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:
- 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.
- Demand-side benefits of scale: (the benefit…
