Michael Porter’s Competitive Strategy: A Must Read for Stock Market Investors

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.

hpq-and-amd-vs-tablet-unit-sales 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!

 

 

Boost Your Returns, Think Long-Term

For stock investors looking to prudently maximize wealth creation for retirement, it’s critically important to approach investments with the goal of generating returns over the medium and long-term.  Having a long-term mindset will help investors to avoid common pitfalls that lead to sub-par returns while helping the investor capitalize on profitable opportunities that arise in the market, and a long-term focus has the added benefit of producing lower transaction costs and tax expenses, which can have a major impact on your portfolio value over time.

Short-Term Thinking and Poor Investment Decisions

To begin with, having a long-term mindset can keep you from selling stocks at exactly the wrong time and missing out on significant gains in the market or an individual stock.   In the short-term, (we’ll define the short-term as less than 1 year, the medium-term will be 2 to 3 years, and the long term will be 3+ years), stock markets and individual stocks can rise and fall for a great number of reasons.  Sometimes big declines are justified, sometimes they aren’t.  It’s the investors job to figure out the reason for the decline and then whether they should buy, sell, or hold considering various factors such as the reason for the decline and, importantly, what has happened in the past in similar situations. However, all too frequently, investors will simply sell based on the price declines because they can’t bear the thought of losing any more value.  Investors who do this are taking a very short-term approach and it’s often a big mistake, because commonly, the biggest gains come shortly after the big declines that provoke an investor to sell.

To show that this is the case, the table below shows years when the S&P 500 price index was down big (over 10%) as well as returns over the following 1 and 3 year periods. Note that our numbers do not include dividends, which would increase the returns for each period if they were included. From 1951 through 2015, there were 11 years where the annual price return of the S&P 500 index was a loss of greater than 10%, and for 8 out of the 11 years, the annual price return over the next year period was positive. Further, the market usually increased by a sizeable amount over the next year.  The median annual return, for the year following a year with an S&P 500 price decline of greater than 10%, was 18.9%.  For the next 3 years following a 10%+ down year, the 3 year compound annual growth rate (CAGR) was positive in 10 out of 11 instances with a median of 11.5%. The CAGR or annualized growth rate represents the average annual returns for the period, including the impact of compounding.

sp-500-years-with-price-declines-greater-than-10-and-subsequent-returns

Source: Yahoo Finance

Sure, this table shows that that there were a few instances when selling after a down year could have saved you from further declines, such as for the 1 and 3 year periods following 2000 and the next year after 2001.  But, more often than not, returns bounced back over the following year and in many cases, they reversed and became substantial gains.  If substantial gains didn’t materialize over the next year following a 10%+ down year, they frequently came over the next couple of years. For example, after 1969’s 10%+ negative returns, the next 1 year return was a modest 0.1%, but the next 3 year returns were strong at 28.2% cumulative and 8.6% annualized.  The 1 and 3 year returns post 1977 were a similar story.

I’m not saying that it’s guaranteed an investor will always do well by buying more or holding on after a big sell off in stocks.  Certainly, in the future, we could have more periods like 2000 when the market’s returns remain negative over an extended period.  But, history tells us that remaining invested or buying more stocks after market sell-offs has almost always been a better strategy than panicking and selling based on market losses.

Now, obviously, in an ideal world, you would sell before enduring significant losses and then buy again near the bottom. However, timing the market like this is incredibly difficult.  Even the best professional investors struggle to correctly time the market and they’re paid handsomely to follow the markets and make investment decisions. Market sell-offs and rebounds tend to happen so suddenly, that investors will frequently sell after the worst of the losses have already occurred and buy after major gains have already been realized.

In the future, we’ll explore other strategies, which are less risky than market-timing, that will help lessen the impact of down markets while allowing the investor to benefit from stronger markets.  For now, I want readers to takeaway the point that, when faced with big losses in the market, it’s historically been a far better strategy to remain disciplined and consider where returns are most likely to go in the future, over a longer time-horizon, than simply moving out of stocks in a big way.

