While some people see equity investing as a technical exercise that involves interpreting price charts and others see it as a purely quantitative process that involves estimating the value of the company based upon its share price near-term earnings potential compared to competitors, I take the view that making successful long-term investments necessitates an understanding of the companies’ underlying competitive positions. I also believe that optimum the framework for such an analysis is that set out by Harvard Business School Professor Michael E. Porter in his 1979 article “How Competitive Forces Shape Strategy“. Porter used the article to introduce his now-famous “five-forces” that can be used to determine whether or not a company has a sustainable competitive advantage. The forces are: (1) the threat of entry; (2) the power of suppliers; (3) the power of buyers; (4) the threat of substitute products or services; and (5) jockeying for position among current competitors. We will take each in turn.
Threat of Entry
Also known as barriers to entry, this concept involves the analysis of how easy it is for new competitors to enter the industry and consequently compete-away the profits currently earned by existing competitors within the industry. Porter lists the following barriers to entry:
- Economies of scale. These can occur in manufacturing (eg Siemens, ABB, GE), marketing (eg. Vodafone, ABInBev), purchasing, financial (larger companies tend to benefit from a lower cost of capital) and managerial (larger companies can hire more specialised workers).
- Product differentiation. This can be seen most clearly in the branded consumer goods industry (eg. Coca-Cola, LVMH) but it also occurs in any industry where the end product is both essential and relatively technologically unique (eg. pharmaceuticals, defence hardware). By selling a branded differentiated product, consumers may be willing to pay a premium price for a relatively cheap physical good due to either loyalty or the intangible connotations attached to being seen with such a product. With unique essential technology, a company can become a legal monopolist, but only so long as the product is not superseded, the patent remains in force, and/or its use remains essential.
- Capital requirements. This is arguably a consequence of economies of scale rather than a separate barrier in its own right. Where economies of scale exist, new competitors need to enter a market “in size”, committing large amounts of capital to purchase fixed assets, to finance inventory and receivables and to finance initial operating losses. Clearly, the greater are the economies of scale, the greater the expected capital requirements to enter the industry. Higher capital requirements mean the pool of potential entrants is much reduced, limiting the threat of entry.
- Cost advantages independent of size. Such advantages include experience (eg. many medium-sized companies in the German & Japanese manufacturing industries), access to unique assets (eg. particular raw material deposits in the mining industry), proprietary technology (eg. Nippon Electric Glass), favourable supply agreements and government subsidies (eg. Boeing and EADS).
- Access to distribution channels. For many consumer goods, the supply-chain is controlled by a small number of participants in each segment, which often includes the retailers and existing product manufacturers. This can prevent new entrants from getting their products to market.
- Government policy. In certain industries, governments award either monopoly or preferential rights to particular operators, preventing or limiting by law entry of potential competitors. Utilities in most countries would fall into this category. Sometimes this happens by accident rather than on purpose, as heavy government regulation (eg in the financial sector and the healthcare sector) acts to create a high cost of entry for potential new competitors.
Power of Suppliers
Where suppliers can exert power over a particular business or industry due to their possession of a stronger competitive position, it is almost certain that such a group of suppliers will raise prices and/or restrict output in order to improve their own returns on capital at the expense of the buyers. Porter identifies the following situations which allow suppliers to exert such power over their customers:
- It is dominated by a few companies and is more concentrated than the industry it sells to. An example in this case would be the iron ore industry, the seaborne trade for which is dominated by BHP Billiton, Rio Tinto and Vale. Iron ore is an essential raw material used in the production of steel, an industry which is much less concentrated than iron ore.
- Its product is unique or at least differentiated. An example of this would be ARM Holdings, which designs the chip-set used in the Apple iPod, iPhone and iPad. Although ARM Holdings is a tiny company, it can still earn high returns due to the specialist nature of its product.
- Switching costs exist. Switching costs are one-off costs that need to be paid in order to change suppliers and do not just include cash costs but also the likelihood of business disruption that may be caused by the change. Examples include changing software provider (eg. SAP and Oracle benefit in this way) or logistics supplier.
- It poses a credible threat of integrating forward into the industry’s business. An example here is the bulk chemicals industry, as participants in the downstream oil industry could easily integrate forward if they so chose (indeed, many are integrated in such a manner).
- The industry is not an important customer of the supplier group.
Power of Buyers
Similar to those that face powerful suppliers, companies that face strong buyers – or buyer groups – can find that they or forced to offer favourable prices or credit terms in order to retain customers. Porter suggests the following factors that enable buying groups to squeeze their suppliers for better pricing:
- It is concentrated or purchases in large volumes. An example of this is the automotive manufacturing industry, which purchases many relatively undifferentiated components from suppliers who have few – if any – other customers. This allows to auto industry to set keen prices for many of its purchases.
- The products it purchases from the industry are standard or undifferentiated. This is a problem for the paper and packaging industry, as most market participants manufacture identical or relatively standardised products. The bulk chemical industries face the same issue as its outputs are – by definition – chemically identical.
- The products it purchases from the industry form a component of its product and represent a significant fraction of its cost. Supermarkets are a good example of this point and of the subsequent point. Cost of goods sold represents the bulk of a supermarket’s cost and are sold-on to the customer at relatively low margins, creating a strong incentive to bear-down heavily on input costs.
