Our investment methodology places paramount importance on a company's competitive advantages. One of the tools used to evaluate these advantages is the Five Forces model developed by the American economist, Michael Porter.
Porter identified five forces  which influence a market’s competitive structure, namely:
- Customer negotiating power
- Supplier negotiating power
- The threat of substitute products
- The threat of new entrants
- Competition in the industry
In this article, we will focus on the threat of new entrants and consider what strengths enable companies, particularly very small companies, to protect themselves against new entrants. When we analyse our universe of high-quality small stock market capitalisation companies, they can be categorised into three types of businesses:
- Niche players
- Companies at the cutting edge of development
- Local champions.
The companies in these categories have all managed to position themselves on a market, despite competition from major multinationals or smaller companies trying to break through. Let’s take a closer look at each of the categories to appreciate the strengths of these companies.
The niche players
The first category we have identified is niche players. Before delving into the detail, let's define this term. “Niches” represent markets which are neither excessively big or small. In other words, there is enough room for a big player, with significant market share, and a few smaller companies. How are these markets protected against the advent of new entrants? A concrete example is the case of the German company Stabilus. This industrial company is far and away the world leader in the manufacture of gas struts and dampers for the automotive sector, with a market share of 70%. The company’s products are vital components for opening and closing car boots and it is the leading, if not the only, supplier to almost all the main car manufacturers. Despite this monopoly, Stabilus only generates sales of EUR 515.3 million from this activity, for global production of 91 million vehicles (2016) . So, to be able to compete with Stabilus – a company which has good relations with its customers, significant economies of scale, and a state-of-the-art production facility – a new entrant would have to invest a significant amount to launch on this market, with no guarantee of an attractive return on capital invested. On the other hand, from a multinational industrial group’s point of view, while the question of financing is not a problem, the size of the market is simply too small to make a significant difference within its big structure.
The companies at the cutting edge of development
Next, let’s look more closely at companies at the cutting edge of development. These companies protect their position on a market by investing a considerable amount in research & development to offer a product which is both qualitatively superior than that of the existing competition and difficult for a new entrant to achieve. By maintaining their lead, these companies can win out over their rivals, even if these are bigger companies with greater financial resources. But how can a small company manage to develop a product which leads the field? One answer to this question lies in the way small companies are structured. Their hierarchies are less entrenched, their decision-making process is shorter, and the employees are more involved in the development of the business. The big groups are not limited to one or two projects when they develop a new product range whereas, for small companies, all their energy is invested in a limited number of projects. Take, for example, Carl Zeiss Meditec, a specialist in the development of tools for microsurgery, with a focus on ophthalmology. The solutions offered by Carl Zeiss Meditec are in direct competition with those of Alcon (a subsidiary of Novartis) and Bausch+Lomb (a subsidiary of Valeant Pharmaceuticals), large companies with very significant financial resources. And yet, Carl Zeiss Meditec manages to take market share from its rivals and discourage new players from starting up, because its products are recognised by the specialists who use them. Practitioners tend to stick to the technology which they are used to working with, so it is difficult for a new entrant to persuade them to change supplier.
The local champions
Lastly, the third category of companies identified can be called ‘local champions’. That means local brands, which enjoy a strong presence in a specific geographic area. These companies often have a long history and have forged their reputation over many years. Local consumers have known these products for a long time and have developed an emotional attachment to them. A good example is the beer market, so let’s consider the Danish brewer Royal Unibrew. It offers beer brands that are little known worldwide. In Denmark and Finland on the other hand, the company offers beers that are extremely popular with local consumers. Its brands have been in existence for many years and people associate them with memories and emotions. This makes it more difficult for a major brewer to establish a new brand on these markets. It also explains why, when a major group like AB InBev or Carlsberg takes over a local company, it leaves the name of the beers unchanged so as not to lose the loyal customer base. Local champions can thus focus fully on their domestic market, they do not have to invest to maintain a global network, and they can withstand international competition on their patch.
The strengths described in this article are good reasons why investing in small caps makes sense. In our BL-European Smaller Companies fund, we aim to limit the threat of new entrants by selecting companies which have a durable competitive advantage and offer a high return on capital.
 Michael E. Porter, “How Competitive Forces Shape Strategy”, Harvard Business Review
 Annual report 2016 Stabilus GmbH