Sustainable Moat: Five force analysis is NOT Enough

Book image

Note: Words in italics are extracts from the book. 

Why five forces important?

The collective strength of the five forces matters because it affects prices, costs, and the investment required to compete. Industry structure determines how the economic value created by an industry is divided—how much is captured by companies in the industry versus customers, suppliers, distributors, substitutes, and potential new entrants. I will skip analysis of five forces, which is covered well by Vishal Khandelwal here.

Before reading the book “Understanding Michael Porter“, I thought doing five force analysis is ENOUGH to do industry analysis and to understand the competitive advantage of any company. But doing five force analysis is only the first step. To truly appreciate the competitive advantage enjoyed by any company, one also needs to analyse VALUE CHAIN of the company and the industry and the STRATEGY being adopted by the company. Else, one will fail to understand competitive advantage being enjoyed by companies like  Shriram Transport, Thomas Cook and Ashiana Housing.

According to Michael J. Mauboussin in his report on “Measuring the Moats”

The central observation is that even the BEST industries include companies that DESTROY value and the WORST industries have companies that CREATE value. Finding a company in an industry with high returns or avoiding a company in an industry with low returns is not enough. Finding a good business capable of SUSTAINING HIGH PERFORMANCE requires a thorough understanding of both industry and FIRM SPECIFIC CIRCUMSTANCES……A company’s ability to create value is a function of the STRATEGIES it pursues, its interaction with competitors and how it deals with non-competitors…..Strategic positioning focuses on how a company’s activities DIFFER from those of its competitors…… The STRATEGIES and resources of below average companies explain 90% or more of their returns.

It’s IMPOSSIBLE to do justice to this book in any post. I have already read it thrice and am sure will read many more times. The most important and helpful aspect of this book are the examples of various companies given by the author. You can download the mind map summary from here. You can also read this article on 25iq blog, which summarizes Michael Porter work much more precisely than I am able to do it.

Why Company A outperform Company B over a long period?

Porter’s answer can be divided into two parts. The first part is attributable to the structure of the industry in which competition takes place. The second part is attributable to the company’s relative position within its industry [i.e competitive advantage enjoyed by the company which needs to be understood by analysing company and industry Value Chain ]. Strategy explains how an organization, faced with competition, will achieve superior performance. “The essence of strategy,” Porter often says, “is choosing what not to do.”

Industry Structure MOST important

The five forces framework zeroes in on the competition you face and gives you the baseline for measuring superior performance. It explains the industry’s average prices and costs, and therefore the average industry profitability you are trying to beat. Before you can make sense of your own performance (current and potential), you need insight into the industry’s fundamental economics. Industry structure is an exponentially more powerful and objective tool for understanding the dynamics of competition. It is systematic, reducing the odds that you will miss something important.

Porter’s research findings on the links between industry structure and profitability challenge several popular misconceptions. Porter has, in fact, found:
First, as different from one another as industries might appear on the surface, the same forces are at work under the skin. Second, industry structure determines profitability—not, as many people think, whether the industry is high growth or low, high tech or low, regulated or not, manufacturing or service. Structure trumps these other, more intuitive, categories. Third, industry structure is surprisingly sticky. Despite the prevailing sense that business changes with incredible rapidity, Porter discovered that industry structure—once an industry passes beyond its emerging, prestructure phase—tends to be quite stable over time. New products come and go. New technologies come and go. Things change all the time. But structural change—and therefore change in the average profitability of an industry—usually takes a long time.

Firm specific factors are equally important.

Abnormal profits

In simple words lesson from above table is not to give undue importance to industry label. I never bothered to do in-depth analysis of companies like Ashiana Housing and Kitex Garments, despite observing fantastic ROE for last 5-7 years My focus was more on the fact that real estate industry and textile industry in total had destroyed wealth of shareholders in India over the last 5-10 years. So, next time you see average ROE of more than 25% for last five years, you should PRESUME that the company enjoys COMPETITIVE ADVANTAGE. Then the second step should be to find out the REASONS for PAST PERFORMANCE and whether the company will continue to enjoy SUSTAINABLE COMPETITIVE ADVANTAGE for next few years.

