Barriers to Entry: Avoiding Low Profit & Competitive Industries

One of the first concepts learned in business strategy classes is often barriers to entry.  Barriers to entry is the term used to describe the factors which would deter new competitors from entering a market. Barriers to entry can be natural or human-made obstacles which make it difficult for a new entrant to compete with established firms. Knowing how to spot and avoid low barrier to entry companies is just as important as being able to spot monopolistic and highly profitable businesses. That being said, companies operating in a market with low barriers to entry can still be a good investment if the cash flow and valuation are right!

Understanding barriers to entry are important for investors because higher barriers allow a company to earn outsized returns on invested capital (ROIC) as competition is scarce. This article will discuss common elements of low barrier to entry businesses and is an accompaniment to IFB’s article on understanding and appreciating high barrier to entry companies.

Commodities & Basic ProductsLow Capital Requirements
Service Industry ProblemsThe Retailer Problem
Low Switching CostsRegulatory Hurdles

The Effect of Low Barriers to Entry

As the laws of nature and economics go, when barriers to entry are lower in a market and profits are being made, more competition will flock to it. Any existing players will have to go to the trouble of fending off competition from new entrants. At the extreme in low barrier to entry industries, ROIC has been driven down to the cost of capital as any company earnings outsized returns quickly attracts competition.

The effect of a low barrier to entry market is similar to the shakeout stage of the industry lifecycle. What the market is left with in a low barrier to entry market are companies earning an appropriate economical ROIC with a natural churn rate in the market as weaker competitors fail. There is a constant drive to gain efficiencies, differentiate products and achieve some customer loyalty in order to gain pricing power. Now let’s discuss some elements of a business that would imply lower barriers to entry.

Commodity/Basic Product

Commodity businesses can be a classic example of a low barrier to entry business and are a good place to start the discussion. Besides potentially high start-up costs to buy/build a mine or farm, commodities are, by definition, homogenous and cannot be distinguished from a competitors products.

That being said, even with commodities, location can play a major role in creating barriers to entry through transportation costs. This is especially the case if the commodity is cheap and transportation is a significant part of total cost to the end consumer. If the mine is located close to where the raw materials are needed, this proximity provides a natural barrier to entry (as long as the region is not awash in the commodity with lots of competitor mines).

Low Capital Requirements

The less capital that is needed to build the business means that barriers to entry are lower. Low capital requirements open up the gates to smaller “mom and pop” market participants. The market tends to be fragmented where demand of the product or service is ample and competition is fierce.

In certain industries it is also possible to lease the assets needed for production. By not having to fully purchase the asset upfront, this lowers the barriers to entry as less capital is needed to enter the business. For example, leasing aircraft is common in the aviation business. Since companies do not need to spend tens of billions of dollars buying fleets of planes, this lowers the capital needed to enter the business. Because of this, the airline industry has tended to experience poor economics as upstarts are quickly entering when economics look appealing, driving the ROIC down for all market participants.

The restaurant industry is another good example where many operators do not own the underlying property but lease the space instead. This lowers the cost of capital and allows many chefs and bakers to pursue the dream of opening their own restaurant or café.

Service Industry Problems

The problem with some service industries is that the service itself can be low skill and easily performed by the majority of people. Consumers are often faced with the choice of performing the service themselves or hiring a third party to assist. The classic example of a common skill business could be a house cleaning/maid service. Common skill services have low barriers to entry due to much of the labor market being able to supply the service but also could start their own business at any time.

The other problem with service industries is that labor is not very scalable. This is especially the case when the service is a physical one such as landscaping or painting. Depending on the service’s profit margins, companies need huge volume in order to cover overhead. This means that the industry is naturally tilted towards smaller players in more fragmented markets.

The last problem with the service industry mentioned earlier is that human capital can be easily transferrable so it is easy for employees to take their skills to another firm or even start their own business. Depending on the costs of obtaining the skillset or regulations/licensing to start operations, this transferability leads to lower barriers to entry.

The Retailer Problem

Companies that are not engaged in the actual production of the end product, such as retailers, are at risk of getting their margins squeezed and even losing their place in the value chain. New developments in online shopping and shipping have made it possible for brands to sell directly to consumers.

Think about the trouble popular historic department stores have had in recent years. The ability of brands to connect straight with consumers and bypass the “middle-man” retailer highlights the retailers’ vulnerable spot in the value chain. Nike is another great example of a strong brand that has decided to sell directly to consumers through its store where consumers can even go as far as to customize their shoes.

Regulatory Hurdles

Government regulation can be a significant barrier to entry adding time, costs, and expertise to the process of starting a business. The more simple regulations are to comply with, the lower the barriers to entry. Obtaining the license to open your own restaurant is a much simpler process (but still a process and hurdle to pass through!) than trying to start your own bank.

On the other side, we can also see regulators make the decision to increase competition in an industry. A great example is the telecom sector where larger, more established players are being mandated to sell “wholesale” data transfer through their networks to new market competitors. Such consumer friendly regulatory policies would lower the ROIC for all players in the market.

Low Switching Costs

Certain products and services are easy for consumers to sample and have compete against one another for their dollars. For example, the switching costs associated with choosing a different brand of ketchup when you are at the grocery store are nil. Now compare this to the costs and headaches associated with switching mortgage providers which can come with significant, real penalty costs as well as hours of time and headaches. Another good industry example is the IT business, where costs for a massive corporation switching from an Oracle to SAP system product, for example, would imply millions of dollars of implementation costs.

Simple and Replicable Product

If the product a business is selling is not unique, technologically complex, or best yet, has patent protection, than competition will be drawn to the industry if they can earn outsized ROIC. In recent years, no name private label brands have been created and expanded by the majority of retailers into common products from ketchup to toilet paper. While name brands might sell for slightly more, a large part of the market can be grabbed by private label brands in these simple products. This change has affected brand name consumer product companies such as Kraft, Nestle, and Unilever to name a few.

Investor Takeaway

Barriers to entry can significantly affect the ROIC that market competitors are achieving and investors are earning. When analyzing a business as an investment, it is important to consider what the barriers to entry are, what industry they are in, and if this company will be able to achieve above average ROIC for many years to come.

Companies operating in a market with low barriers to entry can still be a good investment if the cash flow is right! For investors interested in a pre-built financial model where they can punch in the financial data of any company of interest, they can check out IFB’s financial model and valuation template as well as other courses on IFB’s products page to grow your knowledge along your investment journey.

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