Evaluating Industry Structure

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In his 2016 book "Quality Investing: Owning the Best Companies for the Long Term," Lawrence A. Cunningham explains that the structure of a company's industry is fundamental to its potential as a quality investment.

While many investors focus on analyzing companies in isolation, Cunningham argues that some industries allow all participants to earn attractive returns. These favorable conditions emerge when industry characteristics prevent the destructive price wars that typically erode profits.

This post covers different types of monopolies, oligopoly structures, barriers to entry, and the mechanisms that keep competition rational. It also explains how share donators and industry obscurity affect profitability.

Although economically attractive, traditional monopolies like Microsoft's operating system dominance in the 1990s or Standard Oil's energy control in the 1800s are rare and attract regulatory scrutiny (due to antitrust laws worldwide).

Cunningham suggests investors should instead focus on what he calls mini-monopolies, which are smaller but potentially more durable competitive advantages.

Mini-monopolies form when products deliver unique benefits that customers can't find elsewhere.

These monopolies exist in customer behavior rather than market structure. In other words, they emerge from real purchasing decisions, not from economic models or hypothetical scenarios.

Cunningham offers examples of mini-monopiles across different industries:

The degree of mini-monopoly power varies significantly. Cunningham notes it can range from "profound in the case of the hooked smoker" to much weaker in other products.

Companies often have different levels of monopoly power across their product lines, with some offerings commanding high loyalty while others face normal competition.

As an investor, you should identify which product lines within a company possess this monopoly power and assess their contribution to overall profitability.

Partial monopolies occur when competition exists in some parts of the market but not others, creating what Cunningham calls "broken competition."

Localized supremacy is the most common form, where companies control certain regions while facing competition elsewhere. Cunningham notes that examining market share country-by-country is usually more useful than looking at global market share figures.

The beer industry shows how geographic dominance affects profitability:

Switching costs create another form of partial monopoly. In certain industries, customers who buy a product become locked into purchasing related items or services from the same company.

The profitability of this model depends on how much competition exists for the initial sale, since upfront competition can force companies to subsidize initial purchases to capture future revenue streams.

Here are a few examples from Cunningham:

The strongest partial monopolies layer geographic dominance with high switching costs, creating multiple forms of protection from competition that translate directly into superior margins and returns on capital.

Economic theory suggests that industries with fewer competitors should be more profitable. However, this is only true up to a point.

Many oligopolies (industries with a few dominant players) are outliers where multiple rivals maintain healthy profits, contradicting what we might expect.

Consider two famous duopolies that illustrate this point:

Despite having similar duopoly structures, soft drink manufacturers generate far superior margins compared to aircraft manufacturers.

Why? Soft drink companies sell to millions of individual consumers at fixed prices. Aircraft manufacturers sell to airlines, where procurement departments negotiate every sale and demand pricing concessions. Individual consumers have no such bargaining power.

This suggests that customer concentration and negotiating leverage matter more than the number of competitors. Thus, industries with fragmented customers support multiple profitable participants, while concentrated buyers squeeze margins regardless of how few suppliers exist.

Having exactly one competitor often leads companies to become obsessed with beating their sole rival. This corporate obsession contributes to destructive price competition and lower profits, as seen in the Airbus-Boeing rivalry.

According to Cunningham, adding more competitors reduces this destructive behavior. With multiple rivals, beating everyone simultaneously becomes impossible. Companies instead focus on taking share from weaker players while avoiding direct confrontation with similarly strong competitors.

The hearing aid industry demonstrated this pattern for years. Sonova and William Demant consistently grew by absorbing smaller competitors' market share rather than fighting each other.

In general, market leaders outperform smaller competitors, especially in industries where R&D and marketing advantages grow with scale. The key is finding oligopolies where stable competition exists and the conditions supporting it will continue.

The frequency of new entrants reveals much about an industry's attractiveness. Industries with constant streams of new competitors signal low barriers to entry. Even if most new entrants fail, like with restaurants, their sheer numbers can destroy profitability for everyone.

As Cunningham explains:

In contrast, industries with few new entrants suggest high barriers that lead to more rational competition. When an industry contains many older players, it indicates that long-term survival is possible.

For instance, the confectionery (sweet foods) industry demonstrates very high stability.

Among six major global players, Mars and Ferrero remain privately held, Lindt and Hershey are controlled by founding families or their foundations, and only Nestlé and Mondelēz operate as parts of larger conglomerates.

This ownership pattern suggests an industry that rewards patient capital and organic growth rather than requiring constant equity/debt raises.

Every industry experiences occasional price wars or market share battles. What matters is whether these conflicts escalate into destructive competition or resolve quickly.

The best protection against irrational competition is when all participants can afford to think long term.

Industries with stable technologies, predictable demand, and unchanging competitors reduce incentives for short-term profit grabs. Family ownerships are also attractive because they measure success across generations rather than quarters.

Cunningham elaborates:

Delayed payoffs from aggressive moves also help maintain discipline. In industries with switching costs, cutting prices today means waiting years to recover profits through future customer purchases. This time lag discourages impulsive pricing decisions.

Lastly, companies that can retaliate in multiple markets create another stabilizing force. When competitors meet in several product/service categories or geographies, aggressive moves in one area invite retaliation elsewhere.

This mutual vulnerability encourages peaceful coexistence through what economists call a “tit-for-tat strategy,” which helps explain why pricing remains relatively rational in many parts of the household goods sector.

Price cuts are easy to implement but difficult to reverse. Customers embrace lower prices immediately but resist any increases. This asymmetry means pricing decisions can affect profitability for years.

Discounting looks attractive in the short term. It boosts sales, helps meet quarterly targets, and can gain market share. Success makes it tempting to discount again, creating a dangerous pattern:

The laundry detergent market fell into this trap by training consumers to stock up during sales. Coca-Cola faced similar challenges in North America after years of teaching customers to buy in bulk on sale.

Both industries struggled to restore normal pricing after teaching customers to wait for discounts.

On the other hand, smart companies resist discounting even during difficult periods.

When the 2008 financial crisis reduced champagne demand, LVMH's Moët & Chandon (the company’s wines and spirits division) maintained full prices and built inventory instead.

Eventually, they were able to sell this inventory profitably when demand recovered, preserving both margins and brand value.

Most industries contain weak competitors that consistently lose market share to stronger rivals. Cunningham calls these companies "share donators" because they effectively subsidize their competitors' growth.

Share donators fall into two categories:

Structural share donators take various forms.

Neglected divisions within large corporations often lack resources and attract mediocre managers, causing steady market share losses. This happened with Siemens’ former hearing aid business (private equity buyers acquired it).

Similarly, smaller companies unable to achieve necessary scale as industries globalize become reliable share donators (though not all small firms surrender readily). These structural disadvantages intensify in capital-intensive industries, as Cunningham shares:

While share donators alone don't make an industry attractive, they provide opportunities for well-positioned companies to grow profitably by capturing their losses.

Beyond identifying share donators, Cunningham evaluates two key signals to assess whether an industry will remain stable:

Together, these signals help investors identify industries worth investing in for the long term.

Small, unglamorous industries can offer a layer of protection from competitive disruption.

Products like locks, lenses, ostomy bags, and bathroom fittings serve essential needs but attract little attention from investors or potential disruptors. In short, this obscurity creates protection.

Cunningham elaborates:

The combination of steady demand, limited growth potential, and lack of technological disruption makes these industries attractive for long-term investors.

Their boring nature becomes an asset, providing what Cunningham calls "a layer of protection from competitive disruption" that allows attractive returns to persist.