From Whole Foods to Hewlett Packard: Avoid These 2 Competitive Sectors

Source: Thinkstock

Source: Thinkstock

Competition is a crucial element of capitalism. The idea that anybody can come into the market with a different product is what keeps businesses on their toes and the ultimate winner is the consumer, who gets to choose between more goods at different prices.

But competition isn’t necessarily good from an investment standpoint. Competition, especially price competition, leads to reduced profit margins and it can also entice other businesses into an industry. The result is that you have several businesses vying for the same market earning very little money. For consumers this is great, but in general I would avoid businesses that are in these situations.

Typically this applies to two sorts of businesses: retailers and producers of “commodity goods.”

1. Retailers

Unless a retailer has developed a particular market niche such as Costco (NASDAQLCOST), or unless it has grown to the point where it has a unique competitive advantage [e.g. Wal-Mart (NYSE:WMT)], retailers face an incredible amount of competition and they are often forced to cut their prices to the point that they can barely turn a profit. Again, while consumers benefit the businesses usually suffer.

Within the retail sector there are a couple of sub-sectors in particular that are especially competitive, and I think that except in very rare circumstances they should simply be avoided. The first is the grocery sector. The problem with the grocery sector is that virtually anybody can compete, and the best run grocery chains have to face competition from companies such as Wal-Mart, Target, Costco, and so forth. If you want an example of how competitive this business is, just take a look at the organic food segment of the grocery business. Whole Foods (NASDAQ:WFM) had this business cornered. It was able to charge high prices for its products and it was growing extremely rapidly all over the country. But then several competitors entered the market such as Sprouts Farmers Market (NASDAQ:SFM). Even the aforementioned big-box retailers have entered the space. Because of this we have seen Whole Foods lose its competitive advantage rather quickly and easily, and now it is growing more slowly and it is seeing its margins decline dramatically. As a result the shares are trading just above a multi-year low.

The restaurant space is also incredibly competitive. While a few winners have emerged such as Chipotle (NYSE:CMG) and Yum! Brands (NYSE:YUM) these are hardly attractive investments. These companies may have brand power but there is no reason why competitors cannot enter the market place. Furthermore, even if you believe that these companies can maintain their respective competitive advantages you are not alone, and as a result these stocks trade at very lofty valuations that leave them vulnerable to the downside.

2. The “commodity goods” producer sector

By this I don’t mean commodity producers such as copper or oil producers. In fact these companies hardly compete with one another. What I mean by a commodity good is a manufactured good that is extremely easy to produce and that numerous companies can produce , none of which have a distinct competitive advantage. We have seen this take place in the computer hardware space. Companies such as Hewlett Packard (NYSE:HPQ) and International Business Machines (NYSE:IBM) have seen their hardware businesses slowly decline as they have faced competition from a plethora of other companies. Both have been rushing to enter other segments, but this hasn’t stopped their businesses from declining. As a result, these companies trade at below-market valuations.

The bottom line is that when you choose an investment one essential attribute to consider is that company’s competition. You need to ask yourself how easy it is for another company to enter that market as a competitive threat? While this is a difficult task in some businesses, we have seen that it can be rather simple in others. The following checklist should help you to make a decision regarding a potential investment.

  • Does the company require highly specialized knowledge in order to produce a product (e.g. a patent)?
  • Would a competitor require an enormous capital investment in order to replicate your prospective investment’s business model (e.g. rail transport)?
  • Does your potential investment have brand recognition that gives it a unique competitive advantage?

If you are considering a particular stock and can answer any of these questions in the negative, then you will probably want to reconsider your investment thesis.

Disclosure: Ben Kramer-Miller has no position in any of the stocks mentioned in this article.

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