Latticework of Mental Models: Porter’s Five Forces Analysis

Peter Lynch, who successfully ran Fidelity’s Magellan mutual fund for more than a decade, has often mentioned that investors are well advised to buy a business that’s so good that an idiot can run it because sooner or later an idiot will run it. That’s Lynch’s trademark style of saying that some businesses have structural advantages.

The easiest example that comes to mind is when Vijay Mallya ran two different kinds of businesses i.e the liquor business and the airline business. The alcohol business has great economics and aviation industry is known for its horrible economics. It didn’t matter how skillful Mallya was (or wasn’t). The outcome of the events in these two cases proves Lynch’s point.

So how do you find businesses which have a structural advantage? The search should begin by evaluating the industry. If one can answer following questions then he or she can get deeper insights about the industry.

• Is this a good industry to look for quality businesses?
• Is this is a mediocre industry, but are there companies which are exceptionally good performers?
• What are the growth drivers for the industry?
• What are the challenges?
• What factors might influence how the industry might do in the future?
• Who are the dominant players? Why are they dominant?

Of course, one needs to read a lot about the industry and the companies operating in it to answer above questions. But there’s is smarter approach to get quick insights on the competitive nature of any industry. And that brings us to a very important mental model – Porter’s Five Forces Analysis.

Michael Porter, a business strategist and a professor at Harvard Business School, is well known for his five forces framework. His analysis framework remains one of the best ways to assess an industry’s underlying structure. The five force model doesn’t necessarily tell you if an industry is attractive or unattractive but, in Porter’s own words, it’s a tool to understand “the underpinnings of competition and the root causes of profitability.”

So here are Porter’s five forces.

Threat Of New Entrants

This is essentially a way to evaluate the barriers to entry for new participants in an industry. In other words, how easy or difficult it is for a new player to enter the battlefield and unsettle the existing players? Higher the entry barriers lower is the threat of entry. Following are factors that can limit the threat of new entrants in an industry-

• High fixed costs – E.g. Telecom industry. It’s not easy for new players to enter this industry.
• Economies Of Scale – E.g. For Maruti, the cost of producing an additional car is much lesser than any new car company or even a smaller car manufacturer.
• Government regulations/licenses – E.g. Setting up a bank or alcohol manufacturing needs license from the government and there are limited number of such licenses.
• Existing loyalty to major brands – E.g. Nestle, Coke etc. have a very high brand recall and it may take years, if not decades, for any other similar company to establish such branch power.
• High costs of switching companies (Network Effect and Switching Costs) – It’s not easy to switch your bank account. Similarly, it’s extremely difficult for a new social networking site to displace Facebook or WhatsApp.

The idea is that if new companies can enter into the industry easily then it puts pressure on the existing players to protect their market share. The threat of entry, therefore, puts a cap on the profit potential of an industry, writes Porter, “When the threat is high, incumbents must hold their prices or boast investment to deter new competitors.”

Supplier Power

Supplier power is the degree of leverage a supplier has with its customers in areas such as price, quality, and service. If a company has such a situation where its suppliers control the terms, then it becomes a negative for the company. Because if the suppliers are powerful then they capture more value for themselves by charging higher prices. On the contrary, if a company has a supplier which supplies only to this one company, then the company commands the terms and supplier has no power.

An industry that cannot pass on price increases from its powerful suppliers is destined to be unattractive. Suppliers are well positioned if they are more concentrated than the industry they sell to, if substitute products do not burden them, or if their products have significant switching costs. They are also in a good position if the industry they serve represents a relatively small percentage of their sales volume or if the product is critical to the buyer.

Sellers of commodity goods to a concentrated number of buyers are in a much more difficult position than sellers of differentiated products to a diverse buyer base.

Here are a few reasons that suppliers might have power:

• There are very few suppliers of a particular product. E.g. Microsoft supplies its operating system to a large number of software companies and hence can control the terms.
• There are no substitutes. E.g. A pharmaceutical company which supplies a patented drug to hospitals has more power than any other company which supplies generic drugs.
• Switching to another (competitive) product is very costly. E.g. Oracle supplies its database software to large enterprise customers. It’s an extremely cumbersome and error prone process to switch the database to another vendor. Thus, Oracle, as a supplier, has immense power.

