Financial Education

In the January 2008 Harvard Business Review Michael Porter updates his five forces model and discusses merger and acquisition strategies merely designed to eliminate rivals (rather than improve cost or quality) are risky.

Based on the five forces model, the reduced competition should increase industry profitability in the short term. However, the additional profits often attracts new competitors and a backlash from customers and suppliers.

There are many factors that influence the investment performance of securities and industries. Only some of these are related to the general economy. Structural changes in a variety of categories can affect the prospects for companies and industries.

Demographics

Changes in birth rates can have a profound impact on the overall economy. The “baby boom” in the US drove many trends as the needs of a large segment of the population evolved from diapers to education, from first homes to child-raising and finally to retirement. As the group retires, it may result in wage increases as the workers must be replaced from a smaller pool or in greater demand for financial services advice.

Lifestyle

Are people living in cities or moving to suburbs? Is the divorce rate rising or falling? Are more people buying second homes or discretionary items? All of these can influence industry prospects.

Technology

Technology can make some products obsolete, and introduce entirely new products. It can also effect the efficiency of the overall economy.

Politics and Regulation

Regulations affect many industries, and the political climate, lifestyles and social values can impact the future of those regulations. New regulations, changes to existing regulations, and deregulation can all have profound impacts on company and industry prospects.

There are many issues outside the control of company management or industry participants that nonetheless affect an industry’s viability. Understanding these factors is critical to industry and company research. The primary external factors affecting industries include technology, government, social changes, demographics and foreign influences.

New technologies can render existing products obsolete, but do not always. The automobile superseded the horse and buggy, but the airplane did not replace the auto. Other technologies have emerged and died without ever really challenging existing technology, while others are simply adapted into the existing products.

Government can play a large role in many industries, primarily through regulations. Laws can change over time, altering the competitive dynamics. Whole industries have been created around loopholes in regulations (such as the competitive local exchange carriers or CLECs following the 1996 Telecom Act in the United States) but closing the loophole can kill off the industry. Other industries sell to the government (such as defense or health plans reimbursed by Medicare). These too are dependent upon laws and the budget process, rather than market forces, to prosper.

Social changes are the result of the attitudinal shifts among the population. Smoking, once considered chic, is now frowned upon. Social changes are related to, but often distinct from fashion. In the 1980’s thin neckties were a fashion. In the 1990’s workplaces tended to move toward more casual attire. This may either be a fashion or a social change, depending upon whether neckties and business suits “come back” or gradually disappear.

Demographic shifts are often considered relevant to long-term trends. The large surge in population due to the baby boom has led to industry success depending on the boomer’s life stage.

Foreign influences have increasingly emerged through advances in communication technology and the global economy. “Offshoring” of high technology jobs is a case in point. At the same time, increasing standards of living in developing countries could lead to new demand for industries previously considered mature.

Market based economies do not grow in a straight line. Growth tends to trend in cycles, with acceleration, deceleration, decline (recession) and recovery all being part of the normal course of business. However, not all industries follow the same cycle as the overall economy. Certain industries perform better at different stages of the business cycle. The primary classifications by business cycle reaction are growth, defensive and cyclical.

Growth industries tend to perform better than the overall economy throughout the business cycle. Often growth industries can expand even during a recession. Growth industries are generally characterized by new products or technology.

Defensive industries tend to be stable throughout the business cycle. These tend to be mature industries that will grow well during expansionary times but may see a modest dip if the economy turns down.

Cyclical industries tend to go through boom and bust cycles. However, these cycles may not correlate with those of the overall economy. In fact, some cyclical industries are counter-cyclical relative to the overall economy and perform best during a recession. Cyclical industries tend either to market discretionary products (customers can wait for until they are more confident before buying) or capital intensive. Capital intensive industries often see stable demand, but supply must be added in large “steps.” The sudden availability of excess supply hurts pricing until demand catches up, then eventually another large source of supply must be added and again results in an industry downturn.

Porter’s Five Forces can be used to estimate the overall competitive structure of an industry, and can also be useful in helping understand a company’s position within the industry and in shaping each firm’s competitive strategy. In order to succeed in the long run, a firm must cultivate some sort of sustainable competitive advantage. The three generic strategies that can result in such an advantage are cost leadership, differentiation and focus.

Cost leadership refers to the cost of production, not the price charged to customers. In a market where price is determined by supply and demand, the company with the lowest cost of production will enjoy the highest profits. Cost leaders cannot ignore differentiation - if its products are deemed inferior it will not be able to charge the same price as competitors and the lower cost will not produce sustainable advantage. The key is to maintain approximate parity with regard to differentiating factors while achieving the lowest cost.

Differentiation exploits customer willingness to pay more for something perceived to be of greater value. This can be quality, service, marketing or other factors. Differentiators cannot ignore cost - they must ensure that any additional costs incurred in differentiation are exceeded by the premium customers will pay for the differentiated product.

A focus strategy is based on serving a narrow segment of the overall industry and tailoring its strategy to the unique needs of its focus segment. Typically a focus strategy entails one of the other two strategies - being either a cost leader or a differentiator within the focus niche.

The industrial life cycle is a term used for classifying industry vitality over time. Industry life cycle classification generally groups industries into one of four stages: pioneer, growth, maturity and decline.

In the pioneer phase, the product has not been widely accepted or adopted. Business strategies are developing, and there is high risk of failure. However, successful companies can grow at extraordinary rates.

In the growth phase, the product market has been established and there is at least some historical guide to ground demand estimates. The industry is growing rapidly, often at an accelerating rate of sales and earnings growth. Companies will still face relatively frequent execution issues.

As the product matures, growth slows as penetration reaches practical limits. Companies began to focus on market share rather than growth. Industry demand tends to follow the overall economy.

At some point, many industries peak and begin a steady decline. Shifting tastes or new technologies render some products less relevant. Some firms exit the industry by focusing on other products, bankruptcy or being acquired by rivals. The focus for management shifts to managing expenses and exiting gracefully.

An important factor in whether a firm can be profitable is the attractiveness of the industry in which it operates. A company’s ability to earn at least its cost of capital is strongly influenced by the competitive dynamics of its industry. Porter’s Five Forces Model is a conceptual approach to examining industry dynamics that can be useful in determining industry attractiveness.

Porter’s model says that five factors influence an industry’s profitability because they influence the prices, costs and investments required of industry participants. These five forces are:

1. Buyer bargaining power
2. Supplier bargaining power
3. Availability of substitute products
4. Threat of new entrants
5. Intensity of rivalry between existing firms

The collective strength of these five forces determines the ability of firms in the industry to earn average rates of return that exceed their cost of capital.

An important part of researching a potential investment is understanding the company’s position within its industry, as well as the broad trends facing all companies in the industry. According to the CFA Institute, an effective industry analysis should consider all of the following:

• Industry Classification

• Life cycle position

• Business cycle

• External factors

• Technology
• Government
• Social
• Demographic
• Foreign

• Demand analysis
  • End users
  • Real and nominal growth
  • Trends and cyclical variation around trends
• Supply analysis
  • Degree of concentration
  • Ease of entry
  • Industry capacity
• Profitability
  • Supply/demand analysis
  • Cost factors
  • Pricing
• International competition and markets