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More Trouble Ahead for Builders

Warren Buffett once said, "When an industry with a reputation for difficult economics meets a manager with a reputation for excellence, it is usually the industry that keeps its reputation intact."

That wisdom could prove particularly useful for investors eyeing homebuilder stocks.

The lesson is that the industry in which a business operates dictates much of the company's profit potential. And when competition is intense, profitability is destroyed.

That's exactly what is happening with homebuilder companies today. Supply exceeds demand, and the aggressive price-cutting of homes from big builders such as Lennar (LEN) will eventually cause serious ripple effects among rivals.

Lately, builder stocks have rebounded on hopes that the worst is over for the companies. But one method of analysis provides a healthy dose of reality about the dire situation the homebuilding industry is still facing.

The "Five Forces Framework," a method developed by Harvard economist Michael Porter in the mid-1970s, is widely taught in MBA programs and used by corporate strategists.

It's also a powerful tool for investors to use when deciding whether to buy stocks in a certain sector, and it highlights issues that will continue to erode profitability for homebuilders.

Force One: Degree of Rivalry

Rivalry among companies is one of the most obvious forces in an industry. "It influences the extent to which the value created by an industry will be dissipated through direct competition," writes Harvard Business School Professor Pankaj Ghemawat in his book Strategy and the Business Landscape , which outlines Porter's framework.

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