I have talked about the importance of looking out for investment risks, and also wrote about how to incorporate a stock’s risks in a properly structured investment thesis.
Through a short series of articles, I would like to list six major types of investment risks, and each major type shall be elaborated on within an article. The six types are: (i) Management; (ii) Industry and Competitive Moat; (iii) Political; (iv) Economic; (v) Social; and (vi) Legal/Regulatory.
In a previous article, I had discussed Management risks. In this article, let’s now dive into risks related to Industry and Competitive Moat.
As investors, we should find out exactly how resilient an industry is to economic shocks and/or a sharp fall in customer-demand. Industries which experience sharp rises and falls in demand can have a devastating effect on companies within it, as the companies would need to scramble to adjust their inventories accordingly. If factories have been built for a high level of demand but this does not come through, these plants have to be moth-balled and the company would have incurred sunk costs without any revenues to show for it.
Industries which have stable demand through business cycles tend to be ones where the products or services are seen as necessities – these include (but are not limited to) healthcare, education, and consumer staples such as food.
Important questions which an investor should ask are:
1. Is the industry growing or shrinking?
2. At what rate?
3. Would this be a concern to his investment thesis?
An industry which is stagnant would see incumbents fighting with one another for market share, potentially resulting in price wars which benefit no one. Industries which grow too slowly or too quickly may also pose problems, as companies may not generate enough sales in the former situation while products/services may become obsolete in the latter one.
The above alludes to the Porters 5-Forces Model which I wrote about here. What are the barriers to entry for the industry? Are they high and if so, why? Ideally, high barriers to entry are positive as it would keep out potential competitors and discourage them from entering an industry. An entry barrier can be built based on the high costs needed to operate in an industry, but money may not always be the solution as customer relationships and an outstanding track record built up over time may also act as formidable entry barriers.
Presence of economic and competitive moat
As investors, we should prove that a company has an enduring moat by observing its quantitative as well as qualitative characteristics. Does the company have a higher return on invested capital than its competitors? Or does the company have any special qualities which endear customers to its products or services? Answering these questions honestly would go a long way in establishing if there is a durable competitive moat – if the answer is yes, it will then make a company a potentially attractive investment.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.