Down Debt

Ask the Rational Investor: Assessing the Competitive Strategy of Stocks

Ryan T. Fulmer

Perhaps you have undergone strategic planning at your workplace, business, or a local non-profit and experienced SWOT board – an analysis of strengths, weaknesses, opportunities and challenges. threat.

Often, participants in these meetings debate the long-term vision of their organization and how they will achieve their goals. A favorite alternative to SWOT is that of renowned management consultant and Harvard Business School professor Michael Porter.

Porter’s Five Forces of Competitive Position Analysis was developed in the late 1970s. The concept is simple to understand and has gained great credibility over the ensuing decades. The five forces can be summarized as follows:

1. Competition in the industry.

2. Potential for new entrants into the industry.

3. Power of Suppliers.

4. Customer power.

5. Threat of substitutes.

As equity investors, it is important to assess a company’s strategic plan and priorities to understand how management and the board will allocate free cash flow. Management can allocate cash flow in five ways: reinvestment in the business (such as research and development), construction of new facilities and general strategic capital expenditures, payment of a dividend, share buyback, reimbursement debt or mergers and acquisitions.

Value-conscious investors typically focus on more predictable forms of capital allocation, such as a growing dividend, high-yield reinvestment opportunities, and stock buybacks.

Astute investors can review a company’s five strengths after thorough research and quickly assess the risks and opportunities that exist.

Let’s review an example, such as Mastercard Incorporated. Mastercard, over the decades, has built a network of banks and merchants around the world who accept the card as a form of payment. All parties must have complete confidence in the Mastercard network and that transactions will be processed quickly, accurately and widely across multiple merchants and countries without fraud.

Given these rigid criteria, the industry has naturally consolidated over the decades towards Visa and Mastercard. Discover and American Express now offer their own networks and are mostly accepted everywhere, but remember 10 or 15 years ago they weren’t?

Mastercard’s competitive advantage is clear. Their global network is unique, widely accepted and trusted. These factors translated into exceptional net profitability of almost 46% of revenue compared to 12% for the S&P 500 in 2021.

In Economics 101, we learn that if an industry is highly profitable, it will attract competition. With the emergence of bitcoin and other decentralized financial applications, many investors have wondered if Visa and Mastercard will be disrupted in 2020 and 2021.

One of the risks to a highly profitable business, and number 2 on Porter’s Five Forces, is industry disruptors. Concerns about industry disruption from cryptocurrencies and continued COVID headwinds on international cross-border transactions presented a great opportunity to buy Mastercard stock in 2020-21 if you thought these threats and concerns were exaggerated.

Sources: Company Reports, FactSet, Harvard Business School

Beese Fulmer Private Wealth Management was founded in 1980 and is one of Stark County’s oldest and largest investment management firms. The firm serves high-net-worth individuals, families, and nonprofits, and has been ranked as one of Northeast Ohio’s largest fund managers.