When making new investments, writes Ryan Paterson, it can be a useful exercise to consider in turn each of the 'five forces' identified four decades ago by economist Michael Porter and then write your observations
In 1979, Harvard Business Review published a paper by economist and associate professor Michael E. Porter entitled ‘How Competitive Forces Shape Strategy'.
Porter's ‘Five Forces' framework is a simple but powerful tool for understanding the competitiveness of a business environment and for identifying a strategy's potential profitability. Porter recognised companies often keep a close eye on their established rivals but encouraged them to look beyond the actions of their competitors and examine other factors.
In all, Porter identified five forces that make up the competitive environment and which can hurt prospective profits:
* Competitive rivalry: The strength of competition in the industry.
* Supplier power: The ability of suppliers to drive up the prices of your inputs.
* Buyer power: The strength of your customers to drive down your prices.
* The threat of new entrants: The ease with which new competitors can enter the market.
* The threat of substitutes: The extent to which different products and services can be used in place of your own.
Porter stressed the importance of not confusing them with more fleeting factors, such as industry growth rates, government interventions or technological innovations. These are temporary factors, while the Five Forces are permanent parts of an industry's structure.
When making new investments, it is a useful exercise to consider each of the forces in turn, then write your observations. Looking at things in this way helps you to think through what would enhance the industry position and increase the profitability with respect to each force. What is more, if you find it is in a structurally weak position, it will raise a red flag and then, hopefully, help you to identify companies that are operating in stronger industries.
In which case, it would come as no surprise Monarch Airlines collapsed into bankruptcy towards the end of last year. Indeed, Porter himself identified several years ago the airline industry provided a classic example of his theory.
Monarch was an airline competing in a cutthroat industry, without the scale, brand strength and efficiency needed to survive. Operating costs remained significantly above those of key competitors such as Ryanair or EasyJet, which made it vulnerable to price wars and variations in demand in the intensely competitive low-cost airline sector.
Commercial aviation is one of the least attractive industries because all Five Forces are strong. Established rivals compete intensely on price. Customers are fickle, searching for the best deal regardless of carrier. Suppliers - plane and engine manufacturers, along with union labour forces - bargain away the lion's share of airlines' profits. New players enter the industry in a constant stream. Substitutes, although not as strong, are often readily available - such as train or car travel.
Monarch was in fact the third airline failure last year in Europe. While we now anticipate a little respite for the remaining carriers, as it alleviates some of the pressure on overcapacity, we suspect this will be short-lived. There continues to be pressure from new entrants, and the recent backdrop of higher fuel prices will cause further headwinds.
The most useful thing about Porter's Five Forces - and the reason it became so widely adopted - is it encourages companies to look beyond their immediate business to their industry as a whole when shaping strategy. It opens their eyes to game-changing trends early so they can swiftly exploit them. It can also identify constraints on profitability they will need to work around or even indicate they reshape the forces in their favour just to survive.
There are, however, some blind spots when using the framework. The first is in its composition. As a static model, it provides a snapshot of the wider industry at some point in the past. This can be useful for informing short-term strategy but it can be narrowed by rapidly evolving external factors.
The other weakness is a lot of people use the approach in ways for which it was never intended. Trying to apply it to a specific business rather than at an industry level is the most common mistake.
The Five Forces can provide information to enlighten strategic discussions but we must be mindful that although numerous factors can affect industry profitability in the near term, it is industry structure expressed by the competitive forces that sets profitability in the long term.
Ryan Paterson is research analyst at Thesis Asset Management
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