Enlightened Capital Blog

Simplifying Porter's 5 Forces: Competition Demystified Review

Simplifying Porter's 5 Forces: Competition Demystified Review

Bruce Greenwald’s Competition Demystified accomplishes its goal of simplifying competitive analysis. While Porter’s Five Forces is the most well-known framework for strategic analysis, Competition Demystified simplifies Porter’s Five Forces, by focusing on barriers to entry as the most important competitive advantage in an industry. Greenwald’s book provides value for both investors, and corporate executives looking to improve or maintain their competitive positioning within their industry.

Key takeaways:


1) Barrier to entry (new entrants) is the most importance of Porter’s 5 forces (buyers, suppliers, substitutes, competitors, new entrants). 

2) There are three major sources of barriers to entry: supply cost advantages, demand advantages through customer captivity, and economies of scale. Greenwald views economies of scale as the most durable barrier to entry.

3) To analyze an industry, develop an industry map to determine who the competitors are and if competitive advantages exist. Stability of market share and strong profitability/Returns on Capital (ROC’s) are clear signs that competitive advantages exist in an industry. From there determine what are the sources of competitive advantage.

4) If there are no competitive advantages in an industry, then incumbent firms must focus on operational efficiency. Some firms can generate stronger Returns on Capital despite the lack of barriers to entry through strong management practices. As shown below ExxonMobil’s ROE was 8.1% higher on average than BP’s from 2014-2019, despite both operating in the highly commoditized oil and gas industry.

OG ROE
Source: Bloomberg

5) Without competitive advantages, investments will return the cost of capital over time. As a result, it’s important to identify the key competitive advantages of potential investment opportunities, to identify attractive investment options. 

6) M&A only makes sense if there are competitive advantages in place to enable the announced synergies to come to fruition. Additionally, synergies should largely consist of cost savings. As a result, the takeover premium should be less than the identified cost savings.

Barriers to entry is the most important of Porter’s Five Forces

Greenwald asserts that the most important of Porter's five forces is barriers to entry. The other four forces are important but ultimately secondary to barriers to entry. Strong barriers to entry in an industry allow incumbents to earn high returns on capital. This is a great starting point for investment analysis. If you look at the largest 50 U.S. companies today by market cap, all of them operate in industries with substantial barriers to entry including strong network effects, regulatory obstacles, economies of scale, and supply-side cost advantages to name a few. While these companies may not make the best investment opportunities today, identifying these types of barriers to entry in less mature industries can be a great way to identify attractive investment opportunities.

The three sources of barriers to entry

1) Supply Advantages: Competitive Costs. Cost advantages that allow a company to produce or deliver its products more cheaply than peers. As a result, potential entrants are deterred from entering the industry due to their higher cost structures. These cost advantages typically stem from lower input costs such as preferred access to natural resources, but more frequently proprietary technology protected by patents or experience. However, technology based, or experienced based supply advantages should not be taken for granted. Technology based cost advantages have a shorter life span in faster moving sectors such as biotechnology and semiconductors.

Another source of supply cost advantage is driven by government regulations in many industries have reduced the number of firms and have created barriers to entry. For example, the top 5 health insurers in the U.S. (UNH, ANTM, CVS, CI, and HUM) insure roughly 47% of all Americans as of 2019. Massive consolidation across mand industries has also led to supply side barriers to entry, such as the railroad industry where there are now 7 class 1 railroads down from 18 in 1980.

2) Demand Advantages: Customer Captivity. Access to market demand that competitors do not have. Greenwald describes how this advantage is not just product differentiation or branding, but includes customer captivity based on consumer habits, high switching costs, or high barriers to finding a substitute product.

Buying a Starbucks coffee or choosing a Coke or Pepsi has become habitual for billions of consumers globally creating substantial barriers to entry. Competitive advantages through consumer habits tend to be linked to frequent and nearly automatic purchases such as food and beverage products. This behavior does not translate over to less frequent purchases such as luxury cars.

The banking industry represents a clear example of an industry with high switching costs. While many banking services are commoditized, customers infrequently switch banks due to the hassle of doing so. Another more recent demand side barrier to entry would be network effects. This is evidenced by the growth of many software platforms over the past decade including social networks, search engines, and online gaming.

