Johnston Press (LSE: JPR) newspapers.

2. Product Differentiation: Product differentiation means that established firms have brand identification and customer loyalties, which stem from past advertising, customer service, product differences, or simply being first into the industry.

Not the greatest of barriers, since newcomers will inevitably try to replicate successful well-known products. That said, developing entrenched brands such as those owned by Imperial Tobacco (LSE: IMT) and Gallaher (LSE: GLH) will take a long time. In addition, Metal Bulletin (LSE: MTLB), Emap (LSE: EMA) and Johnston Press have established publications whose reputations with customers may take some time to diminish.

3. Capital Requirements: The need to invest large financial resources in order to compete creates a barrier to entry, particularly if the capital is required for risky or unrecoverable up-front advertising or research and development.

This is often an effective barrier, though can be jumped when investors are over-optimistic (e.g. the funding of telecoms, dotcoms and biotechs in the 1990s). Probably the best watch list example would be Associated British Ports (LSE: ABP). Just how much would it cost to build a brand new port, let alone match the 21 ABP operates? (For the record, ABP recorded operating assets of £800m within its latest results.)

4. Switching Costs: A barrier to entry is created by the presence of switching costs, that is, one-time costs facing the buyer of switching from one supplier's product to another's.

Many investors tend to overlook this barrier. Sadly, none of the watch list shares offer unreasonable switching costs for their customers. The clients of IT firm Sage (LSE: SGE) may suffer such charges, though. Once you've got to grips with the company's accounting and payroll package, it can be more trouble than it's worth to change to another supplier, transferring all that old data, adapting staff to the new system, etc.

5. Access to Distribution Channels: To the extent that logical distribution channels for the product have already been served by established firms, the new firm must persuade the channels through price breaks, cooperative advertising allowances and the like, which reduce profits.

This is a barrier traditionally used by large consumer goods businesses. Retailers generally take a lot of persuading to stock a new line if it means giving less shelf space to a large multinational that already supplies an array of popular, profitable products.

Games Workshop (LSE: GAW) has a distinct distribution channel advantage; it can sell its products through its own chain of dedicated stores, while the competition largely has to mix it with each other within the independent retailers.

6. Cost Disadvantages Independent of Scale: Established firms may have cost advantages not replicable by potential entrants no matter what their size and attained economies of scale. The most critical advantages and factors include proprietary product technology, favourable access to raw materials, favourable locations, government subsidies and the learning or experience curve.

This is one of the more reliable and lucrative barriers, since it tends to revolve around something unique. For instance, just how long would it take a newcomer to gain the proprietary product technology of a Renishaw (LSE: RSW) or Halma (LSE: HLMA)? And favourable locations? Consider ABP; it's already operating from some of the country's most natural seaports.

7. Government Policy: Governments can limit or even foreclose entry into industries with such controls as licensing requirements and limits to raw materials.

This is probably the best barrier of them all, since no amount of corporate innovation can break the law. For instance, commercial radio broadcasters such as Capital Radio (LSE: CAP), Scottish Radio (LSE: SRH) and Emap all require licences to broadcast. It's a similar story with television stations like Ulster Television (LSE: UTV).

ABP also benefits from (local) government and their planning decisions (newcomers can't build a rival port wherever they like). Furthermore, setting up a stock exchange requires the approval of the FSA. And the amount of legislative hurdles tobacco firms must now jump prevents many potential newcomers getting involved.

The author owns shares in Carpetright, DFS Furniture, Games Workshop, Halma, Johnston Press and London Stock Exchange.

A version of this article was first published in May 2002.