#Investing Basics : Barriers to Entry
why it is important to run a company through this model
One of the things that I like to look at when I am evaluating a company, is the ease with which competitors can enter a particular line of business - also known as ‘barriers to entry’.
IN THEORY — Few players in the market > higher market share + growth > better operating margins > higher market capitalization > greater shareholder wealth creation.
If an opportunity exists, and it is relatively easy for new businesses to enter the market, it would increase competition driving down prices and profitability. Higher the barriers to entry, higher the probability for existing players to make outsized returns. Doesn’t always play out this way in reality though.
In this article, we are going to look at several barriers that exist, that you should run a company through when you’re engaging in stock analysis.
I. Capital requirement
The #1 barrier to entry for any business is the amount of capital required to operate it. I’m sure each one of you reading this article would have had a business idea in your lives, but one of the reasons that idea didn’t get hammered into reality, is the lack of capital. Or a lack in the ability to raise capital. Otherwise, we’d all be entrepreneurs.
For e.g. to get into the airlines business, you need a SH*TLOAD of money — which is why you wouldn’t see more than 5-6 serious players in that industry at any point in time.
But if you’re building a skincare brand? Or a SaaS business? You don’t need a lot of capital. You need human resources, yes. Time? Yes. Branding? Yes. But capital is not a barrier. And hence, you’d find many skincare brands in the market and a lot of SaaS products.
Relevant questions to ask when you’re evaluating a company:
Is the business capital intensive? How quickly can the company raise money when required? What is its credit rating? Does it have unsustainable debt?
How many pure play competitors does the company have? Is it difficult for other players to enter the market due to large amount of capex required? How are the company’s key metrics [margins / return ratios] compared to peers?
Despite being capital intensive, is the company able to generate a higher return on capital employed (RoCE)? If yes, that means that the management of the company are prudent allocators of capital.
Let’s take a look at few examples for better clarity.
E1: Olectra Greentech is in the business of manufacturing electric buses. To run this business, it needs to invest heavily on R&D, state of the art facilities, battery technology (partnership with BYD) among other things. The business is capital intensive, with limited players (JBM Auto, Tata Motors, Ashok Leyland and a few other small scale start ups). The barrier to entry in the EV Commercial vehicle sector is high.
E2: Parag Milk Foods sells milk and milk products. To run this business at scale, it needs to invest in milk processing facilities & cold chain distribution. But, a small farmer can also get into this business quite easily - probably not at the same scale. Margins on selling milk therefore, are razor thin. The barrier to entry in the milk business is low.
If a company is operating a business which requires a lot of capital — that doesn’t mean that new competition cannot enter the market. But the new players that do, will need deep pockets.
A few examples come to mind:
Reliance Jio entered the telecom industry out of the blue in 2016, disrupting the industry and becoming the #1 player a few years later. Telecom, is a [very] capital intensive industry - but Reliance entered anyway driving a lot of other telecom players out of business. The high capital barrier to entry didn’t help the existing players.
Rakesh Jhunjhunwala backed Akasa Airlines commenced operations in 2022, in an industry where players like Jet Airways and Go Air were going bust. If you have deep pockets, you can enter most businesses.
II. Regulatory Barriers
Some barriers, are created by the law. Examples could be government regulations, import tariffs, patents etc.
E1: IRCTC is the only company authorized by the Government of India for selling railway tickets online. This gives IRCTC a monopoly status, which is created by the Government. No other company can get in this line of business, unless the GoI opens this sector for private players — which isn’t happening anytime soon.
E2: Novo Nordisk owns the patent for semaglutide - the active ingredient used in Ozempic which is a weight loss drug. This patent expires in 2026 in markets like India, China among others. What this means, is that no one can use this active ingredient to develop a similar drug unless the patent expires — giving Novo Nordisk an opportunity to make outsized returns. Even if you have the capital, you cannot get into the business of manufacturing this drug.
E3: On 29th June 2020, India banned the use of Chinese apps like Tiktok, WeChat etc. These companies cannot operate on Indian soil. If you’re a Chinese social media company trying to enter the Indian market, you’re going to have a tough time.