Understand competitive advantage of the company [Using Value chain analysis]

The five forces shape the industry average P&L. Industry structure then determines the performance any company can expect just being an average player in the industry. Competitive advantage is about superior performance. Competitive advantage allows you to follow the precise link between the value you create, how you create it (your value chain), and how you perform (your P&L). If you have a competitive advantage, then your profitability will be sustainably higher than the industry average. You will be able to command higher relative price or operate at a lower relative cost or both. 

 

cOMPETITIVE ADVANTAGE

Relative price: First, disaggregate the overall profitability number into its two components, price and cost. A company can sustain a premium price only if it offers something that is both unique and valuable to its customers. Apple’s hot, must-have gadgets have commanded premium prices. Ditto for the high-speed Madrid-to-Barcelona train and the trucks Paccar creates for owner-operators. Create more buyer value and you raise what economists call willingness to pay (WTP), the mechanism that makes it possible for a company to charge a higher price relative to rival offerings.

With consumers, buyer value may also have an “economic” component. For example, a consumer will pay more for prewashed salad in order to save time. But rarely do consumers actually figure out what they are paying for convenience, in the way a business customer would. (I once calculated, for example, that consumers were effectively paying well over $100 an hour for the unskilled labor involved in grating cheese.) A consumer’s WTP is more likely to have an emotional or intangible dimension, whether it is the trust engendered by an established brand or the status associated with owning the latest electronic gadget. Automakers are betting that consumers will pay a price premium for hybrid cars that well exceeds their potential savings from lower fuel costs. Clearly, noneconomic factors are at work in this calculation.

Relative cost: The second component of superior profitability is relative cost—that is, you manage somehow to produce at lower cost than your rivals. To do so, you have to find more efficient ways to create, produce, deliver, sell, and support your product or service. Your cost advantage might come from lower operating costs or from using capital more efficiently (including working capital), or both.

Value Chain

The sequence of activities your company performs to design, produce, sell, deliver, and support its products is called the value chain. Most, I believe, know what a value chain is—the metaphor of a series of linked activities is intuitive. But many miss the “so what.” Why does it matter? The answer: The value chain is a powerful tool for disaggregating a company into its strategically relevant activities in order to focus on the sources of competitive advantage, that is, the specific activities that result in higher prices or lower costs. [Value chain comprises activities that managers can control. Ultimately, all cost or price differences between rivals arise from the hundreds of activities that companies perform as they compete.]

Major consequence of value chain thinking is that it forces you to look beyond the boundaries of your own organization and its activities and to see that you are part of a larger value system involving other players. For example, if you want to build a fast food business around consistent, perfect French fries, as McDonald’s did, you can’t make excuses to customers because the potato farmer you buy from lacks proper storage facilities. Customer don’t care who’s at fault. They care only about the quality of their fries. So, McDonald’s has to perform specific activities to make sure that, one way or another, all the potato growers from whom it buys can meet its standards.

Study value chain

How to analyse value chain?

1)      The industry’s value chain is effectively its prevailing business model, the way it creates value It is where most companies in the industry have chosen “to sit” in relation to the larger value system.

2)      Compare company value chain to industry value chain. If Industry value chain = Company value chain, company competing to be best….No company can afford sloppy execution. Inefficiency can overwhelm even the most distinctive and potentially valuable strategies. But betting that you can achieve competitive advantage—a sustainable difference in price or cost—by performing the same activities as your rivals is a bet you will probably lose.

 3)      Find out activities that have a high current or potential impact on differentiation or value creation for customers. Buyer value can arise throughout the value chain. It can come from product design. It can come from choices in the inputs used or the production process itself, both of which are key to the success of In-N-Out Burger, a chain of over 230 hamburger restaurants that uses only the freshest ingredients and prepares its limited menu on-site. It can be created by the selling experience, as any visitor to an Apple Store will tell you. Or, it can arise from after-sales support activities. Every Apple Store, for example, has a Genius Bar where customers can go for free help with technical questions. Whirlwind’s spare parts policy is another example. Whether the customer is a company or a household, examining how your activities are part of the whole value system is the key to understanding buyer value.

