Sunday, August 23, 2009

Beyond Porter’s Darwinism: The Sixth Competitive Force

Professor Michael Porter of Harvard Business School created an outstanding and enduring stream of management thought when he propounded in 1979, through a Harvard Business Review (HBR) article, the theory of five competitive forces. He defined perceptively five competitive forces that help a company understand the structure of the industry it operates in, and stake out a position that is more profitable and less vulnerable to attack. Since then his theories of competitive strategy have been enriched by his own further contributions and collateral contributions by others. In a recent (January 2008) HBR paper, Porter reaffirmed and expanded his theory with additional examples.

The author of this paper provided a first-in-class quantitative framework to Porter’s qualitative paradigm of competitive strategy through his doctoral dissertation (Indian Institute of Technology Madras). The doctoral thesis which focused on the structure and performance of the Indian automobile industry demonstrated that Porter’s theories of competitive forces and competitive strategy have practical relevance and applicability. Continuing his appreciation for Porter’s creative and utilitarian theories, the author believes that there is now a need for reinforcing Porter’s paradigm with the addition of a sixth competitive force.

The sixth competitive force

The five competitive forces proposed by Porter are: (i) the intensity of rivalry among the existing players in the industry, (ii) the bargaining power of customers (iii) the bargaining power of suppliers (iv) the threat of new entrants, and (v) the threat of substitute products and services. While the level of rivalry largely determines industry structure and profitability, savvy customers can force down prices, dominant suppliers can drive up cost structures, aspirant entrants can create additional competition and new substitute products can lure products away from the company’s offerings. All these five competitive forces together determine the industry structure and profitability as well as the firm’s competitiveness.

The implicit essence of Porter’s theory is that corporate competitiveness play is a “win by some - lose by some” play, where the firms which are competitively agile will alone sustain themselves and grow. In a sense Porter’s theory reflects modern corporate Darwinism where only the fittest would survive. While Porter’s theory is an excellent guidepost in reasonably good times, the theory misses out on one critical dimension that one takes for granted in times of growth. The missing competitive dimension is “economic liquidity” which the author would like to term as the sixth competitive force that deserves to be added to Porter’s theory of competitive forces.

Without distracting from the economic rigor that Porter brought to corporate strategy one may say that true economic growth has to be based on foundations that are more broadly based and sustainable than an approach of survival of the fittest. Sustainable economic growth must envisage equitable growth of all sections of the society and profitable coexistence of different types of firms; from global conglomerates to local micro-enterprises.

The global financial meltdown and economic recession of the last two years has led to evaporation of economic wealth in an unprecedented manner. Deep economic recession and failures of global corporations forced governments to inject trillions of dollars to arrest economic collapse and ease liquidity crisis. The economic meltdown has shaken the advanced countries as well as the emerging countries to the roots. It has demonstrated shockingly that industries and societies can be swept away if economic liquidity is ignored by incumbent firms and regulators while crafting corporate strategies.

Economic (or system) liquidity

Firms exist through their products and services to grow customer needs and fulfill them in an ever increasing fashion. Customers embrace additional and new products on a continuous basis to elevate their quality of life. Governments which are committed to economic growth have a stake in a virtuous growth of this corporate-customer cycle. Firms and customers, however, require finance to carry out their respective obligations of manufacture and consumption. The level and sustainability of economic liquidity in the value chain of a firm constitute an essential competitive force.

The five competitive forces outlined by Porter differentially impact, and are impacted, by the competitive force of system liquidity. When finance becomes scarce, the intensity of rivalry pushes down the availability and pushes up the cost of finance. Customers move away from high cost premium products to low cost functional products while firms are faced with increased receivables. Monopoly suppliers dictate their terms of supply while fragmented suppliers suffer extended working capital cycles and uncertain payments. New product development suffers while new entrants hold back their plans. Greater industry volatility and lower industry profitability characterize the industrial system.

The financial sector, comprising banking, home finance, insurance and refinance firms as well as the private equity, venture capital, mutual fund, pension fund, hedge fund and stock broking firms, faces a quick and inexplicable evaporation of finance in an environment of downturn. The velocity of circulation of finance comes to a screeching halt. Leveraging and derivative instruments with speculative elements collapse as the system adjusts to align a virtual world of escalating financial value to the physical world of excess assets. Capital-output ratios suddenly turn awry and adverse.

