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Copyright 2014, Advisor Perspectives, Inc. All rights reserved.

MichaelPorterontheFundamentalProblemforInvestors
ByJohnHeins
January14,2014


AdvisorPerspectiveswelcomesguestcontributions.Theviewspresentedheredonotnecessarilyrepresent
thoseofAdvisorPerspectives.

ToreadtheentirenewissueofValueInvestorInsight,whichalsoincludesindepth
interviewswithmarketbeatinginvestorsTimHartchofBrownBrothersHarriman
&Co.andMarioCibelliofCibelliAssetManagement,signupnowforano
obligationfreetrialathttp://www.valueinvestorinsight.com/freetrial.

JohnHeinsisthecofounderandeditorofValueInvestorInsight.

HarvardBusinessSchoolProfessorMichaelPorterneedsnointroductiontoany
seriousstudentofbusiness.Hisseminalworkonthecompetitivedynamicsthat
determineindustryprofitabilityandonthestrategiescompaniescanemploytopositivelyimpacttheir
competitivepositionslaidoutinitiallyinthebooksCompetitiveStrategyandCompetitiveAdvantage
revolutionizedmanagerialthinking.Soarticulatewashisframeworkforthinkingaboutstrategyand
competitionthatitpassedquicklyintoacceptedwisdom.AsherecentlytoldFortune,Thehighest
compliment,Ivecometounderstand,is,Oh,thatsobvious.Iusedtotakethatascriticism,butnowI
understandthatsthegoaltotakeacomplexproblemandmakeitseemclearandobvious.

Now66andbusierthaneverwriting,teachingandadvising,Portercontinuestotakeonasuccessionof
massivelycomplexproblems,fromrevivinginnercities,tomakingcountriesmorecompetitive,to
transformingthevalueofhealthcaredelivery.Wecaughtupwithhimrecentlytodiscusshislatestthinking
oncompetitivedynamicsandcorporatestrategy.Tooursurprise,healsohadplentyonhismindabout
investingingeneral,andvalueinvestinginparticular.

YourfiveforcesframeworkforanalyzingindustriesThreatofNewEntrants,BargainingPowerof
Buyers,ThreatofSubstitutes,BargainingPowerofSuppliers,RivalryAmongFirmsisanimportantpart
ofmanyfundamentalinvestorsresearchprocess.Hasyourthinkingonitevolvedovertheyears?

MichaelPorter:Whiletheoriginalframeworkwasintroducedmanyyearsago,in2008Iwroteanarticlein
theHarvardBusinessReviewthatreexaminedandreflectedontheapplicationoftheconceptovertime.
Mybasicconclusionisthatthefiveforcesarestillthefiveforces.Therehavebeenvariousnominationsfor
asixthforce,suchastechnologyortheinfluenceofgovernment,butmyviewisthatthosearebest
understoodintermsofhowtheyaffectthefivefundamentalforcesthatultimatelydrivethedivisionof
valueamongindustryparticipants.Forexample,governmentpolicycanraisebarrierstoentryorlower
barrierstoentry.Newtechnologycanintensifytherivalryamongfirmsordecreaseit.

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Copyright 2014, Advisor Perspectives, Inc. All rights reserved.
Industrystructureisprofoundlyrelevanttoinvestmentanalysis,buttoomuchoftheanalysislooksat
industriesinasimplisticway,saywhethertheindustryisgrowingorshrinking,orwhetheritsadowncycle
oranupcycle.Thefundamentalinvestorthatusesthefiveforcestounderstandwhatdeterminesthe
fundamentaleconomicvaluecreationinanindustryandhowitischanginggainsahugeedge.

Doyouthinkyourstrategyprescriptionsforcreatingcompetitiveadvantagehaveequallystoodthetest
oftime?

Myoriginalworklookedatthebroadpositioningchoicesinanindustrylowcosts,differentiation,broad
ornarrowsetofcustomers.Overtime,Ideepenedtheprinciplesforthinkingaboutcreatingauniqueand
sustainableposition,startingwiththevaluechain.Thatwaspartlymotivatedbythe#1questionIhad
gottenaboutthegenericstrategies,whichis,Cantyoubebothlowcostanddifferentiatedatthesame
time?Thisconundrumlettothedistinctionbetweenoperationaleffectivenessandstrategicpositioning.
Operationaleffectivenessisaboutassimilatingbestpractices.Strategicpositioningisaboutmakingchoices
andtradeoffsaboutwhatcustomersacompanyisgoingtoserve,theparticularneedsitistryingtomeet,
andultimatelythevaluepropositionofacompanyrelativetocompetitors.

