Five forces, two directions
Analysing an industry means looking at it from several angles and concluding whether it is attractive as an investment. The most popular framework is the five forces model developed by Dr Michael Porter in 1979. It scores an industry on five forces, split into three horizontal ones (threat of substitutes, threat of new entrants, threat of established rivals) and two vertical ones (bargaining power of suppliers and of customers), with industry rivalry at the centre of the picture.
In some industries the forces make it very hard for owners to earn significant profits: aviation, telecom, retail, textile, sugar and power are the syllabus's examples of unattractive industries. In others the forces are weak and margins stay high for long periods: education, FMCG, healthcare and IT, the attractive ones.
Two quotes the syllabus attaches to industry structure. First: when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. Second: should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks. The point: great management cannot fix bad industry economics, and the investor is better off moving to a different industry.
Industry rivalry
High rivalry, as in aviation and telecom, ends in lower pricing power and lower incomes for everyone in the industry. Innovation, customer service and engagement become essential, and a deep-pocketed competitor can dump products below cost to drive others out, since not everyone can sustain losses for long. Rivalry is high if many companies exist in the segment, products are similar with little or no differentiation, every participant uses the same tactics (lower prices, longer credit), and customers' switching costs are low or nil. Indian telecom is the case: many players per circle fighting for share with competitive plans, and a high prepaid component that lets price-sensitive subscribers migrate to cheaper offers. Charlie Munger, partner at Berkshire Hathaway, put it in one line: if the only basis of competition in an industry is pricing, it is a self-defeating business.
How does a company in such an industry still reward shareholders? Aggressive innovation, inside and out. Internally: more efficient operations, lower working capital, faster turnaround, lower cost of capital. Externally: differentiated products, strong brands, unique positioning. Micromax, a cellular device maker, took a 10% market share within three years of launch by focusing on special features at competitive prices.
Threat of substitutes
Industries change: the telegram vanished when SMS proved cheaper, easier and more accessible; cement pipes lost to steel and plastic; typewriters were replaced entirely by computers; iPods and mobiles retired the radio and the two-in-one. The most famous case is digital photography destroying Kodak's film-based model. Kodak's own engineers invented the first digital camera, but the company did not move to it, to protect its existing business, and later filed for bankruptcy. The ability to foresee change and adapt early defines success. Some industries face no substitutes at all: power, healthcare, education may change how they serve customers but will never be out of business.
The threat is high if substitutes offer an equal or better experience (quality, price, ease) and switching costs are low or nil. Some substitutes take a long time: solar products are cheaper to operate but need upfront capex, and LED lights faced the same deterrent, until falling costs push more customers across.
Bargaining power of buyers
Buyers dictate prices when many sellers offer similar products and matter less when sellers are few. Buyer power is a function of the number of buyers and sellers and the differentiation of products, and of the buyer's size and profile: the government as a buyer has clout. Buyer power is high if competitive intensity is strong (continuous pricing pressure), products are standardised with little differentiation, and close substitutes exist with low switching costs.
Bargaining power of suppliers
A consumer rarely bargains over a hospital's or a school's fees but bargains with the vegetable vendor every day: supplier power is absolute in the first case and nil in the second, unless the vendor is the only one and substitutes are far away. The Indian sugar industry depends on a cane price decided by the government after hearing farmers, so its input cost is what suppliers demand. The Organization of the Petroleum Exporting Countries (OPEC) controls crude supply by adjusting output to hold the prices it wants, which is pricing power. Supplier power is high if suppliers are few and buyers many, suppliers provide critical inputs, competitive intensity in the industry is low with differentiated products, the products have no threat of substitutes, and customers' switching costs are high.
Barriers to entry
An industry without the threat of new competitors is attractive to owners. Barriers include licensing, required competence or skills (IT products), capital (oil and gas), distribution reach (banking and finance) and customer brand loyalty (toothpaste, coffee). This is what Warren Buffett calls the moat: "In business, I look for economic castles protected by unbreachable moats." High barriers bring pricing power: the ability to sell at a premium without fear of losing customers. Barriers are high if the business needs a lot of licensing, patents and copyrights keep entrants out, huge investment in specialised assets is required, and strong brands, distribution networks, specialised execution capability and customer loyalty already exist.
Low competition, high barriers to entry, weak supplier bargaining power, weak buyer bargaining power, few substitutes. An industry with these features has strong pricing power and high margins. Education in India fits: ample and rising demand, students with little bargaining power, multiple permissions needed to start an institute (high barriers), few quality institutions (low competition), teaching staff paid at salaries the management decides (weak suppliers), and competing courses that do not inspire enough confidence (few substitutes). It is also largely protected from recession.
Suppliers and buyers are the vertical forces because they sit above and below the industry in the value chain. Substitutes, new entrants and existing rivals are horizontal because they compete for the same customer. A question that files buyer power under horizontal forces is wrong.
- Dr Michael Porter's 1979 model judges an industry's attractiveness through five forces: three horizontal (threat of substitutes, threat of new entrants, rivalry among established players) and two vertical (bargaining power of suppliers, bargaining power of buyers).
- Rivalry is high with many players, undifferentiated products, identical strategies (price cuts, longer credit) and low switching costs. Substitute threat is high when substitutes match or beat the product on quality, price and ease and switching is cheap. Buyer power is high with strong competition, standardised products and available substitutes. Supplier power is high with few suppliers, critical inputs, low competition with differentiation, no substitutes and high switching costs. Entry barriers are high with licensing, patents and copyrights, huge specialised investment, strong brands, distribution, execution capability and customer loyalty.
- An attractive industry has low competition, high entry barriers, weak suppliers, weak buyers and few substitutes, giving pricing power and high margins; education is the syllabus's worked example. Aviation, telecom, retail, textile, sugar and power are unattractive; education, FMCG, healthcare and IT attractive.
- Buffett: brilliant management meets bad economics and the business's reputation survives; in a chronically leaking boat, change vessels rather than patch leaks. Munger: if pricing is the only basis of competition, the business is self-defeating.