3) Economies of scale. Incumbent firms operating at large scale will enjoy lower costs than their competitors. Greenwald views economies of scale when paired with some degree of customer captivity as the most durable competitive advantage. One of the most important takeaways from the book is that economies of scale can be a substantial barrier to entry even in a very localized market. And as a company expands their market, they make find their economies of scale diminish. Greenwald provides two great examples of economies of scale with Walmart and Coors which I have described below.

Industry Analysis

To analyze an industry, develop an industry map to determine who the competitors are and if competitive advantages exist. Stability of market share and strong profitability and Returns on Capital (ROC’s) are clear signs of competitive advantages. From there it’s important to identify those sources of competitive advantage. The first question you should ask is, are the existing firms in the market protected by barriers to entry or not? If there are no barriers to entry, then the firm must focus on operating as efficiently as possible to maintain its margins and generate reasonable returns on capital. However, the only hope of outsized investment returns is by looking for those industries where there are strong barriers to entry that can be defended by incumbents.

The below map shows the process for the developing an industry map, testing for the existence of competitive advantages and identifying what the sources of competitive advantage are.

Industry Map

For example, the PC industry value chain consists of:

PC Map

Competition Demystified was published in 2005, and it's notable that CPU chips, and software/applications continue to be dominated by the same firms since 2005 showing that the incumbents enjoyed sustainable competitive advantages. Meanwhile, PC manufacturers and networks have largely struggled.

Case Studies

As I mentioned, Greenwald provides two great case studies on what can go wrong when a company with local economies of scale decides to expand its geographic footprint.

Walmart (WMT)

Walmart went public in 1970 with 30 stores in small towns in Arkansas, Missouri, and Oklahoma. In 1985 more than 80% of WMT’s stores were in the 11 states around Arkansas. By the end of 1985 Walmart had expanded to 59 stores in 22 states and by 2000, had more than 3,000 stores in the U.S. and Puerto Rico. While Walmart generated strong operating margins and returns on capital during this entire period (1970-2000), Walmart’s highest returns on capital occurred from 1970-1985 when the company dominated regionally in the Southeast U.S. Return on capital and operating margins declined materially when Walmart expanded throughout the entire U.S. For example, Walmart’s operating margin declined from 7.8% in 1985 to 4.2% in 1997. Similarly, Walmart’s return on capital declined from 35% in 1985 to 15-20% from 1995-2000.

Walmart enjoyed substantial economies of scale in the Southeast U.S. due to lower spend on inbound logistics, as Walmart’s warehouses were located near its stores, aided by the density of stores. Secondly, WMT’s advertising expense was much lower than peers as advertising for retail is local, as Walmart could spread out its advertising expense over a larger number of customers than peers due to how highly concentrated Walmart’s stores were in its region. Finally, managerial oversight and supervision lead to lower expenses, as vice presidents lived near company headquarters and could more easily visit stores and speak with customers. 

These advantages dissipated when WMT expanded outside of the southeast into CA (Target had leading market share) and into the northeast (there were many major competitors). None of WMT’s major cost advantages worked in this expansion as the company had to build more warehouses, increase its advertising expense, and no longer enjoyed managerial efficiencies.

What strategies could Walmart have pursued that would have been more successful? In hindsight, Walmart could have expanded into other retail categories such as groceries (they did eventually) and perhaps home improvement, which would have meant competing with Lowes and Home Depot. Walmart could have also expanded more incrementally, hitting the brakes on their expansion when they noticed margins and returns on capital declining. Finally, Walmart could have investigated the idea of expanding internationally to a small country where they could have recreated their initial local economies of scale advantages.

WMT ROIC

Coors
The story of Coors national expansion strategy is similar to Walmart’s. Prior to its national expansion in 1977, Coors enjoyed strong local economies of scale. Coors was vertically integrated, the company made their own cans, grew its own grain, and used water from its own sources, as well as operated a single brewery. Like Walmart, Coors had lower transportation and advertising expenses than its peers, due to its dominance of a single region. Coors also saved money by not pasteurizing its beer, leading to lower energy costs but also required that products be sold faster and had shorter shelf-life.

However, these costs advantages disappeared when Coors expanded nationally. Transportation costs increased as their beer had to be transported further distances. Additionally, Coors substantially increased their advertising expense to compete on a national basis with Anheuser Busch (AB). As a result, Coors operating margins declined from 20% in 1977 to 9% in 1985, driven by a 1200bps increase in advertising expense and a 200bps increase in SG&A. Meanwhile, Coors couldn't move the needle on its 8% domestic market share despite increasing its geographic footprint, while AB’s market share increased from 23% to 36%.

