The Return of Michael Porter and Competitive Advantage
– David Wanis, April 2021
In March 1979 when Michael Porter published his article “How Competitive Forces Shape Strategy” in the Harvard Business Review, inflation had averaged 6.6% per annum for the prior decade and was running at 10% y/y at the time. Inflation would peak 12 months later however the permanence of inflation was probably considered at the time as normal as disruption is to todays’ investor. Porter’s framework was not tied to an inflationary environment – which is why it has persevered as a useful model in the 40 years since – however it would be unusual for the environment not to have influenced his research and thinking.
The current debate about inflation seems to be not about its presence, rather its persistence. Emerging from a pandemic there are reasonable expectations economic systems are not operating normally. The temporary view of inflation due to these disruptions has a credible basis. The alternative view states a combination of unprecedented monetary and fiscal stimulus will finally consume finite global economic capacity and result in sustained upwards inflationary pressure. The market implied view – referenced by fixed income yields and the relative pricing of equity sectors – seems strongly anchored in the camp of temporary inflation. Given this remains the consensus priced into markets, it is worth considering what a change in market view may entail.
The trend of late has been to point to any company that had a few good years of revenue growth, whose stock has increased 10x and conclude it must have a “moat” – a reason to believe the revenue will soon be turned into cash flow and the gains in the stock price should continue. Moats are a bit harder to sustain than leaps in revenue and share prices, and Michael Porter set out a model of the ways companies can build a sustainable competitive advantage.
We thought it useful to remind ourselves of Porter’s model.
Barriers to Entry: how hard is it for new entrants to compete? Given capital is not a constraint can scale, brand, technology, trade secrets, distribution, reputation, access to scarce resources and government regulation keep new entrants out? Some of the best performing parts of the share market in the past few years are also notable by the ease at which a swelling number of new competitors have entered.
Customer Bargaining Power: there is really only one measure that matters here – can you raise selling prices to your customers? Some of the best quality businesses can gain share at a premium price and pass on unexpected costs. Apple is a king of pricing power. Google and Facebook are not too far behind.
Supplier Bargaining Power: in the same way, the measure that matters here is the ability to resist price increases from your suppliers. If all your customers are coming from leads generated via your Google and Facebook ad spend, you probably have no supplier bargaining power. Lots of businesses are in this position today (Facebook may be the new Westfield in that regard).
Threat of Substitutes: substitution has been the attack vector for most technology companies. Uber didn’t build a better taxi. Airbnb didn’t build hotels. Google in advertising. Afterpay in consumer credit. ETFs in funds management. Clay Christensen’s disruptive innovation model uses the substitute route – often enabled by new technology – to compete. Probably successful because substitutes sit in a strategic blind spot for most companies.
Competitive Rivalry: how intense is the competition among existing players? If there are lots of competitors in a market each with roughly equal market share, high fixed costs, low growth and high costs to exit, they likely engage in endless pricing battles. Think airlines. Most of the winner take all games in emerging growth industries are played to avoid this scenario once growth slows by creating a dominant market share position. The corporate body count along the way can be horrific.
How is Competitive Strategy Relevant to Inflation?
Unlike bonds, equities have no fixed coupon or cash return. It is tempting to conclude this means their coupons are always skewed to the upside, however persistent inflation applied to a company with no pricing power (low quality, narrow moat, poor sustainable advantage – choose your terminology) can erode nominal earnings and destroy real earnings.
Inflation can have a strong narrative component in what starts as a temporary surge – sparked by OPEC in 1973/74 or perhaps a pandemic recovery in 2020/21 – can become embedded in the economy through participant beliefs. We see this behaviour in other, simpler systems such as traffic:
“Phantom traffic jams are an emergent property of the flow of vehicles down a highway. A phantom jam begins when a car in dense traffic slows down even slightly, which causes the car behind that vehicle to slow even more — and the slowing action spreads backward through the lane of traffic like a wave, getting worse the farther it spreads. Eventually, the cars far behind are forced to stop completely or risk hitting the slower vehicles ahead —and so the traffic grinds to a halt over nothing.”
It is very possible spikes in inflation across a complex adaptive system like the global economy cascade into ongoing upward price pressure as actors move to pass on observed or anticipated changes in prices. The bad news is we are not seeing any relief on upward prices anywhere in the supply chain. Commodities at the beginning of the chain are in most cases at prices well above pre-pandemic levels, are continuing to rise and have yet to fully flow through to consumers.
If inflation expectations increase significantly, the most at-risk business is one with few competitive advantages, priced at a high multiple. These things are normally not seen together (why would you pay a high price for no moat?) – but we see them everywhere across the small cap market today.