In order to be a successful investor in the stock market, one needs to approach every investment with a disciplined and well thought out approach. Having a plan is absolutely critical. At a high level, my approach, and that of many professional investors, entails obtaining a thorough understanding of how the business operates, analyzing the company’s financial statements, and then analyzing the investment’s valuation. In this approach, a strong understanding of the business is the foundation that allows for meaningful financial statement and valuation analysis. Without a strong understanding of the business, the other analysis is nearly worthless. When it comes to learning about the business and operational environment of companies, it’s my opinion that Michael Porter’s Competitive Strategy: Techniques or Analyzing Industries and Competitors is hands down the most important read and single resource for investors.
Why is Competitive Strategy such a great read for investors? In my view, the value comes from Porter’s Five Forces model, which provides a framework for understanding all of the competitive forces that shape the environment in which a company operates. These Five Forces include: competition in the industry, threat from new entrants, bargaining power of suppliers, bargaining power of buyers, and the threat from substitutes. Ultimately, it’s these five competitive forces that will determine the long-term profitability and success of the company. Thus, the Five Forces provide critical insight into financial statement analysis and valuation.
Additionally, one very common mistake that investors make is to view a business’s competitive environment through too narrow of a lens. Frequently, investors will focus on one aspect of the competitive environment, such as existing competition in the industry. For example, many investors in computer manufacturers (Hewlett-Packard, Dell, etc) and the makers of other PC components such microprocessors (Intel and Advanced Micro Devices), have lost a significant amount of money in recent years. The reason why is that a substitute product, tablets, have driven a significant drop in PC sales. The two charts below show what happened to HPQ and AMD’s share prices as tablet sales initially ramped, beginning in 2010. Investors that were overly focused on whether or not HP had a superior product compared to Dell or whether AMD had a better microprocessor compared to Intel could have very easily missed the threat posed by tablets.
Sources: Statistica, Yahoo Finance
In contrast, my team and I were able to exit an investment in risky AMD debt before its price declined meaningfully. Because we always considered all of Porter’s Five Forces, we were able to avoid substantial losses. In this case, is was our identification of the threat from substitute products that saved us. True, we were investing in AMD’s debt and not the stock, but the very same approach we used could have been applied by equity investors, and had we exited the stock at the same time we got out of the debt, we would have avoided meaningful losses.
Any investor, whether experienced or very new to the market, can benefit from reading Porter’s Competitive Strategy. The Kindle version is only $19.99 on Amazon. Well worth the price. For readers that are pressed on time, the Harvard Business Review has an excellent article that summarizes the Five Force that can be purchased for $8.95, but the HBR allows readers a couple of free reads, so you may not have to pay anything at all!