Five Forces

Five Forces

The importance of ROE (return on equity) and buying companies with bright prospects is sacrosanct here at the Insights Blog but why? ROE is an important explanatory variable for superior share price performance and so we want businesses that can sustain high rates of return. When I talk about bright prospects it is the sustainability of these high rates of return that I am referring to. Whether the bright prospects relate to a rising tide of customers, the ability to pass on rising costs, the ability to be the low cost provider or the changing competitive landscape, how these factors serve to produce a high rate of return on equity is what we care about.

 More specifically, it’s the marginal return on equity that drives the value, or the return generated on the incremental capital invested in the business to deliver earnings growth.

Created by Harvard Business School professor Michael Porter to analyse the attractiveness and likelihood of profitability of an industry, Porter’s Five Forces are a simple but powerful tool for understanding where power lies in any business situation. Using this tool, you can gain insight into the competitive strength of an investee candidate.

While these Five Forces are typically used by companies to determine whether new products, services or businesses may be profitable, investors can use them to analyse the competitive position of any industry member.

Numerous economic studies have shown that different industries can sustain different levels of profitability. This can be attributed to differences in industry structures. Within those industries however there is a pecking order of companies and Porter’s five forces reinforces the need to understand where your investee candidate sits and whether that high ROE being produced today can be sustained.

The Porter’s Five Forces model is a tool that we have found to be helpful when picking companies in which to invest. I came across this model while I was studying an Information Systems subject at University.

The Porter’s Five Forces model was developed by Michael Porter to help understand a company’s competitive advantage. The five “forces” that are identified by Porter are:

1) Threat of new entrants

New entrants can increase market competition between companies. In the absence of a dominant player, this can lead to erosion of profit margins.

The threat of new entrants is highly dependent on the barriers to entry. For example, it is relatively easy to start a small pizza business, but it would be difficult to compete with or replicate Cochlear’s business due to the massive R&D costs and intellectual property that is hard to obtain.

2) Power of suppliers

Suppliers can place pressure on margins if they are dominant players in the market. This can be observed in the technology retailing market. The market power of Apple products and their ability to drive store traffic means it can dictate pricing, tactical promotional activity levels and margins to the retailers.

3) Power of customers

A profitable company depends on attracting and retaining customers. However, customers hold the power when they can easily switch to a competitor’s product or service.

In a competitive market where there is little product differentiation, particularly in industries where products have become commoditised, customers have the power to force businesses to compete on price. This is evident with online book stores, where consumers have the ability to search for and compare the cheapest prices across online retailers such as Amazon, eBay, Book Depository and Booktopia, forcing traditional bricks and mortar book stores to compete.

4) Availability of substitutes

In the majority of industries there are substitutes that a customer might use if prices become prohibitively high. Substitutes can be seen in the energy sectors, for example, petrol is increasingly being substituted with ethanol in cars.

New technologies also create substitutes. The introduction of electronic downloadable music has been very popular with consumers who wish to purchase and download music at their convenience. CD sales have dwindled much to the dismay of record labels. Companies need to be agile and adapt to new trends. Kodak is a classic example of a company that did not move with the times.

5) Existing competitors

Competitors all fight for market share by developing their brands and by attempting to attract customers. Increased competition can lead to the erosion of profit margins. Innovation can help, however this is difficult for businesses that operate in a commodity-type business. Explosives manufacturers (e.g. Orica and IPL) typically sell the same products as their competitors, and perhaps their investment in R&D for specific applications is a means for them to differentiate themselves from their competitors.

The video below explains Porter’s Five Forces:

Stuart Jackson is a Senior Analyst with Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.