Relevant questions to ask when evaluating a company:
Does the business need frequent governmental clearances / approvals to operate / expand its operations? How susceptible is the business to change in government policy?
Is the business indifferent to the ruling political party? Will the business be adversely affected due to a change in the current ruling party? Is the founder / senior management of the company politically connected? Does the business contribute any money to political parties?
Are there any expected tariffs that could be imposed on the company’s product / services in the future? How much revenue does the company derive from exports?
Regulatory barriers can be powerful — making the connection between business and politics quite strong. Governmental bodies control policy changes, approvals & clearances affecting multiple businesses.
The Adani Group secured contracts to operate 6 major airports in 2019 — despite having no prior experience in running airports.
Reliance Jio’s rise coincided with significant policy shifts in the telecom sector — reduction in IUC (Interconnecting Usage Charges) by TRAI benefitted Jio by reducing costs for connecting calls to rival networks.
Tata Electronics will build India’s first chip fabrication unit in Dholera (Gujarat) with applications in power management ICs, micro-controllers etc. This closely aligns with government’s Semicon India program to promote semiconductor manufacturing and Tata Group is seen to be a major beneficiary of this program.
If a company finds itself on the wrong side of politics — the consequences could be quite adverse.
III. Technological Barriers
Tech companies are consistently investing in R&D so that they can get their hands on the next ‘world changing’ tech and create a big enough moat so that other companies cannot outpace them.
E1: ASML provides EUV Lithography machines which uses ultraviolet light to etch patterns on semiconductors. EUV technology is used to create the most advanced chips for AI, 5G and high performance computing. ASML had invested billions of dollars in developing the EUV technology, and today no other company has the capabilities to compete with ASML.
E2: NVIDIA enjoys near monopoly status in the GPU market. GPUs are critical for neural network training & building AI models. The integration of it’s CUDA software platform with AI stack, provides NVIDIA with a formidable advantage — one which Intel / AMD are trying to challenge, with little success.
E3: Meta Platforms is a social media giant which has control over the attention span of billions of individuals. Indian homegrown players like Koo, Hike Messenger, Moj, Josh have failed to compete with Meta Platforms due to superior network effects enjoyed by Instagram, Whatsapp, Facebook etc.
E4: DreamFolks claims that it has developed a proprietary tech stack connecting banks to lounge owners facilitating seamless lounge access to air passengers. However, Adani Airport Holdings recently came out and said that they’re launching their own platform bypassing any ‘intermediaries’ a.k.a DreamFolks. No wonder, DreamFolks’ share price is down by 60% in the last 6 months, because it doesn’t have a technological moat.
Relevant questions to ask when evaluating a company:
Is the company a ‘tech’ company? If yes, how much money does it invest in R&D to stay ahead of competition? How many people are employed in the R&D division?
What is its market share compared to peers? Is the tech getting obsolete? Does it have any patents?
How easy is it for competitors to replicate the technology? Is there any attrition in tech leadership positions being poached by the competition?
Is there a new technology being developed that could lead to an existential crisis for the company?
For e.g. Quantum computers are being developed that could change the future of computing - making normal computers irrelevant.
Conclusion
I use the ‘barrier to entry’ model to gauge a company’s ability to safeguard it’s market position / profitability. The higher the barriers to entry, the higher the probability of a company to make outsized profits.
If there are no barriers to entry, there will be too many players in the market and companies would have to find other ways to differentiate themselves (branding, marketing, steep discount etc.)
But like I mentioned before, this model shouldn’t be used in isolation. You need to look at other factors like management quality, return ratios, growth drivers and weed out red flags (if any) while conducting analysis of a business.
Only then, a faint picture emerges. Because no one knows what the future will bring with absolute certainty.
Investing is a game of probabilities and as investors, the best we can do is try to predict the future with the information that is available to us. It is a calculated gamble.
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[Note: The author is not a SEBI registered investment advisor and the contents of this article do NOT constitute investment advice. Always do your own research before you invest in a company]
Good read for finding moats!