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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Saturday, July 7, 2007

Industry Analysis: Porter's Five Forces Driving Competition

Porter's 5 Forces Model:

I. Threat of Potential Entrants-
Barriers to Entry
1. Economies of Scale
• Refer to declines in unit costs of a product as the absolute volume per period increases.
• Scale economies may be present in many functional areas: manufacturing, purchasing, R&D, marketing, service network, and distribution.
• Its possible to share economies across businesses within a firm if there are shared costs and/or shared benefits such as intangible assets such as brand strength and know-how
• Barriers can occur with economies to vertical integration
• New entrants are faced with huge cost disadvantages if they can not enter in minimum efficient scale
2. Product Differentiation
• Established firms have brand identification and loyalties, which stem from past advertising, customer service, product differentiation, or being the pioneer.
• Entrants are forced to spend heavily to overcome existing customer loyalties
3. Capital Requirements
• If large sums are capital are needed a barrier may exist especially if its risky or unrecoverable, upfront investment such as advertising and R&D.
• Most firms have access to capital, but if risky cost of capital will be high thus giving the advantage to the incumbent firms.
4. Switching Costs
• If switching costs are high, new entrants must provide a substantial inducement for customers to switch from an incumbent.
5. Access to Distribution Channels
• If incumbent firms have channels tied up, new entrant must provide incentives to channel members to accept its product through price breaks and advertising allowances
• New entrants may have to create new channels if the established ones are characterized by strong, symbiotic relationships among the members
6. Cost Disadvantages Independent of Scale
• Established firms may have cost advantages not replicable by potential entrants no matter what their size and attained economies of scale.
1. Proprietary product technology or patents
2. Favorable access to raw materials- established firms may have locked up most favorable sources
3. Favorable locations
4. Government subsidies
5. Learning or experience curve- unit costs decrease as firm gains more cumulative experience in producing a product. Costs decline because workers improve their methods and become more efficient (learning curve), layout improvements, and technology improvements.
7. Government Policy
• Government could limit entry by licensing requirements and limits on access to raw materials.
• Pollution control and product safety requirements
Expected Retaliation-
• Expectations of existing competitors will influence threat of entry
• History of vigorous retaliation
• Established firms with resources to fight back, including excess cash and borrowing capacity, exceed productive capacity, or great leverage with distribution channels or customers
• Established firms with great commitment to the industry and highly illiquid assets
• Slow industry growth: limits industry’s ability to absorb a new firm
Entry Deterring Price-
• Entry deterring price is the prevailing structure of prices which balances the potential rewards from entry with expected costs of overcoming structural entry barriers and risking retaliation
Properties of Entry Barriers
• Entry barriers can and do change as conditions change
• Firms’ strategic decisions affect entry barriers such as increasing advertising or establishing a distribution network or vertical integration; all can increase economies of scale thus barriers to entry

II. Intensity in Rivalry of Existing Competitors
1. Numerous or Equally Balanced Competitors
• With numerous competitors- increased risk of maverick firms who might think they won’t be noticed
• If few, equal competitors - may be prone to fight each other and if have similar resources, they probably have similar strategies thus same target market
2. Slow Industry Growth
• Slow growth turns competition into a market share game for firms seeking growth..
3. High Fixed or Storage Costs
• High fixed costs create strong pressures for firms to fill capacity which leads to price cutting when excess capacity is present
4. Lack of Differentiation or Switching Costs
• If offerings are perceived as commodity or near commodity, then competition is based on price and service, resulting in intense price competition
5. Capacity Added in Large Increments
• Risks of overcapacity thus periods of price-cutting to fill capacity
6. Diverse Competitors
• Competitors may have a hard time reading each other’s intentions accurately and agreeing on the rules of the game
7. High Strategic States
• Firm may have increased pressure to succeed in a particular industry in order to further its overall corporate strategy.
8. High Exit Barriers
• Exit barriers are economic, strategic, and emotional factors that keep firms from leaving poor industries
i. Specialized assets with low liquidation values
ii. Fixed costs of exit: labor agreements, resettlement costs
iii. Strategic Interrelationships: Image, shared costs
iv. Emotional barriers: loyalty to stakeholders, pride, fear
v. Government and social restrictions: govt. denial or discouragement for exit

III. Pressure from Substitute Products
• Substitutes perform the same function as the products in the industry, satisfy same needs and wants
• Substitutes that merit attention are ones improving their price performance trade-off and highly profitable products
• Substitutes limit returns by placing ceiling on prices

IV. Bargaining Power of Buyers
1. Purchases Large Volumes Relative to Seller Sales
• Raises importance of buyer’s business in firms performance
2. Products Represent Significant Fraction of Buyers Costs or Purchases
• Buyers are price sensitive and will search for best deals
3. The Products are Undifferentiated or Standard
• If buyers can find alternatives may play one supplier against another
4. Buyers Face Few Switching Costs
5. Buyer can Influence Purchase Decision of Consumers
• Retail has power over manufacturers when they can influence purchasing decisions- such as products that require sales assistance like appliances
6. Buyers Earn Low Profits
• Creates great incentives for buyers lower purchasing costs and find or bargain for best deal
7. Buyers Pose Threat of Backward Integration
• If pose threat, buyers are in a position to demand concessions
8. Quality Unimportant to Quality of Buyer’s Product or Services
• If quality is important then buyers are less price sensitive
9. Buyers Have Full Information
• If buyers have full info about demand, actual market prices, and even supplier costs, this provides greater bargaining leverage then when information is poor

V. Bargaining Power of Suppliers
1. Dominated by Few Sellers and More Concentrated than Industry it Sells to -
• Suppliers selling to more fragmented buyers will have more influence in prices, quality, terms
2. Suppliers Do Not Face Threat of Substitutes
• Power of large, powerful suppliers can be checked if they compete with substitutes.
3. The Industry is not Important Customer of Supplier Group
• If suppliers sell to many industries, and a particular industry does not represent a significant fraction of sales, suppliers can exert power
• If industry is important customer, suppliers fortunes will be tied to the industry, therefore they will want to protect it with reasonable pricing and assistance in activities like R&D and Lobbying
4. Suppliers Group Products are Differentiated/ Switching Costs involved
• Buyers facing switching costs or differentiation does not allow them to play suppliers against one another
• High switching costs can place firms at the mercy of their suppliers
5. Suppliers Product is Important Input to Buyer’s Business
• If input is important to manufacturing process or product quality then supplier power is increased.
6. Threat of Forward Integration
• This provides a check for firms to improve their purchasing terms
• Labor must be considered as a supplier. Unions and scarce, highly skilled labor can bargain away potential profits


Rahul said...

excellent compilation of Porter's Five Forces.

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