Experiencing system liquidity

Liquidity for a customer exists essentially through the cash he or she has and the credit he or she can generate. The great American housing bubble has demonstrated how a credit-driven market exponentially expands until an economic downturn leads to institutional collapse and with it the total market collapse. The global consumer is today more appreciative of the need to lead a life that is meaningfully de-leveraged and sufficiently savings driven. This implies that in times to come, the bargaining power of the customers would be strong.

For a firm, which constitutes a part of, or contributes to, the balance four components of the five forces theory, liquidity exists in terms of not only equity and debt financing but also in terms of the various assets it holds, from research and manufacturing assets to process and goodwill assets. The manner in which, and the values at which these assets are acquired and nurtured and the speed with which, and the effectiveness with which these assets are commercialized or monetized determine the system liquidity that a firm faces.

In a growth economy, liquidity tends to be a factor of least concern. Entrepreneurs riding on aspirations and financiers splurging capital on ideas provide an intoxicating feel to the economy. Firms and conglomerates spend to grow. The growth thesis in such circumstances, unfortunately, is based on external funding (whether equity or debt) rather than the firm’s own cash generations. The principle of productivity gets erroneously applied with firms seeking to do far more than what they can achieve through their internal generations. Models of corporate strategy such as Porter’s Five Forces model need to be expanded to factor in system liquidity as an overarching sixth competitive force.

The Six Forces Model

The fundamental limitation, if one may say so, of Porter’s Five Forces model is that it considers all the participants in the industry, viz., the firms, customers, suppliers and new entrants as competitors with conflict of interest (relative to the goal of individual profit maximization). It also considers the creativity of new products as a disruptive force. This model and the underlying assumption may be valid purely from a firm’s short run competitive purpose but is inadequate from a long term industrial or economic purpose.

Porter cites the continued success of Paccar in the heavy duty trucking industry as an illustration of how a firm can achieve sustained long term profitability by analyzing the industry as per the Five Forces strategy and building a competitive position. The example limited to only one firm in an industry, in fact, reinforces the limitation of the Five Forces model. Firms and governments need models of strategy that achieve the maximal diffusion of economic prosperity.

The Six Forces model factors in system liquidity as the central core of the model, which includes the standard five competitive forces of Porter’s Five Forces model, viz., rivalry, customers, suppliers, entrants and new products as forces that are networked to each other and to system liquidity. The model considers system liquidity as the aggregate financial capability of all the four players in the industry, viz., firms, customers, suppliers and entrants. System liquidity, fed not only by the industry but also by the larger economic and financial system, influences and gets influenced by the strategies of the firms, customers and suppliers.

Factoring system liquidity

It would be insufficient and even erroneous to consider the profitability of individual industries in a standalone perspective. As Porter rightly observes, industry structure drives competition and profitability, not whether an industry is emerging or mature, high tech or low tech, regulated or unregulated. Moving beyond this, however, firms in the mode of strategy formulation have to consider the front-end market dynamics and the back-end supply dynamics as collaborative factors. By focusing on system liquidity the Six Forces model brings in an essential value chain perspective and a desirable economic perspective to firm level strategy formulation. Several examples can be thought of.

Reverting to the US Paccar example of the heavy duty truck industry, the concept of system liquidity, if applied by all the firms in the industry, integrates the profitability of the total value chain including the material and component suppliers and the goods transporters. This would enable different players come up with different strategies in collaborative combinations.

The Indian bus makers have languished for decades with low growth rates in bus production volumes, despite the near doubling of Indian population, because they have traditionally followed a firm level competitive strategy (firm against firm) rather than an economy level systemic strategy (firm as a part of the total system). If a firm in the bus industry develops a strategic methodology to enhance the system liquidity, taking the suppliers and customers (passenger transport corporations) in tow, the strategy would be more enduring and profitable in the long run.

The Big Three of the US automobile industry have singularly as well as collectively failed several times over the last few decades not because of the lack of application of the five forces model but more because of a lack of value chain understanding of a complex industry that includes suppliers, dealers and customers as well as oil economics. In contrast, companies such as Toyota as well as several of its competitors of the Japanese automobile industry have turned out superior global performance by viewing themselves as collaborators with their component makers (through concurrent engineering and just-in-time) and customers ( through economic and efficient, yet elegant designs) in a total economic structure.