Another reason why  holding on to stocks or buying more after a decline has been a successful strategy is the simple fact that, historically,  stock markets generally increase in value over time, and the longer the time-period, the more likely it will be that values are higher at the end. Keeping this in mind can help you make better buy decisions and keep you from making poor sell decisions.

The charts below help to illustrate the point. The first chart shows the frequency distribution of annual % changes in the S&P 500 Index price, excluding the impact of dividends on returns.  For example, the highlighted bar in red represents the median annual % price change bucket, and it indicates that there were 6 years between 1951 and 2015 when the annual % change in the S&P 500 price was between 12.5% and 15%. We can also see from the chart that annual price declines in the S&P 500 are not uncommon, as displayed by the bars from 0% to -35%.  From 1951 through 2015, the annual price return for the S&P 500 was negative about 28% of the time.

sp-500-annual-price-return-distribution

Source: Yahoo Finance

However, the picture changes dramatically when we look at annualized returns over longer time horizons. The next chart shows the distribution of annualized return %s in the S&P 500 price index over 5, 10, and 20 year periods. For example, the highest orange bar in the middle of the chart shows that, between 1951 and 2015, there were a total of 14 20 year periods where annualized returns were between 5% and 7.5%.

While declines in the price of the S&P 500 index are still fairly common over 5 year periods, occurring 23% of the time, the occurrence of declines falls dramatically to 13% of the time over 10 year periods, and to 0% of the time over 20 year periods.  Also, it’s important to note, that for both the 5 and 10-year return distributions, price declines most frequently fell into the bucket of between 0% and -2.5%.  If reinvested dividends were included, some of these periods would likely have seen increases.

sp-500-5-10-20-year-price-return-distribution

Source: Yahoo Finance

Long-Term Opportunities in Individual Stocks

So far, we’ve focused on the stock market overall, but for individual stocks, it’s also true that a period of negative returns often provides investors with a great opportunity to pick up more shares at a more attractive valuation and price level.  It may not feel good to experience the loss of value in your account, but investors who learn to ignore the short-term pain and objectively focus on whether they should buy, sell, or hold, given factors such as the reason for the decline, historical stock performance, the current fundamentals and market’s expectations, etc will be far better off than those who panic and sell just because of declining prices.

However, decisions to buy or sell single stocks are more complicated than a decision to buy into the market overall. An investment in a single stock is far more risky than an investment in a diversified mutual fund or an ETF that tracks a broader market such as the S&P 500. Diversified investments in stocks, over time, will reflect the growth of the global economy, and historically since stock markets have been around, global GDP has always improved over time. This is why markets tend to always go up over time.  By contrast, individual stocks will  reflect the health of the company, and it’s not uncommon for companies to go away entirely.  Bankruptcies happen all the time.

This increased risk is why it’s so important to be diversified and limit the size that an investment in an individual stock represents of your overall portfolio.  But, beyond diversification, investors should compensate for this increased riskiness by  devoting more time to researching individual stocks, while keeping in mind how large the investment is relative to your overall portfolio.  For example, you should spend more time evaluating a $10,000 investment in MSFT compared to a similar sized investment in SPY, an ETF that tracks the S&P 500.

When you research individual stocks, there will definitely be times when you reach the determination that a stock’s decline has occurred due to real fundamental problems with the company.  Perhaps a new competitor has entered the market and has consistently been stealing away business or maybe suppliers are going through hard times and they’re squeezing the company on the costs of the goods or services they provide. If there are problems that are likely to have a materially negative impact on financial results and the market still isn’t adequately reflecting this in the stock’s price/valuation, then maybe the right call is to sell the stock, even if you’ve only held it for a relatively short time-frame.

We’ll have more pieces in the future that discuss how to undertake the analysis required to make these sorts of calls.  For now, I simply want to drive home the point that, for individual stocks as well as for more diversified investments, it’s critical for investors to avoid fretting over and making decisions based on short-term price performance without consideration of what’s likely to happen over a longer time-horizon, given context such as the stock and company’s history, fundamental characteristics of the investment, and the market’s current expectations.

