Some businesses generate high returns on invested capital (ROIC) for a very long period. Is it because of their star CEO’s. No. They belong to the industries that has structural advantages. Warren Buffett tells that
When management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.
The next question is what determines the industry structure. Michael E. Porter is a leading authority on competitive strategy. He tells that there are five competitive forces that defines the industry structure. They are called as Porter’s 5 forces. In the article The Five Competitive Forces That Shape Strategy he writes
Awareness of the five forces can help a company understand the structure of its industry and stake out a position that is more profitable and less vulnerable to attack.
If the forces are high then the profitability of the industry will be very low. Airlines and Textile industries have very high forces and hence low profitability. If the forces are low then the profitability of the industry will be very high. Software and Soft drinks industries have very low forces and hence high profitability.
1. Threat of New Entrants
If new companies can enter into the industry easily then it puts pressure on the existing players to protect their market share.
The threat of entry, therefore, puts a cap on the profit potential of an industry. When the threat is high, incumbents must hold their prices or boast investment to deter new competitors. In speciality coffee retailing, for example, relatively low barriers mean that Starbucks must invest aggressively in modernizing stores and menus.
There are several ways to create high barriers to entry.
1.1 Supply side economies of scale
These economies arises when companies produce items at a large volume. This results in lower cost per unit as the fixed costs are spread over more units. If a new company wants to enter, they need a lot of capital.
In microprocessors, incumbents such as Intel are protected by scale economies in research, chip fabrication, and consumer marketing.
1.2 Demand side benefits of scale
This benefit is called as the network effect. Buyers are willing to use the product or service because similar others are using it. Social networks like Linkedin, Facebook and Twitter fall into this category. It takes a lot of time and money for a new company to build such a network.
1.3 Customer switching costs
Switching costs are fixed costs faced by buyers when they move to a different product or service. If the cost is high then the buyers will not switch. ERP software companies like SAP and Oracle enjoy this advantage.
1.4 Access to distribution channels
Large distribution channels are very hard to create. In the little book that builds wealth – Pat Dorsey writes
We can see this companies from Sysco, the largest food-service distributor in the United States, to fastenal, one of the largest distributors of fastening products for manufacturing firms, to large beverage companies such as Coca-Cola, Pepsi and Diageo.
1.5 Government policies
Government limits entries into certain industries in the form of licensing requirements. Slot machine industry is one such example. It is not easy to get approval to manufacture and sell slot machines. Companies that offer higher education degrees like Apollo group need regulatory approval called accreditation. Accreditation make it easier for students to transfer credits to public universities. These approvals are not easy to get.
2. Bargaining power of suppliers
If the suppliers are powerful then they capture more value for themselves by charging higher prices.
Powerful suppliers, including suppliers of labor can squeeze profitability out of an industry that is unable to pass on cost increases in its own prices. Microsoft, for instance, has contributed to the erosion of profitability among personal computer makers by rising prices on operating systems. PC makers, competing fiercely for customers who can easily switch among them, have limited freedom to raise their prices accordingly.
Following are the factors that can make supplier group very powerful.
2.1 Concentrated suppliers
If one or two suppliers, supply to the entire industry then they have more control. Microsoft supplies operating system to the entire PC industry.
2.2 Independent suppliers
If the suppliers, supply to several industries and does not depend on a single industry for its revenue then it has more control.
2.3 Switching costs
If the product supplied by the supplier requires special training then there is a switching cost for the players in the industry. For example Bloomberg supplies trading terminals to the financial industry. Using the software requires a lot of training and the users will be hesitant to switch to a different product.
2.4 Differentiated products
Pharmaceutical companies supplying patented drugs to hospitals have more control on the price. The products have differentiation and their benefits cannot be obtained elsewhere.
3. Bargaining power of buyers
If the buyers are powerful then they can extract more value from the products by offering lesser price for higher quality. Under the following conditions buyers are powerful.
3.1 Few buyers
There are only few buyers who purchase very large volume of products. In this case the buyers demand for a huge price discount.
Intermediate customers gain significant bargaining power when they can influence the purchasing decisions of the customers downstream. Consumer electronics retailers, jewelry retailers, and agricultural equipment distributors are examples of distribution channels that exert a strong influence on end customers.
3.2 No switching costs
If there are no switching costs then the buyers will go for products that are cheaper in price.
3.3 No differentiation
If the products are not differentiated then the buyers can buy the product from anyone.
4. Threat of substitutes
A substitute product perform a similar function as the original product. Video conferencing is a substitute for travel. Email is a substitute for physical mail. When the threat of substitutes is high, the industry as a whole will not be profitable. The factors that increase this threat are
4.1 Low price
If the price of the substitute is very low then people will switch. Several years back long-distance phone connections were very popular. With the arrival of internet people switched to cheaper options like Vonage and Skype.
4.2 Low switching costs
If the switching costs are very low then the customers will switch.
Switching from a proprietary, branded drug to a generic drug usually involves minimal costs, for example, which is why the shift to generics (and the fall in prices) is so substantial and rapid.
5. Rivalry among existing competitors
If the industry has lots of players and there is no product or service differentiation then the competition on price will be very intense. This will bring down the profitability of the entire industry.
Rivalry is especially destructive to profitability if it gravitates solely to price because price competition transfers profits directly from an industry to its customers.
Industries selling commodity products has to deal with this problem. In the Elementary, Worldly Wisdom – Charlie Munger writes
For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles—which are a real commodity product. And one day, the people came to Warren and said, “They’ve invented a new loom that we think will do twice as much work as our old ones.” And Warren said, “Gee, I hope this doesn’t work because if it does, I’m going to close the mill.” And he meant it. What was he thinking? He was thinking, “It’s a lousy business. We’re earning substandard returns and keeping it open just to be nice to the elderly workers. But we’re not going to put huge amounts of new capital into a lousy business.” And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners.
The average ROIC for the airline industry is 5.9% for the period 1992 to 2006. Why is it so low? Porter writes
Consider commercial aviation: It’s one of the least profitable industries because all five forces are strong. Established rivals compete intensely on price. Customers are fickle, searching for the best deal regardless of carrier. Suppliers – plane and engine manufactures, along with unionized labor forces – bargain away the lion’s share of airlines profits. New players enter the industry in a constant stream. And substitutes are readily available – such as train or car travel.
In the Elementary, Worldly Wisdom – Charlie Munger writes
If it’s a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world—safe travel, greater experience, time with your loved ones, you name it. Yet, the net amount of money that’s been made by the shareholders of airlines since Kitty Hawk, is now a negative figure—a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business.
Capitalize on the weakest force
In the heavy-truck industry price competition is stiff. Paccar a company in this industry has been profitable for 68 straight years and earned a return on equity of 20%. How did it do this?
To create and sustain long-term profitability within this industry, heavy-truck maker Paccar chose to focus on one customer group where competitive forces are weakest; individual drivers who own their trucks and contract directly with suppliers. These operators have limited clout as buyers and are less price sensitive because of their emotional ties to and economic dependence on their own trucks. For these customers, Paccar has developed such features as luxurious sleeper cabins, plush leather seats and sleek exterior styling. Buyers can select from thousands of options to put their personal signature on these built-to-order trucks.