Wednesday, December 15, 2010

Porter’s Five Forces Series Part 1 – Threat of Entry

Much has been talked about the usage of Porter’s Five Forces for analysis of an industry which affects a potential company to be invested in, and it is true that investors need to have sound knowledge of the industry characteristics in order to make informed decisions. However, I realized that I never managed to do a detailed study of the Five Forces and how they impact the study of industries in order for investors to arrive at conclusions regarding the attractiveness of a Company to invest in. Aside from analyzing the fundamentals, financials and prospects (as well as Management quality, of course), I believe the Five Forces framework and model developed by Michael Porter can act as a very good backbone for one to establish a sound investment thesis, provided it is done rigorously and objectively.

This series on Porter’s Five Forces and industry and competitive analysis serves to elucidate the factors behind each of the Five Forces, and to discuss the application of each of the Forces towards understanding industry dynamics. Much of the material which will be discussed is taken from, and adapted from, a book called “Value Investing – How To Become A Disciplined Investor”, published by the Financial Times Guides and written by Glen Arnold, who is a Professor of Finance at Salford University. Please do buy or borrow the book if you wish to read more in detail on how he discusses the Five Forces. This blog and my subsequent posts only serve to provide a summary of the points brought up, and to relate my understanding of the Five Forces to SGX-listed companies. The opinions expressed are my own and do not constitute an inducement to either buy or sell securities in any of the Companies mentioned. The Five Forces are (in no particular order of merit): Threat of Entry, Intensity of Rivalry, Supplier Power, Customer (Buyer) Power and Threat from Substitutes. This post shall begin by discussing on Threat of Entry.

Introduction – Threat of Entry

Threat of entry refers to the threat of competitors entering an industry where incumbent companies are operating, thereby reducing profit margins and taking away some of the “fat” which the incumbents currently enjoy. New entry is something which incumbent companies abhor, and some companies put in place barriers which prevent easy entry into a highly profitable business unit or market segment; while others send out a signal to potential entrants of their intention to fiercely retaliate should it encounter such competitive threats.

Barriers to prevent threat of entry

The following are some of the barriers which firms can possess in order to discourage entry by potential competitors:-

1) Large economies of scale and high capital costs – Companies which are large in scale and have massive amounts of assets are difficult to copy as the competitor would need huge amounts of cash to spend on capex and infrastructure. Some examples I can think of are SIAEC which has built six hangars to date, and Tat Hong with their growing fleet of tower and crawler cranes.

2) High risks associated with imitation – The incumbent company may have a unique combination of skills and human resource which the competitors find difficult, if not impossible, to emulate effectively. Some examples given in the book include the McKinsey method, and I can think of other examples which relate to human expertise and internalized knowledge which is difficult to replicate.

3) Access to distribution channels – Competitors may find it very tough to secure a wide network of distribution channels, especially when the incumbents have already firmly established and entrenched themselves with distributors. Some examples could be food distribution where new entrants may find it an uphill task to request for supermarkets to stock up their produce as they do not have the prior relationships. Logistics companies also need to tie up with trucking companies to smoothen the flow of their operations, and a new entrant may find it difficult to negotiate favourable terms.

4) Switching Costs – This relates to the buyers of a product or service and how easy it is for them to switch from one supplier to another. If there are high switching costs, then it would not be easy for an entrant to offer a competitive product or service which can lure buyers away from the incumbent.

5) Differentiation – This involves establishing a reputation such that the product or service offering means something of higher value than what the competition can offer. Once this is established, it is very difficult for buyers to make a switch.

6) Experience – Incumbents may have accumulated experience and knowledge over the years of being in an industry, and this is embodied within their staff and corporate culture. It would be nearly impossible for a new entrant to obtain this knowledge and expertise. An example which was given is Intel, which has decades of experience in developing micro-processors; thus it makes it very difficult for new entrants to catch up.

7) Government legislation and policy – Government regulations and restrictions may play an important role in preventing new entrants from entering certain industries. For example, airlines are regulated in Singapore and thus Singapore Airlines enjoys an enviable position as the national carrier. On the telecommunications front, there are also three strong incumbents SingTel, M1 and Starhub and the Government is hesitant to grant a license for a fourth operator as the market is already reaching saturation point.

8) Control over raw materials as outlets – Some companies may have exclusive relationships with the supplier of their raw materials, and these may either be explicit (i.e. contractual) or implicit (an established long-term relationship). New entrants may find it tough to penetrate the market unless they are able to somehow grab the attention of the raw material supplier, but often this comes at a considerable cost and may eat into gross margins.

This post summarizes the factors which affect threat of entry, and how an investor can select a company which has the above factors to discourage or prevent easy entry into their turf from potential competitors. In the next post, I shall explore the next Force which is Intensity of Rivalry between existing companies (within the industry).


isaac said...

Hi sgmusicwhiz,

read thru alot of your recent entries. You're a very detailed person! Hope I can learn more from you. Would you like to do a link exchange? My blog is in my google account.


Akatsuki said...

Mz, the stock i was referring to was Cogent Limited, small firm (new to market) with great balance sheet, P/L , cashflow figures. It has its weakness like whether the company is in a great industry? Whether there are future growth in it etc. If you got the time, you can do a short analysis on it? Haha.

Musicwhiz said...

Hi Isaac,

Thanks, have added your blog to my list. I noticed you do trade structured warrants and I have to strongly caution you to avoid such leveraged products as the price movements can whipsaw you quickly and leave you with massive losses.

Stick to equities and only use spare cash to invest. Do thorough research before you commit your funds, and sit tight for the long-term.

Good luck!

Musicwhiz said...

Hi Akatsuki,

I took a quick look at it. Not too impressed. Taking out the one-ff gain shows that the company had actually incurred a net loss.

Also, the fact that it was so recently listed means track record is not there.

Perhaps let's wait a few more years before deciding, OK?


Isaac said...

Hi Musicwhiz,

thanks for your advice.
I've been thinking these few days too, about my warrant trading.
There's alot of anxiety involved in speculation, and since I'm just starting out, might not be too suitable for me. I'll be writing a post regarding this soon. Even though I've earned some money, I think i shall lay off derivatives until at least CNY, and get myself acquainted with TA in the meantime.

Thanks for the link exchange, I hope to learn more from you :)

Musicwhiz said...

Hi Isaac,

With regards to trading, you won't find much help on my blog! Derivatives are highly risky due to their leveraged nature, so I'd advise utmost caution. I understand the market is buoyant now, which is why more and more are jumping in. But be very careful or else you can lose a huge chunk of your capital, and more.....

All the best!