The fact is that sometimes investments take time to produce results. Microsoft (MSFT) is one fairly extreme example. The chart below compares MSFT’s weekly stock price to the S&P 500 Index adjusted price level from mid-2001 to the current time.  Again, these are price returns only.  All returns mentioned would be higher if we included reinvested dividends, which are a major part of stock investments.

From mid-July 2001 through early June 2011, MSFT produced a total price return of -13.3%, equating to an annualized price return of -1.4%.  This underperformed the S&P 500, which produced a total price return of 5% and an annualized price return or CAGR of 0.5% over the same period. But patient MSFT investors were ultimately rewarded.  For the period from mid-July 2001 through November 21st 2016, MSFT generated a total price return of 159.1% and an annualized price return of 6.4%, compared to total and annualized price returns of 81.5% and 4%, respectively, for the S&P 500 index.

Further, investors who viewed “The Great Recession” as a buying opportunity for MSFT’s stock have done very well. From early March 2009 (the depths of “The Great Recession”) through November 21st 2016, MSFT’s stock priced has returned 387.4% in total and 22.7% annualized, which compares to a total price return of 221.7% and an annualized price return of 16.3% for the S&P 500 index.

msft-weekly-stock-price-history-vs-the-sp-500

Source: Yahoo Finance

It is certainly no easy task to pull the trigger and buy more of a stock that has seen dramatic declines, particularly when there’s tremendous uncertainty like there was during the last recession. Also, it’s unlikely that you’ll be able to buy at exactly the right time, such when MSFT reached its recessionary lows in March 2009. Still, I strongly believe that profitable decisions, like the one to buy MSFT after the declines produced by the recent financial crisis, are well within the capabilities of non-professional investors.  It takes some work, discipline, the right mind-set (such as a longer-term focus), and the right analytical tools, but I firmly believe that it’s very doable for investors to make similarly profitable investment decisions, and in future posts, my goal will be to provide the necessary tools.

We’ve shown that it’s a mistake to make investment decisions based on short-term price movements, focusing mainly on the decision to sell based on declining prices, but it also holds true that you shouldn’t make buy decisions based only on recent price gains (in fact, I’m generally always more inclined to sell after any gains).  However, indiscriminate selling due to a drop in an investment’s value seems to be a more common problem, and it’s worth understanding why because it might help you avoid making the mistake.

It’s no secret that investment losses are painful.  Any investor who’s watched their portfolio value decline has experienced this and knows it’s true.  What isn’t so obvious, is that investors generally fear losses more than they like equivalent gains.  In other words, an investor would prefer to avoid a $1,000  loss over making a $1,000 gain. Because losses are so painful, the urge to sell and stop any further pain frequently trumps any expectations about the potential for future gains. This is known as loss aversion and it was first demonstrated by Daniel Kahneman and Amos Tversky.  For investors, it’s important to be aware of this cognitive bias when making investment decisions.  It may keep you from making the wrong decision!

Higher Transaction Costs and Tax Expenses

If you’re trying to capitalize on short-term price movements in a stock, you’ll be required to buy and sell more frequently than an investor who buys a stock with the intent to hold it over the medium to long -term unless there are changes that materially alter your view about the return potential of the stock (we’ll go into more detail about what can drive the decision to sell an investment in future posts). The less frequent transactions generated by long-term investors will lead to lower commission costs. While the commissions paid to a broker may appear small, they can add up quickly, and after accounting for the impact of compounding, they can have a meaningful impact on the value of your portfolio over time. Consider two investors, one that makes 10 trades over the course of a year and one that makes 100, with each trade costings $7.95.  Due to the impact of compounding, over 30 years, the commission costs from that year alone will reduce the more frequent trader’s portfolio value by over $12,000 compared to the less frequent trader, assuming 10% annual returns (the approximate long-term average for the S&P 500, including reinvested dividends). That’s a big difference and we’re only considering the costs from one year.

Further, if you buy a stock and sell within a year, the capital gains will be taxed as ordinary income.  By contrast, you’re likely to pay a much lower rate on long-term capital gains. For example, investors who fall in the highest income tax bracket will be taxed on long-term capital gains at 20%. Similar to transaction costs, tax expenses can add up over time and have a significant impact, particularly when you consider the effects of compounding.