We’re big advocates of a bottom-up approach here at The Motley Fool. We invest in individual companies instead of betting on sectors. This approach can help us ignore the relentless ‘noise’ of the market, but taking this approach too far can be dangerous too.
Companies do not exist in isolation and do not have complete control over their destiny. It is therefore important to consider the impact market forces could have on an investment candidate. Michael Porter, a professor at Harvard, has designed a model of analysis that helps us investigate how a company functions inside its industry.
Porter’s Five Forces provides insights into how the competitive picture may impact sales and profitability at a given company in the future.
Force number one asks: How easily can another company enter this industry”
Threat of new entrants
Industries with relatively few players often boast outsized returns on capital. Investors will always be drawn to such industries, but unless a company has a wide economic moat (or durable competitive advantage) new competitors will inevitably emerge, vying for a cut of the juicy profits. This increased competition erodes margins until return on capital reverts to the mean. Investors who bought in at its zenith will be left nursing nasty losses.
To avoid this fate, don’t be drawn in by big margins. Instead ask yourself how easy would it be to recreate this business if money was no object. If you could create a viable rival without in-house knowledge, hard-earned customer relationships, regulatory approval, brand-building, patent approval or any other differentiator, the company in question likely has a weak competitive position.
Threat of substitutes
The force of substitution is the threat of customers choosing a different product over yours. Driverless cars might substitute taxi drivers. One engine part may be interchangeable with a competing product. When analysing a product, ask: what might be substituted for this? If a service or product is differentiated and strong enough that it has few threats of substitution, it could have the potential for outperformance.
Bargaining power of customers
In industries where competition is rife, the balance of power often shifts towards the customer base. This can result in price-sensitive consumers, minimal brand loyalty or even open the doors to price negotiations, thus reducing profitability.
Bargaining power of suppliers
When there is both bountiful supply and suppliers, a company can tend to source its inputs more cheaply because of increased competition. However, if a company must buy a special chemical that is only made by one supplier, it has little scope to negotiate on price if there are few or no viable substitutes.
Industry rivalry
Who are the other big players in the candidate’s industry? What are they good at? Where do they fall down? Do they have any distinct differentiators? Can they threaten the candidate in the future? Understanding how your candidate compares to peers is or paramount importance to forming an opinion on its future.