Some investors are content with earning something close to the market return. Others want to significantly beat the market and are willing to take on higher risks to pursue that big return.

But consistently beating the market is not easy. Nobody consistently bats 1000. That’s the nature of investing, especially aggressive growth investing. The key is to have gains from the winners that are bigger than losses from the inevitable losers. Thus, stock picking is very important.

One of the models that I personally use to hone in on attractive industries and stocks is called Porter’s Five Forces.

I like the model because it’s intuitive and relatively simple to understand. Think of it as five basic questions to ask about a company. It doesn’t guarantee success but it is helpful in understanding the company and identifying attractive characteristics for investment. It can also be applied to analyze industries.

Clout With Vendors and Customers

1) Bargaining Power of Buyers: This factor examines the degree of buyers’ bargaining power (i.e., the customers). Another way to look at it is to ask how much pricing power does the company you are analyzing have? Can it increase prices without losing a significant number of customers?

For example, Apple (NSDQ: AAPL) is able to charge a premium price for its products thanks to high customer loyalty. The company makes quality products and its exclusive iOS operating system locks users into its ecosystem. Switching out of iOS is a major hassle, creating high switching costs for customers, which makes them more willing to pay extra to stay.

On the other end of the spectrum, if a company sells a product without much differentiation, then it will not be able to liberally raise prices because customers could easily switch to another vendor. Thus, a company that supplies a unique product or service will more likely have higher bargaining power with customers.

2) Bargaining Power of Suppliers: Compared to the previous factor discussed above, this factor looks at the other direction on the supply chain. While a company sells to its customers, it also buys goods and services from its suppliers. Ideally, a company will have strong bargaining power with both its buyers and suppliers.

Going back to the Apple example, because Apple is such a massive powerhouse, it has a lot of bargaining power with its suppliers. Because of the size of Apple and how much revenue a contract with Apple can bring in, vendors are willing to settle for less attractive terms to do business.

If a company is a unique supplier of an important product or service, it will likely have strong bargaining power. On the other hand, if there are many suppliers but only a few large buyers, the suppliers will likely have little bargaining power.

Success Attracts Competition

3) Threat of New Entrants: The fact of the matter is that if a company experiences success, others will smell the money and try to grab a piece of the pie. This factor looks how easily new competition can emerge to possibly eat away at the incumbents’ business.

Businesses that have a high barrier of entry are better protected. Factors that create a high barrier include large startup capital requirements, proprietary technology, and government permits and licenses. Additionally, the power of the incumbents, if strong, could also dissuade new companies from entering the same business.

Besides barrier to entry, in some cases there’s also the barrier to exit to consider. A high barrier to exit means that it’s difficult for a company to exit its business so that it makes more financial sense to keep going despite bad economic returns. Such a scenario hurts not only itself but others in the same industry.

Substitutes and Rivals

4) Threats of Substitutes: Technology is always evolving. The emergence of a strong substitute could turn a company’s fortunes upside down in a short amount of time. A classic example is the camera. For decades, to take photos we used film cameras. Then digital cameras came along and replaced the film camera. But soon after that, smartphones with high-quality embedded cameras made it pointless to have a separate camera.

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To analyze the threat of substitutes, you have to not only pay attention to substitutes that already exist, but also to technologies in development that could one day emerge as substitutes.

5) Rivalry Among Existing Competitors: This factor looks at how a company co-exists and competes with its competitors. In general, industries in which competitors are fiercely looking to take market share from each other—for example, mobile carriers—can lead to price competition and tight margins for all.

On the other hand, if the largest competitors are able to rationally co-exist, everyone can. An example would be the automobile oligopoly. Comparable models across different makes tend to be similarly priced.

If a company is so well positioned that it can set prices and be a price leader, that’s even better. Apple is yet again the exemplar.

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