Many people assume diversification is good because it minimizes risks…
One of the most important and interesting business ‘concepts’ I learned in my business courses in my final year was Porter’s Five Forces Analysis. To this day, I have continued to use it as a basic, general foundation to determine what I think of a business. The more ‘advantages’ that a business has, the more I am going to look deeper into the company to see whether their stocks are well worth investing.
Michael Porter has claimed that this framework should be used upon an industry with highly related products for similar customers, but actually I like to use it to evaluate individual firms as well. So if both the firm and the industry have a lot of ‘advantages’, I have more belief that the firm is a good company to invest in. And let’s say the firm and the industry do not match in their advantages; say company A has a weak bargaining power of buyers but the industry in general does not have such a problem, then we must ask ourselves why company A is performing poorly in that aspect.
I understand for ‘horizontal’ competition such as threat of new entrants and threat of substitutes, these can’t be just looked at from an individual firm perspective; they must be looked at from an industry perspective. Whereas for ‘vertical’ competition such as bargaining power of suppliers and bargaining power of buyers, I believe these can differ even between businesses in the same industry. Reasons can vary, one of them can be power of a brand.
Anyway, I will briefly explain each of the five forces and explain how we can find how advantageous a firm/industry is in that aspect. As always, you can go to the Porter Five Forces Analysis Wikipedia page for a more detailed insight on what it is.
Threat Of New Entrants
Applicable for industry level only. Basically, how easily can new competitors penetrate the market? Obviously, the easier it is for competitors to step into the market, the more potential competition in the industry, which may mean less profits or growth for the existing firms in the industry. As an investor, you want to pick companies in an industry that is difficult for new entrants to penetrate. It could be reasons such as high costs for starting, many government policies restrictions, high customer loyalty to existing brands already, specific knowledge requirements etc. Fruit juice shops, for example, require little knowledge and therefore wouldn’t qualify to be having an advantage in this factor.
One way to determine how ‘easy’ it is to enter the market is ask yourself, if you had to start this business do you think you could do it? For example, almost anyone can make fruit juices, even you could. You can also look at the annual reports for the company working in those industries and see what they are saying about government policies – whether they are being supported or being restricted and how so. You can also look at the annual reports and see the costs and expenses these companies occur and determine whether the environment they operate in is a high cost or low cost environment.
Threat of Substitutes
Applicable for industry level only. If a customer doesn’t use that company’s products, can it find substitutes easily? If so, are the switching costs high or low? Again with fruit juices, there are so many other beverages that consumers can choose from – soda, water, enhanced water etc. I believe the demand for fruit juices is there, but given that fruit juices are unavailable or pricey, consumers can easily make the switch to other beverages.
Like with the threat of new entrants, you can determine the threat of substitutes by your everyday knowledge. With the fruit juice example above, these alternatives were conjured from the top of my head. Additionally, just looking at news and seeing any new innovations and how consumers adapt their behaviors will also give you a clue. The fixed line phone is getting unpopular as consumers are relying more and more exclusively with their smart phones for example.
Bargaining Power of Customers / Buyers
I’m just going to be lazy and extract the definition of this from Wikipedia. Basically, the bargaining power of customers is “the ability of customers to put the firm under pressure, which also affects the customer’s sensitivity to price changes.” Again with the fruit juice store example, let’s say a certain fruit juice store charges ridiculous prices. No problem, the customers can just go to the fruit juice store down the block and purchase from them instead. But let’s imagine that the fruit juice store is the only one available within miles. In a unique situation like this, the fruit juice store has more command over what they want to charge their prices.
Of course, many factors affect the power of customers. Are there a lot of competitors in the industry? If so, the bargaining power of customers is higher. Are there a lot of substitutes? If so, the bargaining power of customers is higher.
So how do you determine how high or low the bargaining power of customers is? Again, just in general if you were to purchase the product or service, how likely is it that you will continue purchasing it if the prices were raised? If it’s likely, then it’s probably got high bargaining power. Secondly, you can look at the gross profit margin. The higher this margin is, the more advantageous it has over the bargaining power of customers. The logic is simple. If the company can charge a much higher price than its Cost of Goods Sold (COGS), and customers are still buying it, then something unique about its products or services is making customers willing to pay such a high price.
In fact, I love investing in companies that display a high gross profit margin for the simple fact that customers aren’t willing to stop purchasing despite price changes or economic uncertainty.
Bargaining Power of Suppliers
Most companies, especially companies in the secondary or tertiary industries, will have suppliers. The bargaining power of suppliers is essentially how much power a firm (or industry) has over its suppliers. Easily, a good example that has good bargaining power over its suppliers is Walmart. Because its distribution channel is all over America, many suppliers derive a majority of their revenue from Walmart. So Walmart has the say in what it wants from suppliers instead of the other way around. And since Walmart has so many suppliers, it doesn’t rely itself on any single supplier.
On the contrary, if a firm depends on one supplier, and the supplier knows this, the supplier has power to control over what price it wants to sell its goods, the delivery logistics of these goods etc. In that case, the firm becomes less powerful and perhaps less profitable. Logically, I try to stay away from firms that do poorly for bargaining power of suppliers.
This one’s a little bit trickier to determine. I believe looking at the ‘Costs of Goods Sold’ of a company can help this. If the COGS eats up a majority of the revenue, and if the COGS is inconsistent over the years, then it may be that the company has difficulty in controlling its COGS. If you find this, then you must ask yourself why this is the case. Bloomberg platforms provide a function where you can search for the supply chain (type SPLC) and once you find these companies, look into their reports.
Intensity of Competitive Rivalry
How intensive is the competition between the firms in the industry? If they are super intensive, firms may be engaging in price wars to the point that profit margins are reduced extensively for every single firm, eroding profitability for everybody in the industry. Or firms may be engaged in intensive advertising, so to even the field, the firms in the industry may all have to increase the advertising expenses. The less intense the rivalry, or the more “cooperative” these firms are with one another, the better it is for each firm and the industry as a whole.
Again, you can observe from everyday life experience to determine the competitiveness of the industry. For example, automobile companies always launch marketing campaigns and often target one another in their ad campaigns as well. Or airline companies are constantly reducing their air fares to attract customers.
I’ve also read annual reports where companies have declared that their revenue growth has been declining because of new competitors and price competition. So sometimes the annual reports will bluntly state this fact as well.
I think sometimes by reading the news you can also get a feel as to how the companies are behaving towards one another too.
As I’ve said before with all investing tools, these are simply tools in helping you shape your decision as to which businesses to invest. It is the combination of analysis from different tools that should guide you as to which investments are worthy to be made. In the case with Porter’s Five Forces, the more advantages a company has over each of these forces, the more worthy they should be considered to invest.
What other ways can you think of to help determine the extent of the power that each firm / industry holds in each of the forces?