So what could Coors have done differently? Coors likely could have increased its market share and returns on capital by staying local and only expanding at the margin. Coors likely would have beat AB in a price war locally, given their local economies of scale advantage. 

Coors Operating Margin

The key lesson here is that local economies of scales can be a sustainable competitive advantage. But only if the incumbent chooses to defend their turf rather than expand to regions where they do not enjoy economies of scale. Be worried if one of your investments starts to expand outside of their local economies of scale. Similarly if you are an executive at a company who is looking to expand geographically to areas with no economies of scale, based on Competition Demystified, I would advise against that, and instead focus on strengthening your competitive position in the geographies where you enjoy economies of scale. Perhaps there are opportunities to expand into an adjacent product lines within your territory, or to vertically integrate and still maintain your economies of scale.

Valuation from a strategic perspective

Greenwald is not a fan of discounted cash flow (DCF) valuation models for investment decisions, given that the terminal value represents such a large percentage of the overall value generated from a DCF analysis. Because small changes to your assumptions can have an outsized impact on the output of your model, the reliability of these calculations is highly compromised. Garbage in garbage out!

Instead Greenwald focuses on the three-step approach below. At a high level, the Total Value of a firm equals the Asset Value plus the Franchise Value plus the Value of Growth. The franchise value represents a firm’s Earnings Power Value (current earnings/cost of capital) minus its asset value.

Competition Demystified goes into much greater detail on this process, but the key points are that a firm’s Total Value will only exceed its Asset Value if the firm enjoys sustainable competitive advantages. Additionally, pursuing growth will only increase the firm’s value if there are competitive advantages in place. Otherwise other firms will enter the industry driving the EPV down to the Asset Value. The firm’s franchise value is the excess return the company earns due to its competitive advantages.

Greenwald also wrote an excellent book on Value Investing, if you're interested in a deeper dive on his approach. 

Three tranches of value

Incorporating competitive analysis into Corporate Development

Corporate development includes mergers and acquisitions (M&A) as well as new ventures and brand extensions. Greenwald describes how these decisions need to be approached through the lens of competitive analysis and barriers to entry. Greenwald is overly critical of most M&A due to the high premiums acquirers typically pay in addition to the fact that shareholders can more easily diversify their investments on their own.

As a result, there is a high hurdle for a company considering an acquisition. M&A only makes sense if there are competitive advantages in place to produce the synergies that justify the acquisition. Additionally, the synergies should largely consist of cost savings. There may be opportunities for the management of the acquirer to improve operations for the target, but these benefits are rarely realized.

Conclusion

Competition Demystified makes a valuable contribution to competitive analysis by elevating barriers to entry as the most important of Porter’s Five Forces and minimizing the importance of the other four forces. Intuitively, if an industry has high barriers to entry, incumbents should have a strong competitive position with suppliers, buyers, substitutes, and this inherently reduces the number of competitors.

This framework is valuable for both investors and corporate executives looking to deploy capital internally or to expand through acquisitions. Additionally, the focus on major sources of barriers to entry (supply, demand, and economies of scale), is a great starting point for both industry and company analysis. Finally, the book provides numerous examples across industries and time, and provides many tools for analysis, helping practitioners to improve their investment decisions.

Thanks for reading and please sign up for my blog! You can follow Enlightened Capital on twitter here!

 


No thoughts on “Simplifying Porter's 5 Forces: Competition Demystified Review”

Get the latest information

Subscribe to the Enlightened Capital Blog and get the latest information sent to your inbox.

ec logo design 1247w 669E38 twitter social media icon design template vector 22339994

contact@enlightened-capital.com 

Disclaimer: Enlightened Capital is for entertainment purposes only. Nothing we write here can be considered advice or guidance for investment decisions or, for that matter, any other decisions. If uncertain, always consult an investment advisor and/or accountant.

Enlightened Capital makes no representations as to accuracy, completeness, currentness, suitability, or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Furthermore, Enlightened Capital assumes no responsibility for the accuracy, completeness, currentness, suitability, and validity of any and all external links you find here. Enlightened Capital assumes no responsibility or liability for postings by users in the comments section.

© 2020 Enlightened Capital. All Rights Reserved.