Porter's Five Forces

A short post today, the second of two posts on MBA tools of Business Management (I could churn out more, but let's be honest, there's only so much Business School type stuff one guy can take).

I've previously mentioned the 'Growth-Share Matrix' and the traditional SWOT analysis, which encourages businesses to look at their Strengths, Weaknesses Opportunities and Threats. It's a decent enough tool, but attracted criticism for its very simple nature.

To improve upon this, Porter came up with his 'Five Forces' model which helps to determine the attractiveness or otherwise of a market.

The tool was designed for businesses, but can equally be useful to investors in assessing businesses to invest in, or indeed other markets: gold or other commodities, real estate or other assets.

Three of the forces which Porter identifies are external, and two are internal.

One of the key points behind Porter's model was that it largely reflects micro issues as opposed to the macro environment, which has the implication that even in an industry or sector where profits are generally scarce, some companies or individuals may still outperform if they understand their core competencies and strategies, and apply them effectively.

A good example is the aviation industry. Historically, the industry has not been profitable, and yet, some airlines have thrived against all odds by understanding the market forces and applying appropriate strategies.

Porter highlights 3 forces of 'horizontal' competition: the threat of substitute products (or services), the threat of established rivals and the threat of new entrants

He also notes and forces from 'vertical' competition, being the bargaining power of suppliers and the bargaining power of customers.

The Five Forces

New entrants - industries which are profitable tend to attract new competition resulting in profitability detoriorating (theoretically to zero), so it is important for businesses to establish a moat (such as a quality brand).

Threat of substitute products or services - which may result in customers switching.

Bargaining power of buyers (customers) - the extent to which customers can put a company under pressure, which affects the sensitivity of buyers to changes in price.

Bargaining power of suppliers - suppliers can also hold power over a business if there are few substitutes.

Intensity of competitive rivalry - the intensity of competitive rivalry determines the competitiveness of the industry.

Applying the model

If you run your own business, you will (consciously or otherwise) have assessed the status of each of these forces.

As an individual investor, it is helpful to consider companies which score favourably with regards to Porter's five forces. Buffett likes 'franchise' style companies with unbreachable brand moats and with effective market monopolies for a very good reason - over time they tend to outperform.

Porter noted that his Five Forces model was designed to be used at the 'line of business' level rather than the industry group level - it is a tool to help applying strategy development. The selection of which industry to compete in should be a decision of corporate strategy.

Market forces in real estate

Smart investors in property also consider the markets which they invest in by assessing similar forces. 

Considering each force in turn should cause investors to ask themselves a raft of questions in order to assess risk. 

Here are just a few ideas:

-the threat of new entrants - are more properties being built in the locality? Is there land available for release? Are there few restrictions on land use? Are there few restrictions on the height of buildings which could lead to huge new tower blocks being built and oversupply?

-bargaining power of buyers - is there much stock available on the market? Are vacancy rates high?

-bargaining power of suppliers - are developers struggling to offload new stock or selling it easily? Will developers be forced to sell at a discount? Is the market heating up or slowing down? Will buying off-the-plan secure capital gains on completion or risk negative equity? Is there a risk of "buying at tomorrow's prices today?"

Threat of substitute products - investors should look for properties with scarcity value - what special features will your property have which others do not? Are you an investor in a commercial block in a town with few other alternative units? Are there dozens of other properties available for tenants which are just like yours?

Intensity of competitive rivalry - is market sentiment high or low, increasing or decreasing? Are auction clearance rates struggling in your chosen suburb? Is consumer confidence increasing or sliding? How cheap are mortgage rates at present? Will interest rates be ratcheted up or are they holding steady? 

One of the key lesson of Porter's model is that while at an industry level profits may seem low or non-existent, at the micro level there are those who continue to outperform by sticking to their core competencies, understanding market forces and applying appropriate measures to mitigate risk.