Ihavebeenfocusedonthetimeless,unvaryingfundamentalsthatunderliecompetition.Theresno
questionthatconditionschangeandthatchangeisrelentlessandimpactsindustriesandcompanies.ButI
havealwaystriedtounderstandtheprinciplesthatneverchange,andusethemtounderstandthe
consequencesofchangeandtheimplicationsforcompaniesandmanagersinsettingdirection.Those
principleshavestoodthetestoftime.

Broadlyspeaking,wouldyousaytherateofchangeinindustrystructuresandcompetitivepositionshas
increased?

Wedonthaveanyrealproof,butthegeneralfeelingisthatthingsarechangingfaster.Ibelievethat
everyonealwaysthinksthattheirperiodofhistoryisonewherethingsarechangingfaster.

Informationtechnology,however,hasclearlybeenabigdisrupterandaspeedaccelerator.Iwouldalsosay
theaggressivenesswithwhichmanagementisshuttingthingsdownandcuttingcostshasdefinitelygone
upoverthelast10or20years.Thatispartlyduetothefactthatcapitalmarketsaremoretransparentand
investorsaremoredemanding.Butonmanyotherdimensionsofcompetition,Imnotsosuretherateof
changeisthatmuchfaster.

Everyyearortwooverthepast20yearssomebodyhaswrittenanarticlesayingstrategyisnolonger
relevantbecausetheworldischangingtooquicklyandtheimperativeistostayonestepaheadbychanging
feverishly.IdontknowmanyCEOswhoactuallybelievethis.JustabouteverycompanyIveevercomein
contactwithrecognizesitneedsastrategy.Itneedstounderstandwhoitisandhowitsgoingtocreate
distinctivevalue.Thatswhatallowscompaniesandmanagerstomakechoicesabouthowtodealwithall
thetrends,versusjustimitatethenextguy.

Elaborateonyourearliercommentthatinvestorsindustryanalysiscanoftenbesimplistic.

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Copyright 2014, Advisor Perspectives, Inc. All rights reserved.
Industrytrendsandtodaysgrowthratesareeasytosee.Whatsmoresubtleistounderstandhowthefive
forcesarechanging,andwhatthatmeansforwheretheoverallvaluelies.

Forexample,averyimportanttrendworkingitswaythroughmanymanufacturingindustriesisthat
productswithembeddedsensorsaregettingsmartandconnectedtomanufacturersandusersviathe
Internet.Smartconnectedproductscanhaveavarietyofimpactsupanddownthevaluechain.For
example,bytransformingthenatureofaftersaleservice,wherethereisashifttowardmorepreventative
andefficientmaintenanceversusatraditionalbreakandfixmodel.Butthetrendisneithergoodnorbad.It
alldependsonhowitsgoingtoimpactthefiveforcesinaparticularindustry.Doesitimpactbarriersto
entry?Doesitcreateswitchingcostsforthecustomer?Doesitcreatenewbusinessmodelsfocusedon
sellingtheuseoftheproductratherthantheproductitself,rebalancingcustomerpower?Takingthetrends
andthenworkingthemthroughthefiveforcesframeworkiswheretheinsightcomes.

Anotherexampleisthatanindustrydoesnthavetobegrowingtobeinteresting.Ayearortwoago
investorenthusiasmfortheprintingindustrywasnonexistentbecauseprintisbeingsubstitutedforby
electronicmedia.Butdecliningindustriescanbehighlyprofitableifcapacityleavesthemarketandbarriers
toentryrise.Demandcanholdupinlesspricesensitivesegments.Imnotmakingthecaseforeveryoneto
runoutandbuyprintingcompanies.Butifyoulookdeeplyenough,youmayhaveevengreatereconomic
opportunitiesinsomedecliningindustriesthanyoudoingrowthindustrieswhereeveryoneisrushingto
getin.LookatthestockpriceofR.R.Donnelley[RRD]overthepastyear.

Youmentionedthatinvestorshavebecomemoredemanding.Doyouconsiderthatanunalloyedgood?