Today, Amazon gets its products from its vendors on credit for many months. There aren’t any other e-commerce platforms as big as Amazon so the credit terms are governed by Amazon. This is a kind of structural advantage that you want your stock to have.

Buyer Power

Buyer power is the bargaining strength of the buyers of a product or service. It is a function of buyer concentration, switching costs, levels of information, substitute products, and the offering’s importance to the buyer. Informed, large buyers have much more leverage over their suppliers than do uninformed, diffused buyers.

Here are a few reasons that buyers might have power:

• Purchases large volumes. E.g. Companies that rely on a single client for all their businesses. Many small auto ancillaries are locked into a single automobile manufacturer, which as a buyer has all the power.
• Switching to another (competitive) product is simple. E.g. E-commerce especially in India where customers aren’t loyal to one website. Buying from another website is just a click (or touch) away.
• Customers are price sensitive. E.g. Again e-commerce is a good example here. People are concerned about the best deal and lowest prices.
• The product is not extremely important to buyers; they can do without the product for a period of time.

Substitution Threat

Substitution threat addresses the existence of substitute products or services, as well as the likelihood that a potential buyer will switch to a substitute product. A business faces a substitution threat if its prices are not competitive and if comparable products are available from competitors. Substitute products limit the prices that companies can charge, placing a ceiling on potential returns.

Technological disruption is becoming a bigger and bigger factor in bringing a threat of substitution. For example, with the advent of WhatsApp, the SMS business for most telecom companies has taken a big hit. Even the long distance voice calling businesses is on the brink of extinction because of internet calling like Skype. Similarly, Kodak, a worldwide leader in photography went bankrupt when its primary product was substituted by cheaply available digital cameras.

The main issue is the similarity of substitutes. For example, if the price of coffee rises substantially, a coffee drinker may switch over to a beverage like tea. If substitutes are similar, it can be viewed in the same light as a new entrant.

Sometimes this threat can come from a totally different direction. For example, as video conferencing and virtual reality technologies become more mature, cheaper and easily available, it poses a significant threat to the airline industry’s revenue that come from business travelers. Now who would have anticipated that?

Competitive Rivalry

If the industry has lots of players and there is no product or service differentiation then the competition on price will be very intense. This tends to bring down the profitability of the entire industry. So competitive rivalry is essentially a measure of the intensity of competition between existing firms in an industry. Highly competitive industries generally earn low returns because the cost of competition is high.

A highly competitive market might be a result of many players of about the same size i.e. there is no dominant firm. In such cases there’s is little differentiation between competitors’ products and services. E.g. Telecom and Airlines industries. You could see the price wars that is frequent among the players in these industries. The price undercutting is a race to bottom where there’s hardly any bottomline left for any of the competitors.

Another place where you see competitive rivalry is in a mature industry with very little growth in which case companies can only grow by stealing customers away from competitors. A good example is oral care industry in India, especially the toothpaste market which is pretty much saturated in terms of growth potential. Patanjali’s growth is coming at the expense of Colgate and HUL’s market share.

What is important in evaluating the extent of competitive rivalry in an industry is the number and capability of competitors. If an industry has many competitors, and they offer equally attractive products and services, then a company most likely have little power in the situation, because suppliers and buyers will go elsewhere if they don’t get a good deal from the company.

On the other hand, if no one else can do what a company does, then it can often have tremendous strength.

Conclusion

We started this discussion with Peter Lynch’s insight about looking for a business which even an idiot can run. The same idea, when expressed in Warren Buffett’s words, reads –

When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.

Porter’s five force framework is a tool to find such industries and businesses which have bad or good economics. And it’s not just for an investor but also for entrepreneurs and business operators.

By thinking about how each force affects the industry, and by identifying the strength and direction of each force, an investor can quickly assess the strength of a company’s position and its ability to make a sustained profit in the industry.

Porter’s framework gives you a view of the industry from one vantage point. Remember, no metal model alone can provide all the answers. To make a better decision, more often than not, you have to use multiple models.

Take care and keep learning.