This is Lesson #18 of my Mastermind Value Investing Course. I am sharing it here given a lot of request from readers.
One of the legendary investors, 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.
Now, Lynch’s comment begs an important question – What dictates a company’s economic returns?
I am not asking what determines a company’s share price performance or what determines stock price returns for shareholders. Instead, it’s more important to know what drives a company’s economic profitability and sustainable value creation.
What Drives Value Creation?
Sustainable value creation has two dimensions — how much economic profit a company earns and how long it can earn excess returns.
Both dimensions are of prime interest to investors and corporate executives.
Sustainable value creation as the result solely of managerial skill is rare. Competitive forces drive returns toward the cost of capital. Investors should be careful about how much they pay for future value creation.
One of the key determinants of sustainable value creation is the industry a company operates in.
This is especially true for companies that are leaders in that specific industry. For laggards in a sector, value creation is largely a result of company-specific factors – like their internal strategies for improvement.
Anyways, in the analysis of how or whether a company can create value sustainably, the industry is the correct place to start.
It’s important to answer these important questions:
- 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?
One great way to answer these questions is…
Porter’s Five Force Analysis
Michael Porter is well known for his five forces framework, which remains one of the best ways to assess an industry’s underlying structure.
While some investors and analysts employ the framework to declare an industry attractive or unattractive, Porter recommends using industry analysis to understand “the underpinnings of competition and the root causes of profitability.”
Porter argues that the collective strength of the five forces determines an industry’s potential for value creation. But the industry does not seal the fate of its members.
An individual company can achieve superior profitability compared to the industry average by defending against the competitive forces and shaping them to its advantage.
Here is how to look at each of these factors:
1. Threat of new entrants, or barriers to entry, is arguably the most important of Porter’s five forces. While people commonly treat Porter’s five forces with equal emphasis, I believe that threat of entry and rivalry is the most important as it defines how companies in an industry behave and perform.
Factors that can limit the threat of new entrants in an industry include:
- Existing loyalty to major brands
- Incentives for using a particular buyer (such as frequent shopper programs)
- High fixed costs
- Scarcity of resources
- High costs of switching companies
- Government restrictions or legislation
2. Supplier power is the degree of leverage a supplier has with its customers in areas such as price, quality, and service.
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
- There are no substitutes
- Switching to another (competitive) product is very costly
- The product is extremely important to buyers – can’t do without it
- The supplying industry has a higher profitability than the buying industry
3. 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:
- Small number of buyers
- Purchases large volumes
- Switching to another (competitive) product is simple
- The product is not extremely important to buyers; they can do without the product for a period of time
- Customers are price sensitive
4. 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.
Here are a few factors that can affect the threat of substitutes:
- 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.
5. Competitive rivalry describes 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 result from:
- Many players of about the same size; there is no dominant firm
- Little differentiation between competitors’ products and services
- A mature industry with very little growth; companies can only grow by stealing customers away from competitors
What is important here is the number and capability of competitors in an industry. 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.
Porter’s Five Forces Analysis Template
Click here to download the following template to do Porter’s Five Forces Analysis of any industry.
Let’s understand Porter’s Five Forces Analysis using an example.
Let’s assume you are deciding to switch careers and start a farming business – you have always loved nature and staying at the countryside, and want to switch to a career where you are your own boss.
You create the following Five Forces Analysis as you think the situation through:
Porter’s Five Forces Example: Buying a Farm
Click here to download this template to do your own analysis of any industry.
While you thought the opportunity in farming was great, the above analysis may cause you worry, because:
- The threat of new entry is quite high. If new competitors look at your farming business if you’re making a sustained profit, they can come into the industry easily, thus reducing your overall profits.
- Competitive rivalry is extremely high. If someone raises prices, they’ll be quickly undercut. Intense competition puts strong downward pressure on prices. Good for your consumers, bad for your business.
- Buyer power is strong. Your buyers will tend to be large in size and you will be selling them a commodity product that they can buy from anyone else as well. This again implies a strong downward pressure on prices.
- There is some threat of substitution. If you produce tea or wheat, and prices of these products rise, consumers may shift to coffee or rice respectively.
Unless you are able to find some way of changing this situation, this looks like a tough industry to survive in.
Maybe you will need to specialize in a sector – like floriculture or organic farming – that’s protected from some of these forces, or find a related business that’s in a stronger position.
Let us understand Porter’s Five Forces through studying another industry – Automobile.
Before we move ahead, let us assess the basic structure of the industry.
The auto manufacturing industry is highly capital and labour intensive. The major costs for producing and selling automobiles include:
- Raw materials – Automobiles consume raw materials like steel, aluminium, dashboards, steering wheel, gears, brakes, fuel engines, seats, tyres, etc. and all these are purchased from suppliers.
- Labour – While machines play a significant role in manufacturing automobiles, there are still substantial labour costs in designing and engineering the products.
