Industry profitability, as measured by a firm’s return on capital employed (ROCE), is determined by how successfully a firm can capture the value it creates for its buyers, which can differ depending on the structure of the industry. When the structure is favourable, companies are typically able to retain a decent proportion of the value (e.g. medical supplies). Conversely, in an unfavourable environment, much of this value would be competed away to others (e.g. autos), be it customers (driving down prices), suppliers (inflating costs), substitute products (reducing differentiation) or potential or existing rivals (eroding market share).
It is also important to distinguish between cyclical factors that affect short-term profitability, such as the weather or a particular business cycle, from the structural fundamentals that shape long-term profitability. This is manifested through the collective strength of the five key competitive forces (defined by the consultant, Michael E. Porter) that governs price, cost, and investment input required:
Often one or more of the five forces will take prominence in an industry. For example, in an industry with an oligopolistic market structure, natural barriers exist inhibiting new entrants via cost economies of scale. Further, these companies command superior pricing power as consumers have limited alternatives; therefore the main threat lies with its existing adversaries. expired domain list On the other end of the scale, in an industry comprising of many competitors where entry barriera are low, substitutes can easily transpire and so the bargaining power of customers becomes a greater risk. In this case the firm suffers intense pressure from a multitude of the ‘forces’, weighing down profitability.
A firm must be able to identify the dominant force(s) within its industry and position defensively against them to stay relevant in the long-run. Thereby, industry structure will become a critical influence on the competitive strategy undertaken. It is also essential to realise that industry trends can change over time. A firm is not tied down by its industry, on the contrary, it can actively improve the industry’s intrinsic attractiveness by finding innovative ways to compete and alter the overall industry dynamics for the better as long as the strategy they employ is a constructive one.
The application of classic Porterian criteria is central to our selection of “global franchise companies”. Although the underlying thinking can be critiqued as having become generic, even homespun, it is remarkable how strong these factors are in explaining long term equity returns at the individual company level. The key words here are “long-term” as most investors, including institutional investors, simply do not invest with long enough time horizons for Porterian forces to exact their toll. The impatient human mind is drawn into shorter term trends and is prone to overreact to temporal data changes. A watchword for this over-caffeinated approach is “thematic investing”. Beware the thematic investor.