Netnet,Iwouldsaycapitalmarketshavemadeitharderforcompaniestoactuallyhaveastrategyand
maketheinvestmentsthataddressthetruefundamentalsoftheirindustrystructureandtheircompetitive
position.Weveseenariseingamingaroundguidanceanddeliveringquarterlyearningssurprises.Theres
alsoatendencyforinvestorstolatchontoonecompanythatseemstobedoingwellandpushfor
everyoneelseintheindustrytoimitateit.Analyststendtoevaluatecompetitorsonthesamemetricseven
thoughdifferentmetricsareappropriatefordifferentstrategies.Allofthisencouragesconvergence,which
istheenemyofstrategy.Theworstmistakeinstrategyisforacompanytocompetewithrivalsonallthe
samethings.

Givenallyourworkwithcompaniesandindustries,arethereanyseculartrendsyoudsuggestinvestors
examine?

IntheU.S.economy,thesinglebiggestopportunitythatwillhaverippleeffectsacrossmanyindustriesis
thenewenergysituation.Thisiscertainlynotasecretandhasalreadyhadsignificantimpactonoilandgas
producingregionsandontherailroadsandpipelinesthattransportallthenewproduction.Thenextorder
effects,whicharejustbeginning,willbeonindustrieswhereoilandgasareimportantfeedstocksorinputs,
suchasinchemicalsandplasticswhereU.S.productionnowhasacompetitiveadvantagewhereithashad
adisadvantage.Furtherdowntheline,otherenergyintensiveindustriesandcompanieswillbenefit.

AnotherareaonwhichIspendalotofmytimetodayisaroundtheideaofcreatingsharedvalue.Thisgets
attherelationshipbetweenbusinessandimportantsocietalissuessuchashealth,education,povertyand


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Copyright 2014, Advisor Perspectives, Inc. All rights reserved.
theenvironment.Historicallycompanieshaveaddressedsocialissuesthroughcorporatephilanthropy,
whichisdetachedfromthebusinessand,somewouldsay,spendsshareholdersmoney.Morerecently,
corporateresponsibilityinitiativeshaveledtomuchreportingandfocusonreducingsocialharmsagain,
tangentialtothebusiness.

Buttherealpowerofabusinessinsocietyisinbeingabusinessmeetingneedsataprofit.Werejust
startingtounderstandthattheworrisomesocietalproblemswefacerepresentthegreatestbusiness
opportunities.

Thepharmaceuticalindustryisagreatexample.Itwasbuiltlargelytoserveahalfbillionpeopleliving
primarilyinrichcountrieswithestablishedhealthcaresystemsandrelativelyhighincomes.Butanother6.5
billionpeopleareouttherewhoseneedsarelargelyunmet.CompanieslikeNovartisandNovoNordiskare
startingtoaddressthose6.5billionpeopleprofitablywithnewkindsofproducts,pricingmodelsand
distributionsystems.Thepotentialtocreatesharedvalueishugeandapplicabletovirtuallyeveryindustry
andsector.

Canyougivesomeotherexamplesofcompaniescreatingsharedvalue?

Becton,Dickinsonisamedicaldevicecompanywhoserecentgrowthisbeingdrivenbyaddressingpublic
healthneedslikerisksfromneedlestickinfectionsworkingcollaborativelywithgovernmentsandnon
governmentalorganizationstodoso.DowChemicalcreatedaBreakthroughstoWorldChallenges
program,taskingeachofitsbusinessunitstofindbusinesssolutionstoarangeofglobalproblems.Onebig
hitwasthedevelopmentofOmega9canolaandsunflowerseedsthatproducecookingoilwithnotrans
fatsandlowsaturatedfats.Theseedsyieldforfarmerstwicetheoilperhectarethansoybeans,andtheoils
havelongershelfandusagelivesforcustomers.ItsalsobecomeoneofDowChemicalsbiggestselling
productlines.Thisiscreatingsharedvalue.

Itscrucialforeveryenterprisetounderstanditsfundamentalpurposeinsociety.Latelywevebeensaying
thatourfundamentalpurposeistomakemoneymaximizeshareholdervalue.Butthisdefinitionof
purposeisuninspiringandevenrisky.Companiesalsodefinepurposeintermsoftheproducttheyproduce.
Butpurposeoughttobeaboutthefundamentalneedsinsocietyacompanymeets.IfNestlethinksofitself
asjustafoodcompany,itmightthinkthatthegoalistogetpeopletoeatmore.ButifNestlethinksofitself
asanutritioncompany,ithasaligneditspurposearoundmeetingafundamentalsocietalneed.Thatopens
upoptionalityandopportunityforNestletodifferentiateitselfandinnovateinwaysthatcreateshared
value.

