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Recognizing High Barriers to Entry to Enhance Returns

Barriers to entry are often one of the first concepts learned in business strategy classes. Barriers to entry describe the factors which would deter new competitors from entering a market. Barriers to entry can be natural or human-made obstacles that make it difficult for a new entrant to compete with established incumbent firms.

Understanding barriers to entry is important for investors because higher barriers allow a company to earn outsized returns on invested capital (ROIC) as competition is scarce. High barriers to entry industries are typically called monopolistic or oligopolistic because of the low, or even non-existent, competition. This article will discuss common barriers to entry with industry examples where they can be seen.

Economies of Scale

Cost advantage can be achieved from having massive operations, where additional units of production can be achieved at a lower marginal cost than the previous unit due to the increase in volume. For a new entrant, building these same economies of scale could take years, if not decades, and require billions of dollars in capital expenditures.

Economies of scale make it hard for new entrants to compete with incumbents, especially on price, as new entrants are normally producing at a higher cost per unit. New entrants could face pricing pressure from incumbents trying to lower prices and squeeze them into unprofitability. Networking effects, where the value of a service increases with the number of users, is similar to the effect of economies of scale.

Industry Example: As the first entrants into the ride-sharing industry, Uber and Lyft have achieved a network effect that will be hard for new entrants to catch up with. The mobile app itself is not that difficult and expensive for a team of software engineers to build, but getting the significant mass of drivers and users in each area in order to allow matching is what creates a good customer experience. I personally prefer Uber because it has more drivers and often arrives quicker. When Lyft entered my metropolitan area, it had to offer significant discounts in order to attract riders.

High Capital Requirements

Large spending by incumbents on areas such as machinery and equipment, research and development, or advertising can make it hard for new entrants to compete. These higher costs to enter the market make it riskier (and less likely) for start-ups to consider entering the industry as there is more capital to potentially lose.

Industry Example: Chip manufacturers, such as Intel, have high barriers to entry due to the expensive machinery involved in production as well as the intensive research and development needed to keep their products technologically advanced.

Supplier and Distribution Agreements

Oftentimes, market incumbents will move to lock up exclusive supply arrangements of key input materials as well as distribution agreements with retailers. Such strategies make it hard for new entrants to obtain quality materials for production in significant amounts or place their products with popular retailers for ultimate purchase. Vertical integration, whether backward or forwards in the value chain, is often undertaken by market incumbents in order to cement their position in the industry.

Industry Example: The major oil and gas companies are all integrated players involved in the extraction, refining, and final sale at the pumps. This integration helps them achieve high ROIC and fixes their relationship with other parts of the value chain.

Regulatory Hurdles

Government policies can place considerable compliance and product licensing costs on new entrants. Depending on the industry, meeting government regulations can add significant costs and time to enter the market. Incumbent players have the specialist knowledge to navigate the regulatory hurdles and the established operations to spread out the costs of compliance. Certain industries that lend themselves to natural monopolies (telecom, electricity) due to economies of scale will often be controlled by the government.

Industry Example: The telecom industry faces multiple regulatory hurdles such as the purchase of spectrum licenses at auction, to requirements for local content on channels. Some of these regulatory hurdles have been loosened in recent years, particularly in Europe, where governments have started to mandate wholesale prices of spectrum and bandwidth to new entrants in order to drive competition and lower prices for consumers.

Patents & Intellectual Property

Similar to regulatory hurdles, governments allow the creation of patents and intellectual property by firms in order to incentivize innovation in the economy. Such intellectual property creates an exclusive period for the incumbent to use the innovative patent which can be expensive or impossible for new entrants to develop a workaround to use themselves.

Industry Example: Patents are very critical in the pharmaceutical industry where hundreds of millions of dollars are spent researching and developing new therapies. Such patents give incumbents an exclusive time period to control the market before the product is allowed to be made in a generic off-patent form by third parties.

High Switching Costs

Certain products and services lend themselves to complex integration and high costs to switch to another provider. These switching costs can come from long-term contracts being the norm of the industry which carry steep penalties for exiting early, or a complex product that requires significant integration and high set-up costs. A new entrant trying to grab market share would need to price their product appropriately to make up for these high switching costs.

Industry Example: Switching providers of critical software, say from Oracle to SAP, can be an expensive and complicated ordeal for a corporation. The set-up costs associated with the new software can easily run into the millions taking into account the cost of external consultants as well as required overtime from internal staff.

Brand & Customer Loyalty

Successful incumbents will often have achieved a strong brand through advertising and/or product quality. Sometimes this brand effect can be so strong that consumers will refer to all similar products by the brand name of the incumbent; think Jello®, Kleenex® or Band-aid®. Overcoming the established brand of incumbents will be difficult and new entrants will often have to price themselves lower than established brands as they compete for market share.

Industry Example: Coca-Cola, or Coke for short, is a name synonymous with carbonated soft drinks and the company is able to achieve outsized profit margins to this day. Even the well-established Pepsi brand has to price themselves slightly lower than Coke and no-name soft drinks are often half the price.

Takeaway for Investors

Being able to recognize barriers to entry is important for investors because barriers allow a company to earn outsized returns on invested capital (ROIC) due to competition being scarce. Also, understanding when barriers to entry are starting to be breached or removed can help investors avoid unfavorable changes in a company’s finances.