- Advertising – Look around you and you will find how automakers spend millions on print and television advertising. Apart from this, they spent large amounts of money on market research to anticipate consumer trends and preferences.
The automobile market is thought to be made primarily of automakers, but auto-parts or auto-ancillary makes up another lucrative sector of the market. We will exclude that in this discussion.
As far as key players are concerned, the Indian automobile market is made up of the following companies:
- Cars: Maruti Suzuki, Tata Motors, M&M, Honda, Toyota, GM, Hindustan Motors, Volkswagen, Mercedes
- Two-wheelers: Bajaj Auto, Hero Motocorp, TVS, Honda, Suzuki, Eicher Motors, M&M
- Commercial vehicles: Tata Motors, Ashok Leyland, Volvo, Force Motors
- Tractors: M&M, Escorts, Eicher, Swaraj, TAFE, John Deere
Here are a few important resources you must go through to understand more about the automobile industry:
- SIAM – Society of Indian Automobile Manufacturers
- McKinsey report on global automobile industry
- Tata Motors’ June 2013 presentation
Porter’s Five Forces Analysis: Auto Industry
Let’s now do Porter’s Five Forces Analysis to understand the attractiveness and profit potential of the automotive industry.
1. Threat of new entrants: Globalization, the tendency of world investment and businesses to move from national and domestic markets to a worldwide environment, is a huge factor affecting the auto market.
This is also true of the Indian automobile market where, more than ever, it is becoming easier for foreign automakers to enter and take away market share from established players.
Of course, an average person can’t come along and start manufacturing automobiles, but there is a great threat for existing players from the big foreign manufacturers who have already created a base in the Indian market.
The emergence of foreign competitors with the capital, required technologies and management skills has already begun to undermine the market share of Indian automobile companies, and across segments like cars, two-wheelers, and commercial vehicles.
2. Power of Suppliers: The automobile raw material and ancillary supply business is quite fragmented (there are many firms).
Many suppliers rely on one or two automakers to buy a majority of their products – like Munjal Showa (shock absorbers) and Sona Koyo (steerings) derive a large part of their revenues from Hero Motocorp and Maruti Suzuki respectively.
If an automaker decided to switch suppliers, it could be devastating to the previous supplier’s business. As a result, suppliers are extremely susceptible to the demands and requirements of the automobile manufacturer and hold very little power.
3. Power of Buyers: Before the coming of the foreign automakers, the bargaining power of Indian automakers – Premier Auto and Hindustan Motors – went unchallenged.
The Indian consumer, however, became disenchanted with many of the products being offered by certain automakers and began looking for alternatives, namely foreign cars.
While the consumer have become more powerful now given the wide choices available and price competition among automakers, they (consumers) are still price sensitive and don’t have much buying power as they never purchase huge volumes of cars.
4. Availability of Substitutes: Now, this is a great threat for automakers. After all, we are not just talking about the threat of someone buying a different car, but also that of people taking alternative modes of transportation like bus, train or airplane to their destination.
The higher the cost of operating a vehicle, say a car, the more likely people will seek alternative transportation options.
The price of fuel (largely petrol and diesel) has a large effect on consumers’ decisions to buy vehicles.
When determining the availability of substitutes you should also consider time, money, personal preference and convenience in the auto travel industry. Then decide if one car maker poses a big threat as a substitute.
5. Competitive Rivalry: Highly competitive industries generally earn low returns because pricing power is low and the cost of managing competition is high.
As far as the auto industry is concerned, competitive rivalry differs across segments. So, while the rivalry is intense in car manufacturing, it’s largely a 2-4 key players market in commercial vehicles (Tata Motors, Ashok Leyland, Volvo) and 2-wheelers (Bajaj Auto, Hero Motocorp, Honda, and TVS).
While automakers have historically tried to avoid price-based competition, but more recently the competition has intensified – occasional price discounts, preferred financing and long-term warranties have helped to lure in customers, but they also put pressure on the profit margins for automobile sales.
Porter’s Five Forces Example: Automobile Industry
Key Points to Remember
Porter’s Five Forces Analysis is an important tool for analyzing an industry and assessing its potential for profitability.
It works by looking at the strength of five important forces that affect competition:
- Supplier Power: The power of suppliers to drive up the prices of a company’s inputs.
- Buyer Power: The power of customers to drive down a company’s prices.
- Competitive Rivalry: The strength of competition in the industry.
- Threat of Substitution: The extent to which different products and services can be used in place of a company’s products and services.
- Threat of New Entry: The ease with which new competitors can enter the market if they see that a company is making good profits (and then drive its prices down).
By thinking about how each force affects its industry, and by identifying the strength and direction of each force, a company can quickly assess the strength of its position and its ability to make a sustained profit in the industry.
As an investor, you can use this framework for assessing whether a specific industry can be a hotbed of profitable investment ideas or mediocre ones.
Also Read: Measuring The Moat ~ Michael Mauboussin