- It earns low profit margins, which create great incentive to lower purchasing costs.
- The industry’s product is unimportant to the quality of the buyers’ products or services. Business support services such as the provision of office-cleaning and waste removal both fall into this category.
- The industry’s product does not save the buyer money. This statement applies to the entire cost of goods sold for a retailer (ie. products are sold to the customer in the same form they are purchased from suppliers) and many of the input costs of a manufacturer. Consequently, reducing the costs of such inputs allows the buyer to pass the savings on to customers (thus becoming more competitive on price and potentially increasing revenue) or to increase profit margins.
- The buyers pose a credible threat of integrating backward to make the industry’s product. This is a threat which can easily be made by large capital goods manufacturers such as GE, Siemens and ABB, who have the capital and the knowledge to produce many of their component inputs if they are unhappy with the pricing on offer from suppliers.
Threat of Substitutes
Porter notes that where a product or service is unique (and therefore has no substitutes), companies are able to charge much higher prices than if the face competition from alternatives. Good examples of this are certain raw materials which have unique properties, such as the platinum group metals (used in automotive catalytic converters) and rare earth metals (used in electronic equipment). Porter believes that where substitutes do exist, those that require most management [and investor] attention are those that: (1) are benefiting from trends improving their price-performance trade-off relative to the industry’s product; or (2) are produced by industries which currently earn high profits. He notes that substitutes can arrive rapidly if technological developments create significant price reductions or performance improvements.
Jockeying for Position
Porter argues that the intensity of competition is likely to be greatest when the following conditions are present within an industry:
- Competitors are numerous or are roughly equal in size and power.
- Industry growth is slow, precipitating fights for market share that involve expansion-minded members. The packaging industry suffers from this characteristic. Although incomes are growing in the developed world, the marginal pound of income is generally spent on services (healthcare, leisure, tourism, etc), meaning the market for packaging grows only in the low single digits (it is not economical to transport packaging). This leads to occasional price wars as rivals seek to out-grow each other.
- The product or service lacks differentiation or switching costs which lock in buyers and protect one combatant from raids on its customers by another. A good example of this is the paper industry, as the product is homogenous and switching costs are zero (indeed, most large printers will source their paper from a number of suppliers).
- Fixed costs are high or the product is perishable, creating strong temptation to cut prices. A good example of this is the airline industry, as any empty seats perish as soon as the plane takes-off, while the marginal cost of carrying an additional passenger on a flight is almost zero (small additional fuel cost and possibly some free drinks/low-quality food). Consequently, small declines in customer demand can lead to large declines in industry pricing.
- Capacity is normally augmented in large increments. A good example of this is chemical industry. Given the economies of scale that are present, any new chemical plant has to be very large in order to be competitive on price. Consequently, capacity additions need to occur in large amounts. This can destabilise pricing equilibrium when the new capacity comes into production. I would also add to this that capacity additions which are subject to long time-lags between the investment decision being made and the arrival on the market of the new products generally lead to more unstable and competitive industries. An example of this would be the wine industry, as new vines do not generally bear a crop until the third year after planting and take around six years to bear a full crop. Consequently, the wine industry is plagued by occasional supply gluts which act to drive-down prices, as recently happened in Australia.
- Exit barriers are high. This is most significant in industries where significant investments have been made in fixed assets (also known as sunk costs), such as the auto industry or the airline industry. Such fixed assets tend to be sold to rather than destroyed upon bankruptcy of a market participant, making it difficult for the industry to reduce supply to bring it into line with demand. Airlines may regularly go bankrupt, but the planes always live to fly another day, maintaining overcapacity in the industry (I recognise that planes get put in storage in the Mojave Desert, but these quickly come back into the market once supply and demand start moving back towards balance).
- The rivals are diverse in strategies, origins and “personalities”. An example of this is the oil industry, where large integrated firms (eg Exxon-Mobil, BP, Shell) compete with nationalised/semi-nationalised state-champions (eg. Petrobras, Saudi Aramco, Gazprom) and a plethora of small exploration and production companies. The interaction of politics, long investment time-lags, variable progress in energy efficiency improvements and the diversity of operators has led to many booms and busts in the oil exploration and production industry.
At this point in his paper, Porter begins to give advice to company managers as to how they can incorporate this analytical framework into their business strategy; however, he gives no advice to shareholders as to how they might consider this analysis as part of their investment process. I would make the following suggestions on this subject:
- Progressing beyond the Graham-Dodd value investing strategy, it may be justifiable to pay a higher multiple of earnings or book value for a company that has been identified to possess a long-term competitive advantage and therefore has the ability to increase prices and earnings over time.
- Changes in the five forces can lead to major turning points for companies and industries which may give rise to significant changes in company profitability. Consequently, identifying such changes prior to other investors can lead to opportunities to earn handsome profits (or protect against disastrous losses).
- Certain industries fare particularly badly on the five forces model (eg. paper & packaging, airlines) and I would argue that these should be avoided for long-term equity investments. However, that is not to say that companies operating in these industries do not present occasional interesting trading opportunities at certain points in the profitability cycle or from a special situations perspective.