Mental Models 4 Life

While going through some old documents this week, I rediscovered a set of notes I took while reading Michael Porter many years ago. On rereading the notes, I find (again) his ideas to be really simple and compelling, worthy of sharing as a mental model for both practising data scientists and a value investors.

A principled way to understand how a company adds value, its competitive advantage and the general structure and dynamics of the industry it operates in is through Porter’s Competition framework. In this post, I first describe some of Porter’s key insights on the nature of competition and value creation, followed by a brief description of the five-forces framework for understanding industry structures. Many of the statements below come directly from Porter; it’s best to hear directly from the horse’s mouth.

The sequence of activities a company performs to design, produce, sell, deliver, and support its products is called the value chain, which is part of a larger value system. In Porter’s analysis, a company’s series of choices about its value proposition and its value chain is what gives rise to competitive advantage.
From that perspective, strategic competition means choosing a path different from that of others, and competitive advantage manifests itself in simple quantifiable ways: compared with rivals, you either operate at a lower cost, command a premium price, or both.

How might a company makes its choices to get into a position with good competitive advantage?

One of Porter’s core message on competitive strategy is that instead of competing to be the best, companies can –- and should -– compete to be unique. In particular, competing to be the best feeds on imitation, but competing to be unique thrives on innovation. To understand what choices to make on one’s value proposition and value chain, the first step is to understand the structure and dynamics of the industry one is in, which leads us to the Five Forces Analysis covered next.

Porter’s Five Forces is a framework for analysing the competitive intensity and, therefore, the attractiveness (or lack thereof) of an industry in terms of its profitability. The five forces are

• Threat of new entrants — Barriers to entry are advantages that existing, established companies have over new entrants and they can come in different forms, including economies of scale, network effects, switching costs for customers, etc.
• Threat of substitute products or services — A substitute product or service uses a different mechanism or technology to try to solve the same customer need.
• Bargaining power of customers — This is related to the ability of customers to put a company under pressure by asking for more quality or demanding lower price. A common way to measure this is customer’s sensitivity to price changes in a product or service before they churn.
• Bargaining power of suppliers — Suppliers of raw materials, labor, and services to an organisation can be a source of power over the organisation when there are few substitutes. This factor is similar in nature to the Bargaining power of customers, but with the roles reversed.
• Competitive rivalry of existing players — This refers to the behaviour and competitive intensity of existing players in an industry, to which a company must respond in order to establish its own competitive advantage.

The following figure shows a simple example of Five Forces Analysis to understand the industry structure for brick-and-mortar retail in India around 2012.

As mentioned above, a company’s series of choices in its value proposition and value chain is what gives rise to competitive advantage, and strategic competition means choosing a path different from that of others. A good competitive strategy needs to pass these tests:

• A distinctive value proposition — Are you offering distinctive value to a chosen set of customers at the right relative price?
• A tailored value chain — Is the best set of activities to deliver your value proposition different from the activities performed by rivals?
• Trade-offs different from rivals — Are you clear about what you won’t do so that you can deliver your kind of value most efficiently and effectively?
• Fit across value chain — Is the value of your activities enhanced by the other activities you perform?
• Continuity over time — Is there enough stability in the core of your strategy to allow your organisation to get good at what it does, to foster tailoring, trade-offs, and fit?

Where the choices made by a company involve trade-offs, the competitive strategy becomes more valuable and more difficult to imitate. We can think of fit across value chain as an amplifier: it amplifies the competitive advantage of a strategy by lowering costs or raising customer value (and price); fit also makes a strategy more sustainable by raising barriers to imitation.

Example: Wal-Mart’s early strategy was to chose isolated rural towns with populations between 5,000 and 25,000, whereby the company can put good-sized stores into little one-horse towns which everybody else was ignoring. This choice insulated Wal-Mart from direct rivalry with other discounters and gave it many years of breathing room to develop and extend its positioning as a provider of everyday low prices.