Tuesday, August 28, 2007

High Barrier with Low Profit

Conventional wisdom says that when you create a high barrier of entry for your business, it will be harder for new competitors to enter. As a result, your profitability will be high, right? Ehm, you are wrong on this one. Several excellent examples show that despite the validity of high barrier, it does not guarantee profitability. In fact, some lower barrier business can thrive in this business.

The truth is, many people equate high barrier business with high capital requirement. Capital creates barrier but that creates setback too. When you spend so much capitals on your business, it is harder for your business to turn a profit. Look no further than Amazon.com (AMZN). In the early part of the decade, Amazon was busy erecting barriers for its business, expanding its selection from books to lawnmowers. That strategy seemed to work well for Amazon but it takes them a whole lot of time to be profitable. Congrats to early Amazon.com shareholders. You would do well as the company has turned profitable for the last few years. However, cumulatively, Amazon still lost a combined $ 2.02 Billion since its existence.

That alone should deter you from investing in companies depending on capital to erect barriers. For one, the future is uncertain. The longer it takes to be profitable, the higher risk it won't achieve that. Heck, I can even give you more examples of high barrier low profit proposition. How about the airline industry? Sure, nowadays, the barrier to entry is a lot lower. But, you still need to spend all those capitals to hire fleet, pilots and so forth. So far, the only established airlines that consistently make a profit is Soutwest Airlines (LUV).

You might say that low capital business cannot compete with high capital business. That thought again is wrong. How about restaurant operators such as Mc. Donalds? Opening a restaurant does not take that much capitals. How about creating an information based website such as CNET.com or MySpace? While these business has lower capital barrier, if you can make your product & service unique, you will be on your way.

While high capital is a barrier for new competitors to emerge, it does not guarantee profitability. Meanwhile, low capital business may have thousands of competitors springing up each day. But, with your business unique proposition, your business can thrive and profitability will be on the horizon. Therefore, creating barriers with high capital expenditure is not a prerequisite for business success.

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