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The most important factor to consider before making a long term stock market investment isn’t, how good the management of the company is, how the company is currently priced, and it is certainly not what the stock looks like on a Japanese Candlestick Chart. The most important factor to consider before making a long term stock market investment is whether the company you’re looking at has a sustainable competitive advantage, which will allow it to be profitable for many years to come.
Companies like, Apple, Johnson & Johnson and VISA thrive. While companies like American Airlines, British Petroleum and FIAT Chrysler, barely scrape by.
Well, that’s what you will learn in this summary and this is a “Top Five Takeaways Summary of Competitive Strategy”, written by Michael Porter.
About the Author
Michael Eugene Porter (born May 23, 1947) is an American academic known for his theories on economics, business strategy, and social causes. He is a Professor at Harvard Business School, and he was one of the founders of the consulting firm The Monitor Group (now part of Deloitte) and FSG, a social impact consultancy. He is credited for creating Porter’s five forces analysis, which is instrumental in business strategy development today.
Michael E. Porter is the author of 18 books and numerous articles including Competitive Strategy, Competitive Advantage, Competitive Advantage of Nations, and On Competition. A six-time winner of the McKinsey Award for the best Harvard Business Review article of the year, Professor Porter is the most cited author in business and economics.
Porter credits Harvard professor Roland “Chris” Christensen with inspiring him and encouraging him to speak up during class, hand-writing Porter a note that began: “Mr. Porter, you have a lot to contribute in class and I hope you will.” Porter reached the top of the class by the second year at Harvard Business School.
At Harvard, Porter took classes in industrial organization economics, which attempts to model the effect of competitive forces on industries and their profitability. This study inspired the Porter five forces analysis framework for analyzing industries.
In 2000, Michael Porter was appointed Bishop William Lawrence University Professor at Harvard, the university’s highest recognition awarded to Harvard faculty.
Porter stated in a 2010 interview: “What I’ve come to see as probably my greatest gift is the ability to take an extraordinarily complex, integrated, multidimensional problem and get arms around it conceptually in a way that helps, that informs and empowers practitioners to actually do things.”
Takeaway #1: Porter’s Five Forces
If you are a business student, you will probably recognize this. Porter’s Five Forces is a model for determining the potential returns of an industry, which is taught at every business university in the world and for a good reason.
Warren Buffett, the greatest investor of all time, refers to a company that is performing well consistently as a company that has a sustainable moat. Companies that are performing well, are constantly challenged by competitors of all sorts, but with a deep and wide moat, preferably with lots of crocodiles, the companies can sustain such attacks. In Warren Buffett’s annual shareholder meeting of 2001, he admits that he and Porter think alike when it comes to determining this moat.
“We call it a moat, and he [Michael E. Porter] turns it all into a book”Warren Buffett
This state of competition within an industry is decided by five forces and long-run returns on invested capital are decided by these two. The five forces are;
- Threat of entry
- Threat of substitution
- Bargaining power of suppliers
- Bargaining power of buyers
- Intensity of rivalry
The goal for a particular firm should be to position itself strategically within its industry, so it can best defend itself from these forces, or, if possible, manipulate them to its favor.
In the coming takeaways, we will do a deep dive into these forces so that you will be able to determine how well a firm is positioned for yourself.
Takeaway #2: Threat of Entry
The first force to consider is how easy it is to enter the industry.
Football is a really competitive sport, because it is really easy to enter. All you need is a ball and it can be practiced all over the world. Slalom Skiing, on the other hand, is less competitive, as it requires expensive equipment to participate in and can only be practiced in countries with skiing resorts. You want to invest in companies within industries where the threat of entry is low. Preferably, you’d like to own a monopoly, so your company can decide pretty much whatever prices it wants, but governments usually interrupt here.
An industry is difficult to enter if it possesses high barriers of entry, and you want entry barriers as high as the Chinese Wall. Here’s six examples of such barriers.
- Economies of scale
- Product differentiation
- Capital requirements
- Switching costs
- Cost disadvantages
- Governmental policies
Economies of scale
If larger players in the industry can achieve lower costs, it is difficult for a new firm to enter as it, per definition, must be small in the beginning. Economies of scale can exist in business functions such as production, marketing, distribution, administration, etc.
Existing firms have high customer loyalty already, which may be difficult to replace. This is why pretty much every company wants to create a brand name.
If entering the industry is associated with high upfront costs, such as building a large production plant or spending lots of money on R&D, it will scare some competitors off.
It may not always be so easy to convince a customer to switch from a product to another because it may be associated with things such as retraining, new testing, product redesign, etc. For instance, I don’t want to switch from my iPhone simply because I dread having to relearn a new mobile interface again.
A firm coming in late may face cost disadvantages like being late in the learning curve or getting less favorable access to raw materials.
Access to an industry can be completely denied by a government. For example, YouTube is banned in China. In addition to this, the threat of entry can be mitigated by the retaliation of the companies within the industry.
A firm will enter the industry, if it forecasts that the potential reward for being in it is greater than the cost of overcoming these barriers of entry and the retaliation that is likely to happen. An industry that is almost impossible of entering is that of railroads. It takes a ton of capital and it is an enormous risk to build a second railroad network next to an already existing one, so therefore, it keeps competitors away. On the other hand, YouTubers have very low barriers to entry. It is relatively easy for someone to start a channel from scratch without any prior experience. Therefore, competition on YouTube is very high.