4)      Study cost drivers: Your relative cost position (RCP) is built up from the cumulative cost of performing all the activities in the value chain. Are there actual or potential differences between your cost structure and those of your rivals? The challenge here is to get as accurate a picture as you can of the full costs associated with each activity, including not only direct operating and asset costs but also the overhead costs that are generated because you perform this activity.* To get a handle on this, you can ask yourself what specific overhead costs could be cut if you stopped performing this activity. Eg. Scale matters in the auto industry. But a deeper understanding of the cost drivers is critical. Honda, for example, is a relatively small car. company. This might lead you to conclude that Honda would have a cost disadvantage. But Honda is the world’s largest producer of motorcycles, and overall it is a huge producer of engines. Since engines account for 10 percent of the cost of a car and Honda can share the cost of engine development across its product lines, this scope advantage offsets its overall lack of scale.

Strategy

Strategy is the antidote to competition. Strategy means deliberately choosing a different set of activities to deliver a unique mix of value. If all rivals produce the same way, distribute the same way, service the same way, and so on, they are, in Porter’s terms, competing to be the best, and not competing on strategy.

Strategy explains how an organization faced with competition will achieve  superior performance. What value your organization creates and how will you capture some of the value for yourself. 

Specifically, a robust strategy is defined by its ability to pass five basic tests

1) Unique value proposition a company offers its customers.
The value proposition is the element of strategy that looks outward at customers, at the demand side of the business. A value proposition reflects choices about the particular kind of value the company will offer.

Value proposition
2) Unique value proposition will translate into a meaningful strategy only if the best set of activities to deliver it is different from the activities performed by rivals. “If that were not the case, every competitor could meet those same needs, and there would be nothing unique or valuable about the positioning.”

Choices in the value proposition that limit what a company will do are essential to strategy because they create the opportunity to tailor activities in a way that best delivers that kind of value. Tailoring is possible only if there are limits, only if you are not trying to be all things to all people. In other words, limits make it possible to develop a value chain that is different from that of rivals who have chosen to offer a different kind of value.

3) Trade-offs:

Trade off

 Making trade-offs means accepting limits—saying no to some customers, for example, so that you can better serve others. Trade-offs arises when choices are incompatible. Because a successful strategy will attract imitators, choices that are difficult to copy are essential. Trade-offs makes it difficult for rivals to copy what you do without compromising their own strategies. Role of trade-offs in strategy is deliberately to make some customers unhappy [imagine about low cost airlines like Indigo or SouthWest Airlines]

Just think about the strategy followed by Piramal Enterprises in its formulation business as highlighted in this post  “Ajay Piramal wants you to know that by refraining from fighting big MNC pharma companies on their turf (as many Indian pharma companies have done), he was able to get a much better value for the formulations business from them on his turf.

Another source of trade-offs is inconsistencies in the image or reputation. Maxwell, which for most of its history was a dominant player in economy segment through its VIP brand is trying to penetrate into premium category. In my view, Maxwell faces the risk of inconsistencies in image or reputation. Whether they can overcome this challenge is any body’s guess.

The second misconception is about whether it is possible, in today’s supercharged, hypercompetitive world, to sustain a competitive advantage. This is a world in which anything can and will be copied, a world in which the best you can hope for in competing is a series of very temporary advantages. Sound familiar? This is, once again, competing to be the best. But think about it for a minute, and you’ll see that this argument fails to square with the facts. It’s true that choosing a unique value proposition alone is no guarantee of sustainability. If you find a valuable position, imitators will take notice. But competitive advantages can and do persist for decades, as companies such as Southwest Airlines, IKEA, Walmart, Enterprise Rent-A-Car, BMW, McDonald’s, Apple, and many others attest. What do the strategies of such diverse companies as these have in common? The answer lies in just one word: trade-offs.

4) Fit:

Fit

Fit has to do with how the activities in the value chain relate to one another. Its role in strategy highlights yet another popular misconception: that competitive success can be explained by one core competence, the one thing you do really well. Fit means that value or cost of one activity is affected by the way other activities are performed. Fit is basically a system of activities something that requires the integration of decisions and actions across work groups, departments and functions.

5) Continuity
Continuity

 

 

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One Response to Sustainable Moat: Five force analysis is NOT Enough

  1. Fasil says:

    Awesome post, I have read this book recently and this post is complete re-collection of the book “Understanding Micheal Porter”. Kudos to your work Anil

    Like

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