QUALIPORT
Competitive Industries To Avoid

By Maynard Paton (TMFMayn)
July 14, 2003

Corporate guru Michael Porter outlines five industry 'forces' in his celebrated book Competitive Strategy: the threat of new entrants, the power of customers, the power of suppliers, pressure from substitute products and existing industry rivalry.

Of the five forces, determining the current competitive rivalry within an industry is probably the most important consideration. If the industry is already a tough one with profits under constant pressure, then further investigation into the possibility of new entrants and substitutes may not be required.

Porter writes: "Rivalry in some industries is characterised by phrases as 'warlike', 'bitter', or 'cutthroat', whereas in other industries it is termed 'polite' or 'gentlemanly'. Long-term investors should avoid industries where 'warlike' conduct is the norm. Porter notes the following 'interacting structural factors' can cause intense rivalry (and most likely, shareholder grief).

Numerous or Equally Balanced Competitors: When firms are numerous, the likelihood of mavericks is great and some firms may habitually believe they can make moves without being noticed. Even where there are relatively few firms, if they are relatively balanced in terms of size and perceived resources, it creates instability because they may be prone to fight each other and have the resources for sustained retaliation.

Food retailing is an industry with numerous participants, but with a relative few that dominate the sector. You've got many smaller specialists (such as frozen food firm Big Food (LSE: BGP) and convenience operator Co-op), some of which have the wherewithal to beat the big players in their own particular niche. Though Tesco (LSE: TSCO), Asda, J Sainsbury (LSE: SBRY), William Morrison (LSE: MRW) and Safeway (LSE: SFW) have strong sector standings, all have consistently engaged in vigorous price wars over the years.

Slow Industry Growth: Slow industry growth turns competition into a market share game for firms seeking expansion.

The banking industry is one that inherently suffers from slow growth. Attempts to expand largely rest on stealing customers from elsewhere, which is evidenced for example by the constant introduction -- by the newer players -- of cheaper mortgages and credit cards, and higher-paying savings accounts.

High Fixed or Storage Costs: High fixed costs create strong pressures for all firms to fill capacity, which often lead to rapidly escalating price-cutting when excess capacity is present.

An airline is the obvious candidate for high fixed costs -- the cost of a flight doesn't vary that much whether the plane is full or just half-full. Knowing breakeven comes at a certain 'load', the temptation is to lower prices if ticket sales are falling short (once the plane has taken off, the value of an unsold seat becomes worthless). With other airlines probably going to the same destination and thinking along the same lines, it all makes flying planes a difficult business.

Lack of Differentiation or Switching Costs: Where the product or service is perceived as a commodity or near commodity, choice by the buyer is largely based on price and service, and pressures for intense price and service competition result.

There's probably no better example of a product judged on price and service than insurance. There are plenty of providers around and intense pricing does indeed result. With renewals performed every year, the consumer has every opportunity to switch at no cost. Save for Warren Buffett and one or two others, most investors in insurance don't do well.

Capacity Augmented by Large Increments: Where economies of scale dictate that capacity must be added in large increments, capacity additions can be chronically disruptive to the industry supply/demand balance.

Building and construction is an area where large increments are the name of the game. Canary Wharf (LSE: CWG) for instance added plenty of new London office space in the early 1990s. This hurt most commercial landlords in the capital, who had to cope with both the sudden increase in supply and the poor economic climate of the time. In fact, history may be repeating itself at the moment, with Canary continuing to add millions of square feet to Docklands as the London office market softens.

Diverse Competitors: Competitors diverse in strategies, origins, personalities and relationships to their parent companies will have differing goals and differing strategies for how to compete and may continually run head on into each other in the process.

With a seemingly infinite variety of foods, menus and dining formats, there must be few sectors as diverse as the restaurant industry. Operators range from large multinationals to one-man bands, the latter being likely to accept sub-normal returns on capital and reduce profitability levels for everybody else. Furthermore, different restaurateurs have different ambitions. ASK Central (LSE: AKC) may be gunning for long-term growth, whereas Chef & Brewer may be seen simply by parent Scottish & Newcastle (LSE: SCTN) as an avenue to sell more of its beer. Too many industry 'strategies' do not a balanced market make.

High Strategic Stakes: Rivalry in an industry becomes even more volatile if a number of firms have high stakes in achieving success there.

There was no higher strategic stake than dominating the Internet a few years ago. A land grab ensued, as telecom and media businesses jockeyed for position in the 'new economy' gold rush.

In the mad dash to rule 3G, the ultimate winners of the spectrum license auction all -- in hindsight -- overpaid. Marconi (LSE: MONI), Cable & Wireless (LSE: CW.) and AOL Time Warner (NYSE: AOL) were others who made big money investments -- and big money mistakes -- in their efforts to beat off rivals. High ambition, high strategic stakes, high priced blunders.

High Exit Barriers: Exit barriers are economic, strategic and emotional factors that keep companies competing in business even though they may be earning low or even negative returns on investment.

The motor industry suffers from high exit barriers. The manufacturers have large and expensive production plants to run and aren't the easiest things to close and re-open when circumstances dictate. Rather than build a plant at great cost only then shut it down, there's always that next model that could revive the plant's fortunes...

Furthermore, many football clubs have a high exit barrier. Though renowned for their losses, the clubs generally stay in business because of human emotion. Most boardrooms (and deep-pocketed local benefactors) would rather waste millions on the club's finances than admit their favourite team should be closed.

More On Porter: Substitutes For Your Shares | Great Barriers To Entry | The Best Customers For Your Shares