Takeaway #3: Threat of Substitution
Substitute products are those that do not belong in the same industry, but that fulfill a similar need. For example, a mobile phone is a substitute for a landline phone, and many other things by the way. Social media is a substitute for newspapers. A train is a substitute for a car, yet these obviously do not belong in the same industry.
Substitutes create price ceilings for industries. As an investor, you, therefore, prefer to invest in companies where there’s only a low threat from substitutes.
There are two substitutes that you should especially watch out for; those that are becoming cheaper relative to their performance, and those that earn high returns on capital. Such substitute industries are likely to have more entries in the future, which will drive prices down within that industry and have spillover effects in the industry that you are considering to invest in yourself.
Companies within the industry of power grids, face pretty much no substitute at all. We need electricity and nothing is likely to change that in the coming future, in my opinion. No matter how that electricity is produced, someone must transport it.
On the other side of the spectrum, we have the newspapers. For a very long time, they had a monopoly-like status for the service of delivering news to their hometowns. These days, however, they face competition from online papers and social media, which has pretty much killed the industry and the companies within it.
Takeaway #4: Bargaining Power of Suppliers/Buyers
These two forces can be included in the same takeaway as they mirror each other perfectly. If industry A is the supplier, industry B is the customer and it’s in this relationship that a kind of power struggle can occur. A supplier can stop delivering the product, raise prices, or lower quality. Similarly, a buyer can stop buying the product, demand lower prices, or demand higher quality. You want to invest in companies within industries that are winning this power struggle, both against their suppliers and customers.
Here are six factors that help an industry to mitigate the power of its suppliers:
Large portion of supplier’s sales
If the industry represents most of the supplier’s sales, they live and die together, and it’s in the supplier’s interest to remain friendly.
Large portion of buyer’s budget
Similarly, if the cost is a large one for the industry, it typically commands more power in the bargaining process as it is a very serious incentive to keep prices low.
In the case of commodities, the industry can get lower prices than otherwise.
Low switching costs
If it is simple and relatively cheap to switch from one supplier to another, suppliers will be in less of a position to command premium prices.
Threat of backward integration
Backward integration is when a company decides to compete directly with its suppliers in their industry, in other words take over their operations. For example, an auto manufacturer may decide that it wants to create all the components of the cars itself, and that it also wants to mine all the ores necessary for creating such components, now this is not very likely. Nonetheless, the simpler it would be for an industry to take over the operations of the supplying industry, the better.
Unimportant for buyers quality
If the product that is purchased is unimportant for the quality of the industry’s product, high prices are never accepted. It should be noted that workers for an industry count as suppliers, as well.
If you mirror this, you’ll get six factors that help an industry to mitigate the power of its buyers.
An example of an industry that has been good at mitigating the power of its suppliers is that of the supermarkets. Suppliers of goods to these firms, at least most of them, must accept that supermarkets are powerful players of distributing their products, if they want to be represented on the product shelves. The airline industry is in a different situation. With only two main suppliers of airplanes, Airbus and Boeing, it was a tough industry to be in, even before the current COVID-19 situation.
Takeaway #5: Intensity of Rivalry
The final force to consider is how tough the competition among existing firms in the industry is. Price-cutting, advertising battles, new product introductions, and increased customer service are common weapons of choice here and they all lead to lower profitability for companies within the industry. Therefore you prefer to invest in a company within an industry where the intensity of rivalry is low.
Here are a few factors, which typically lead to low competition:
- Concentrated and/or a few companies
- High industry growth
- Low fixed costs
- High differentiation
Concentrated and/or a few companies
You prefer to see that the industry is dominated by a few players only. Companies are then familiar with the hierarchy of the industry, and larger companies can often discipline smaller ones that try to do something stupid.
High industry growth
With a growing industry, most companies can fulfill their promises of expansion to their shareholders without waging price wars.
Low fixed costs
High fixed costs often lead to overcapacity and incentives for firms to sell products at lower prices just to cover the fixed costs. For example, an industrial company may just have built a new production plant that can produce 1000 units of product x per day. The price difference of producing 1000 units or say 700 units a day could be quite small. If the demand for the product is only 700 units a day at the current price, the company may decide to cut prices to sell at the full capacity of 1000 units as this doesn’t cost much extra anyways. The car manufacturing industry face this problem, for example.
Generally, you don’t want to see such behavior in industries that you invest in.
If customers perceive the products of the companies within the industry as somewhat different, price sensitivity will be much lower. Commodity products such as oil and gas producers and mining companies have very low product differentiation and therefore have problems with this.
An example of an industry that has been able to mitigate the force of rivalry is, soft drinks. The major players here have such strong brands that their products are perceived as different. Therefore, they have commanded high returns on capital for many decades now. Hairdressers exist on the other side of the spectrum, they haven’t been able to handle this force very well.
Again, in the long run, the returns of an industry are pretty much determined by these five forces. At times, it is a single force that is responsible for the excessive or depressive returns of an industry, but at other times, it’s a combination of the five. For the investor, it is important to notice that a specific company within an industry may handle the forces much better than the rest of the competitors.
While a sustainable competitive advantage is the most important factor to consider before investing in a stock market company in the long run, there are many other important factors to consider too. Check out other investing books in our app.
What did you learn from the book summary of Competitive Strategy? What was your favorite takeaway? What do you disagree with? Comment below or tweet to us @storyshots.
Hats off to The Swedish Investor for this awesome summary. Check out the audio and animated versions on our app.