In this edition of BRST Insights, I share some perspectives on Michael Porter’s highly popular Five Forces Framework to assess competitive landscape of industries.
The starting point of assessing the investment attractiveness of any stock is to assess its industry attractiveness, which in turn, is highly dependent on the industry’s competitive landscape. Conventionally, competition is deemed to exist only between rival companies. However, Michael Porter, the guru of competitive analysis and strategy, offers a different perspective. According to Porter, competing for profits involves multiple players, not just rivals. Besides rivals, companies compete for profits also with -
•Customers, who would always want to pay less and get more,
•Suppliers, who would always want to be paid more and deliver less,
•Producers who make substitutes, and
•Potential rivals (i.e. new entrants).
Porter captured all these dimensions of competition in his highly famous Five Forces Framework depicted on the next page.
Five Forces perspectives – Inter-firm rivalry is key
In their book Playing To Win, authors A G Lafley and Roger Martin offer some interesting perspectives on the Five Forces Framework. They write –
“The five forces can be divided into two axes. The vertical axis … determines how much value is generated by the industry (and is therefore available to be split up among industry players). If it is very difficult for new players to enter the industry and there are no substitutes to the industry’s product or services to which buyers can turn, then the industry will generate high value.”
“The horizontal axis determines which entity will capture the industry value – suppliers, producers or buyers … The degree to which there is fierce rivalry affects which group captures value too. If rivalry between competitors is high, the dynamic will facilitate the appropriation of value by suppliers or buyers. A low degree of rivalry will protect profitability for the producers.”
It is insightful to note that Inter-firm rivalry is at the centre of both axes i.e. it influences both value creation and value distribution in any industry. This is best explained by two contrasting examples.
Inter-firm rivalry – Telecom & Paints
Both Telecom and Paints are consumer-facing businesses. In India, there are only 4 major players in both. And yet the profit trend in both are in stark contrast to each other.
The profit trend of three telecom majors (Exhibit 2) reflects the impact of inter-firm rivalry. Till FY-2008, the market had only these three players, and profits were on the rise. In 2008, a slew of new telecom licenses were issued, the impact of which was felt FY-2011 onwards. Then, in FY-2012, the Supreme Court cancelled all the 2008 telecom licenses, and profits began to look up again. However, the last three years have seen the entry of Reliance Jio, and the industry has gone into losses, despite there being only 4 major players (Bharti, Vodafone, Idea and Jio). Vodafone and Idea have now merged, but there’s no respite in profits which continue to decline in the first half of FY-2019.
Contrast the above with the Paints sector (Exhibit 3). Profits here have risen consistently, suggesting benign inter-firm rivalry.
Key takeaways
•Inter-firm rivalry is the core determinant of a company’s Quality of business. Higher the inter-firm rivalry, lower the Quality of business and vice-versa.
•The number of incumbents is not that important. Inter-firm rivalry can be high even when incumbents are few.
•Businesses with intense inter-firm rivalry don’t create value for shareholders, and are best avoided.
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