Understanding Porter's Five Forces for Investors

One of the biggest lessons I learned about the sustainability of a business was when I was seriously bullish on Pure Wafer (LON:PUR) -  a firm providing silicon wafer reclaim services. Everything seemed to be going really well until the management released some seriously bad news. Investors were warned that “revenue is likely to be slightly below expectation due to greater pricing pressure in the global wafer reclaim market.”  The share price plummeted by 17% in just one day. It continued to fall by another 18% over the following weeks. I’d been caught with my pants down.  

After some time and painful analysis I recognised that I had to learn from this and avoid a similar situation in the future. I realised that if I had used a framework to understand the forces which govern competitive pressures on businesses, I could have saved myself a lot of heartache and money.

In my search, I stumbled across Michael E. Porter, a Harvard academic who in 1979 published How Competitive Forces Shape Strategy. This paper outlined what are now known as ‘Porter’s Five Forces’ that influence competition. We’ll go through in each one in more detail in order to understand how these pressures can impact a company, their profits and returns for shareholders.

Why competition is bad for profits:

My experience of competition had been tied to price wars, but Porter tells us that competition comes in many other forms, including:

• new product introductions;
• advertising campaigns;
• service improvements..

 

These can all divert money from shareholders’ pockets. Advertising is expensive. So too are new products, and some of them don’t even sell. Improving a service or product also demands a great deal of time, effort and financial resources.

Force 1. Threat of Entry:

So in theory a company should do better when it has fewer rivals. This is why Porter was concerned with the ‘Threat of Entry’ to an industry, and strove to identify barriers which would make it difficult for upstarts to challenge incumbents.

If competition burns your money, how do we keep competitors out? Well, its difficult for firms to enter a market if incumbents enjoy:

1. Supply-side economies of scale: (production costs fall as production volumes rise). In order to compete, new entrants must enter on a large scale or tolerate lower profit margins.
2. Demand-side benefits of scale: (the benefit of using a product grows as the number of other users increases). New entrants must expand market share through discounting until they build up a large customer base.
3. Customer switching costs: (the cost of switching to a competitor's product exceeds the advantage gained by using a competitor's product). When this is the case, new entrants run the risk of failing to find new clients.
4. The costs of competing in a particular industry is likely to exceed the potential profits: Some industries require entrants to endure start-up losses. Also, some niche industries are so small that only a handful of companies - usually the incumbents - can profit.
5. Government policy/regulation hinders new entry to the industry: Regulatory licences in, for example, the liquor retailing industry make it hard for competitors to enter a market. Governments can also heighten barriers to entry through means such as patents that protect producers from imitation.
6. Industry incumbents enjoy advantages over new entrants to the industry (some incumbents benefit from preferential access to the best sources of raw materials, or established access to distribution channels).

 

Force 2. The Power of Suppliers:

Remember that suppliers can steal your money too. They can do this by charging higher prices or shifting costs to industry participants. The bargaining power of supplier groups is enhanced if:

1. The supplier group is more concentrated than the industry it sells to: Suppose you’re a supplier. You have a large base of potential customers. One or two customers won't pay up. It doesn't matter. You can credibly threaten to do business with other someone else. This puts you in the better bartering position.
2. The supplier group does not depend heavily on the industry for its revenues: You’re still a supplier. Most of your revenues come from one or two industries, so you've got to hang together or hang separately. You’re more likely to protect that industry with reasonable pricing, not to mention R&D and even lobbying.
3. Industry participants face switching costs when changing suppliers: Suppose you’re supplying a client with a complex data processing system. You've done this for the last ten years and now, all of a sudden, they want a discount, although they need you more than you need them. They would need to retrain their employees to use a new programme, and transfer ten years worth of data to the new system. This would cost them time and money. Do they really want to switch suppliers? Again, this puts you in the better bartering position!
4. Supplier products are differentiated: Imagine everyone going crazy about the latest gadget. What if you were the only person that knew how to make that gadget? How much money could you charge!
5. The supplier group can integrate forward into the industry: Its another stand off between a buyer and a supplier over prices. This time the supplier threatens to integrate forward into the industry and dislodge the buyer. If you were a buyer, and your supplier meant what they said, you'd come to the negotiating table soon enough.

 

Force 3. The Power of Buyers:

What about buyers? Can they spoil the party? They can, by forcing down prices or demanding better quality or more service (thereby driving up costs). The bargaining power of buyer groups is enhanced if:

1. There are few buyers: If you are the only customer that visits a shop in a while, you're likely to charge a very high premium!
2. The industry's products are standardised: Think brinks. The only difference between one brick and another is likely to be in the price. This puts buyers in an advantageous position.
3. Byers face few switching costs Again, think data systems. The buyers' bartering position would be significantly improved if switching to a new data system was straight forward.
4. Buyers can credibly threaten to integrate backward and produce the supplier product: The producers of soft drinks have long controlled the power of packing manufacturers by threatening to make, and at times actually making, packaging materials themselves.

 

Force 4. The Threat of Substitute:

You also want to invest in a company that makes products which can't be substituted. If you are making money, but anybody can replicate your products, the chances are that they will, and you will likely be forced to drop prices. The threat of substitute is high if:

1. Competitors' products offer an attractive price-performance (ie, better value for money). Industry profitability is limited when you get better relative value from a substitute product.
2. The cost for buyers switching to a competitor's product low: Again, think data systems…

 

Force 5. Rivalry Among Competitors:

According to Porter, the four forces of competition which we have just discussed combine to influence rivalry between competitors. Rivalry is likely to become more intense when:

1. Competitors are numerous and are of roughly equal size and power: Size and power can often be synonymous in the business world. Think economies of scale. A small upstart would need to tolerate tight profit margins when taking on an established stalwart with enormous production capacities. Also remember that the capital requirements would be much higher for a small firm challenging a larger one.
2. Industry growth is slow: When the pie is bigger, no-one needs to fight. There’s plenty to go round. The inverse is true when the pie is smaller. Everyone scraps for whatever they can get.
3. Exit barriers are high: It’s can be difficult for companies to switch from one industry to another. Assets and experience may be highly specialised. Management may be dedicated to a particular line of business. This means that when the going gets tough, industry incumbents have no choice but to stay and fight.

 

Price competition is also particularly likely when:

1. Products or services of rivals are identical in terms of their utility: When several products or services have a similar function, companies are driven to distinguish their product through pricing differences, although a company could be protected if it enjoys demand-side benefits of scale.
2. Fixed costs are high and marginal costs are low: Fixed costs are constant whatever the amount of goods produced. Marginal costs are the costs added when producing additional units. When fixed costs are proportionally high, this creates pressure on companies to cut prices below their average cost in order to steal incremental customers while still covering fixed costs.
3. Capacity must be expanded in large increments to be efficient: Large capacity expansions usually disrupts the industry supply-demand balance. This leads to periods of overcapacity and consequent price cutting.
4. The product is perishable: Perishability creates a time limit within which a product must be consumed. This is why prices fall as food sell-by dates approach.

 

So in future, if I’m in it for the long haul and planning to hold onto shares for a number of years - I’ll be looking for a good company in an uncompetitive industry, with barriers to entry so high that competitors can't just jump over the fence and steal the company’s money.  I’ll also look for a company in a strong bargaining position, regardless of whether they are a supplier or a buyer, with products that can't be substituted.