The US retail and distribution companies, in diverse sectors such as consumer items and pharmaceuticals, which tweaked sourcing strategies for competitive advantage paid dearly with compromised product quality while some US food and beverage makers prospered by taking the farm sector as part of their strategic planning processes. Despite advance fleet planning and proactive partnerships for aircraft sourcing, global airline firms as well as the two aircraft makers and their suppliers face repeated crises due to a lack of concern for system liquidity. On the other hand power projects which have positive relationships with power equipment makers, power distributors and regulators achieve better financial closures and timely project execution.

As firms become huge national assets, the need to recognize system liquidity as an essential competitive force becomes even more intense. The battle between the two Ambani brothers (Reliance Industries and Reliance Natural Resources) in its essence is not a battle over price of the gas; it is on the other hand an ugly concomitant of corporate strategies formulated without an appreciation of economic liquidity encompassing gas using utilities, industrial customers and regulators.

Sanitizing the business models

Lack of appreciation of systemic liquidity as the sixth competitive force leads companies to develop aggressive strategies that build scale and scope, erect entry barriers, counter suppliers and distributors (at times through integration) and acquisition of businesses and products. These strategies, all of which are investment intensive, are conceptualized and executed typically during boom times. These are also oftentimes financed out of external debt and equity financing. Several Indian companies acquired overseas businesses as a result of such competitive strategies.

Dr Reddy’s Laboratories, a leading Indian pharmaceutical major acquired Betapharm of Germany to achieve leadership in the European generics space. Inadequate appreciation of economic liquidity in the European generic markets and a high business valuation of the acquisition which was feebly supported by internal profitability and generously aided by debt led to severe operating pressures on Dr Reddy’s. Acquisition of JLR and Rover brands from Ford by Tata Motors all but plunged the cost-efficient Indian automobile leader into a deep financial crisis. Tata Steel’s Corus acquisition strategy was perhaps better titrated because of the homogeneity and synergy of technological, product and customer base. Global generics leader Actavis continues to face the pressures of debt funded expansion and acquisition spree.

Corporate strategists no doubt consider enhanced investments and operational synergies while working out business models which enhance competitive stakes based on the five Forces model. There is, however, a need to consider system liquidity of the combined value chain as a sanitizer for the profitability model. If an expansion or acquisition is debt financed or if the expansion or acquisition takes the company into cost-intensive zones it would be necessary to downgrade profitability projections significantly. The elasticity of system liquidity to economic downturn would be a critical parameter.

Regulators have a role in ensuring that models of corporate growth are not hijacked by strategic adventurism. The institutional failures that triggered the global meltdown are proof enough of the perils of a totally unregulated play with external funding, whether of debt or equity variety. Like banking institutions, listed companies should be expected to operate as per prudential financial norms and capital adequacy norms relevant for different industries. In addition, listed companies should be subject to ‘stress tests’ on an annual basis by independent specialist organizations. In the ultimate analysis, firms need to exist and grow not merely to fulfill leadership aspirations but more significantly for wider economic growth.

The author believes that the Six Forces model which integrates the competitive force of system liquidity with Porter’s classic five competitive forces of intensity of rivalry, bargaining power of customers, bargaining power of suppliers, the threat of substitute products and the threat of new entrants would elevate firm level corporate strategy into a highly beneficial macro-economic endeavor.

Posted by Dr CB Rao on August 23, 2009


Kiran said...

Dear Dr. Rao,

Thanks for your excellent blog. The ‘system liquidity’ is an important component of model; it should serve as an axis. So important, it needn’t be confined to corporate strategy alone and could be extended to countries and their relevance in global economy. It is the life blood / grease that keep the countries from sputtering / force that keep the other 5 components relevant.

The perils of over debt leveraging, be it regular customer/ corporation / country is very real and no one is an exception because sooner or later the day of reckoning will arrive. It is very unfortunate that corporations (Ex. GM) / Country (Ireland) that survived great depression couldn’t survive great recession of 2008-09 due to miss-management of their balance sheet.

Though the author recommends performing periodical stress test to ascertain the financial viability of corporation / country, it is very unfortunate to know that the industry standard / well renowned regulatory bodies (Moody’s, S&P) are paid for by the very corporations they are rating. It will be a while for the misplaced trust to be restored, till then every investor, investing in a corporation / country needs to watch out for the Capital Reserve Ratios

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