Understanding Competition Before You Invest

Frequently, we have expressed the idea that it is wise for investors to choose to invest in companies that they know – and especially companies that they have had personal experience with. Specifically, for newer investors, this can be a good technique to make sure that they fully understand the investment decisions they are making and the long-term implications of those decisions. One crucial factor in understanding companies before making an investment decision is having a general understanding of the current position of a company within the markets. Among other things, investors might find it useful to consider the competition within the market that the company operates. To do so, it will be beneficial to understand the two main models of competition: perfect competition and monopolization.

Perfect competition is a theoretical market structure in which all firms compete directly with each other. Companies in perfectly competitive markets sell identical products at the same price. They do so because, with no differentiation between products or services, firms must be “price takers,” which means that they cannot influence the market price of their products. For example, if five firms in a market all sell an identical product for $10 and Firm A wants to sell the same product for $12, firm A would not be able to compete within the market, solely because of the price of the good. Likewise, if Firm B could produce and sell the same product for only $8, the rest of the firms would be forced to lower their prices to $8 in order to compete in the market, or customers would start to only purchase the good from Firm B.

On the other hand, monopolization is the idea of competition in which one firm or corporation dominates the entire market – or at least the majority share of the market. Hypothetically, this firm could charge whatever prices it chose for its goods because there would be no other significant firms to pose any kind of competition to it. Obviously, this could leave consumers open to corrupt behaviour from a corporation that seemingly has no checks and balances, so many monopolies are regularly discouraged by anti-trust laws in the United States. These laws ensure that there will be an open, competitive market in most industries. However, not all monopolies are illegal, as natural monopolies still exist. These kinds of monopolies occur when barriers to enter a specific field are so high that only one main company can meet them, thereby becoming the only competitor in the industry out of sheer competitive advantage.

Typically, however, most normal market competition lies somewhere between these two polar opposite models. For example, it is hard to have a perfectly competitive market because much of the time, companies take to differentiate in product quality, marketing, or selling. Therefore, it is rare that companies are selling two products that are exactly the same, or at the same price. Contrastingly, due to anti-trust laws and the rarity of natural monopolies, true monopolies rarely exist. Instead, it is much more common to see industries that have relatively high competition or low competition.

Judging the kind of competition that surrounds a company can be a good way to think about the company’s business in the long-term. For example, if the company is surrounded by few competitors in an industry that has high barriers to entry, it might not have to compete as much on price than companies in markets with low barriers to entry. Or, if a company is competing in an industry that has low barriers to entry, but the company is able to diversify itself from its emerging competition, it might be simpler to predict that the company will remain successful relative to its competitors in the long run.

From this analysis, we can make predictions that will benefit our understanding of the companies and markets that we are investing in. Finally, this kind of analysis of a market’s competition might be helpful for investors who are looking to further diversify their portfolios, because they can better understand differences between markets and pin point companies in each market that they believe might function well in conjunction with their investment strategies.