Judge a company's competitive advantage and check it against its returns and margins.
A company can describe its market position well, and an industry can look attractive from outside. Neither tells you how much profit the company will keep over the years. To judge that, you need a way to assess its competitive position and a way to check that assessment against its accounts.
Michael Porter, an economist, set out the Five Forces framework in a 1979 Harvard Business Review article, and it still carries his name. It judges how much profit an industry lets its companies keep. Five forces compete for that profit. Buyers push prices down and suppliers push costs up. Rivals are the companies already in the industry, and new entrants are companies that could join it. Substitutes are products from outside the industry that do the same job.
For each force, ask how much bargaining power it holds against your company. Score it from 1 to 5, where 5 means the force works hard against the company, and write down your reason. Then sum up the industry's overall quality and name the dangerous force or forces.
Marcus, the analyst studying Larkspur through this course, started by asking a colleague why customers stay with a supplier like Larkspur. Larkspur is an invented Singapore-listed precision engineering company that makes parts for chip equipment, with a parts business and a coatings segment it acquired. Its figures below are invented examples, in S$ millions unless stated. The colleague used to work for a chip equipment maker and explained it in ten minutes: nobody gets fired for keeping a qualified supplier, and qualifying a new one takes most of a year. Lesson 6.2, "Business review and risk factors: what management must disclose", is where this claim was written into Larkspur's business model.
Marcus scored the forces like this:
Buyers 5: two customers take 62% of revenue and are far larger than Larkspur. One has started qualifying a second supplier, which is the most power a buyer can hold. Suppliers 2: Larkspur buys metals, components and machine time from many sources. Rivalry 3: several precision engineers in Singapore, Malaysia and Japan chase the same customers, but a part is rarely contested once qualified. New entrants 2: a newcomer needs capital, a quality record and about a year of qualification before it earns anything. Substitutes 2: a customer could bring a part in-house or redesign it out of the machine, but rarely does.
He concluded it is a decent industry with one dangerous force. The profit Larkspur keeps depends on how hard its two big customers press on price.
Warren Buffett popularised the word "moat" for a lasting competitive advantage. A moat is whatever lets a company earn returns above its cost of capital for many years, when competition would normally push them down. Lesson 8.4, "Return on invested capital vs cost of capital", explained that returns tend to drift back towards the cost of capital, and a moat is what stops that drift. Moats come from a short list of sources: switching costs for customers, costs nobody else can match, a brand people pay more for, a network that becomes more useful as it grows, and a licence or patent others cannot get.
Larkspur claims the first. Its moat is switching cost through qualification: the cost and time, most of a year, that a customer would need to qualify a new supplier, which keeps it with the current one.
Claims are cheap, so test them. A real moat shows up in the accounts as returns that stay above the cost of capital and margins that stay steady, especially in a bad year. Compare return on invested capital with the cost of capital in the latest year and in the worst recent year, then compare operating margins across the cycle with a comparable peer group, using the range and the median.
Lesson 8.4 gave Larkspur's FY5 return on invested capital as about 15.6%, against a cost of capital of about 9%. In the FY4 downturn, revenue fell 15% and return on capital fell to about 11%, still above 9% but only by two points. A company with no moat would usually fall to or below its cost of capital in a downturn year, so this supports the claim, narrowly.
Larkspur's operating margin ran from about 11% to 16% across its cycle. The five peers chosen in Lesson 9.3, "Choose a peer group that is really comparable", had latest-year operating margins between 10% and 15%, with a median of 13%. Larkspur sits inside the peer range and is not an outlier. It looks like a solid member of a competitive group, without pricing power over its customers.
A segment note can show which part of the business actually holds the moat. Larkspur's coatings segment used about S$60 million of capital, including its goodwill, and earned close to nothing in FY5, so its return on capital was barely above zero. Remove the weak segment and recalculate with operating profit x (1 - tax rate) / segment capital. Without coatings, parts made operating profit of about 55 on remaining capital of about 237. At an example tax rate of 17%, that is 55 x (1 - 0.17) / 237 = about 19% after tax.
The moat belongs entirely to the parts business, and the coatings purchase diluted it. Lesson 9.5, "Capital allocation: dividends, buybacks, acquisitions and reinvestment", follows up on that acquisition.
Marcus's verdict was that the moat is real but narrow. Returns stayed above the cost of capital through one downturn by a thin margin, and margins match the peer group without beating it.
Every moat changes, so ask which way it is moving, and write down evidence in both directions. At Larkspur, one large customer is qualifying a second supplier. That is the clearest possible sign the switching cost is being paid down. On the other side, Larkspur has had new parts qualified in each of the last two years, and each deepens its place in its customers' machines.
Marcus turned this into three checks for each results announcement: top-two customer share of revenue, gross margin, and the number of newly qualified parts. Read them together. Gross margin is the first thing to fall if customers push on price. If the top-two share stays near 62% while gross margin slips, the customers are using their power. If the top-two share falls and no new customers replace it, the second supplier is taking volume.
When the five forces score and the numbers disagree, believe the numbers and go back to the reports to find out why. For Larkspur they agree: it is a decent business whose biggest risk is its two largest buyers.
For the activity, score your own company on the five forces from 1 to 5, then set its return on capital and margins, including its worst recent year, beside the score.
Score your company on each of the Five Forces. Then check whether its margins and return on capital back up your scores.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).