Michael Porter Five Forces Analysis is an important framework to understand an industry’s structure.
It is also a framework used by top companies’ management to drive their firm’s strategic direction. However, I do like to point out a particular force which could potentially affect a firm’s competitive edge and profitability. Firstly, an introduction to the diagram of the framework and a brief description of the Five Forces below:
Source: Google Images
Threat of Substitute Products
The existence of alternative products available in the market which increases the propensity of customers to switch to other products.
Bargaining Power of Supplier
These companies supply market inputs such as raw materials, components, labor and services to the firm. Their bargaining power increases if they are relatively concentrated.
Bargaining Power of Buyer
Buyers can be end-consumers or institutions where their bargaining leverage increases as the buyers get more price sensitive to factors such as brand identity, product differences, quality and performance.
Degree of Rivalry Among Existing Competitors
The intensity of competition within the industry driven by factors such the number of competitors, industry growth and the existence of exit barriers.
And The One Force…
Threat of New Entrants into the Industry
This force suggests the likelihood of new players entering the industry or existing firms to expand, driven by the size of the barriers to entry. Such barriers include having an economies of scale, brand identity, a high switching cost, large capital requirements, access to distribution channels, government regulations and cost advantages.
The consequence of having an unprotected industry drives down a company’s returns level to where there is no economic profits, i.e. net operating profit after tax = cost of invested capital. A company earning fat returns will have its profit margins reduced as more firms enter the industry to seek business opportunities. As new entrants increase, market demand gets fragmented. Costs per unit rise as fixed costs are spread over fewer units sold, prices fall and the large profit which initially attracted new entrants disappear. One example of a low barriers to entry industry is the clothing retailers in Hong Kong such as Giordano (0709.HK), Goldlion (0533.HK) and Bossini (0592.HK). The weakness could be due to a lack of customer captivity in clothing. Any entrant has an equal opportunity to create and maintain a brand. Such weakness creates a lack of customer captivity in companies within the industry. Moreover, as more clothing retailers switch to e-commerce, hence lowering entry barriers, traditional clothing retailers might find themselves facing further competitive pressure.
On the flip side of a coin, large monopoly firms such as the Singapore Stock Exchange (SGX: S68) creates a high barrier to entry given that it is subjected to strict government regulations in the financial markets and hence able to capture Singapore’s securities market.
Value in Action
Michael Porter’s Five Forces Analysis is a good introduction to investors wishing to understand industry structure. A force which investors should pay particular attention to is the Threat to New Entrants into the Industry as it might potentially affect a firm’s profitability and competitive edge.
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All views and opinions articulated in the article were expressed in Willie’s personal capacity and do not in any way represent those of his employer and other related entities. Willie does not own any shares in the companies mentioned above.