YourehelpingtoleadamultiyearHarvardinitiativeonU.S.competitiveness.Whatwouldyouhighlight
askeyinsightsfromthateffortsofar?

Thisstartswiththedefinitionofcompetitiveness.Inourdefinition,theUnitedStatesiscompetitivetothe
degreethatcompaniesoperatingherecancompetesuccessfullyinglobalmarketswhilesimultaneously
maintainingandincreasingwagesandlivingstandardsfortheaverageAmerican.Ifbusinesssucceedsby
cuttingjobsandincomes,theU.S.isnottrulycompetitive.WerefindingthattheU.S.hasseriousstructural


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Copyright 2014, Advisor Perspectives, Inc. All rights reserved.
competitivenessproblems,whichleadsustobelievethatthecountryislikelytofacesloweconomicand
jobgrowthforyearstocome.

Everyoneseemstounderstandthemacroeconomicproblemsweface.Butourworksuggeststhatwealso
haveanumberofseriousmicroeconomicproblemsthatarejustasimportant.

WhiletheU.S.retainscorestrengthsinthingslikeentrepreneurship,innovation,scienceandhigher
education,weveletsomeofthebasicsslide.Weneedtosimplifyandstreamlineregulationaffecting
businesstofocusonoutcomesratherthanimposecostlyreporting,complianceanddelays.Ourlegal
systemisinflictinghighcostsonU.S.businesses,asisourhealthcaresystem.Roads,bridgesandportsare
indisrepair,andourcommunicationsandenergyinfrastructuredoesnotmatchtheworldsbest.

ThecorporatetaxsystemisdisastrousforU.S.competitiveness,withthehigheststatutoryratesinthe
OECDanddisincentivestorepatriateforeignprofitsbacktotheU.S.Atthesametime,thesystemhasso
manycomplexexclusionsanddeductionsthattheU.S.endsupcollectinglowertaxesthanmanyother
countries.

Ourpubliceducationsystem,crucialtotheabilityofworkerstocompeteandtomaintaintheirincomes,
continuestofallfurtherbehind,especiallywithrespecttomiddlelevelskillsinvolvingsometechnical
training.Overall,skilldevelopmentisbroken,leadingtounfilledjobsandhighunemployment.What
troublesusisthattheU.S.hasnotbeenwillingandabletoreachconsensus,passlegislation,andaddress
anyoftheseproblemsindecades.

Inthesamewaycompaniesneedtodefinetheirpurpose,youvesaidthesamethingaboutinvestors.
Explainthat.

Ibelievethefundamentalpurposeofinvestingistodeploycapitaltoproductiveusesintherealeconomy.
Itstheabilityofbusinessestousecapitalwelltomeetneedsataprofitandgrowthatcreatesallthe
wealthinsociety.GovernmentandNGOsdontcreatewealth;theyutilizetaxesanddonationstomeet
societalneeds.Directingcapitaltocompaniesthatcanuseitproductivelytocreateeconomicvalue,and
thuswealth,isultimatelythemostprofoundbenefitinvestorscanhaveonsociety.

Beyondallocatingcapital,investorsalsoplayavitalroleinmonitoringwhatcompaniesaredoing,pushing
fortransparency,andinterveningtocatalyzechangeifthecapitalemployedisntgeneratingtheeconomic
valueitshould.Allofthisraisesthefundamentalwealththatisbeingcreated,andthiskindofwealth
creationdoesnotcomeattheexpenseofotherinvestors.

Theconcernisthatitseemslikethevastmajorityofenergyandeffortininvestinghasbecomeabout
otherthings.Itsaboutindexing.Itsaboutmomentum.Itsaboutprogramtradingtocapitalizeontiny
movementsinshareprices.Itsaboutlocatingyourserversclosertotheexchangesoyoucantradeinand
outalittlefaster.Imallforpricediscoveryandliquidity,butimprovementsherehavediminishingreturns
forfundamentalwealthcreation.Oneinvestorsgainisoftenanotherinvestorsloss.

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Copyright 2014, Advisor Perspectives, Inc. All rights reserved.
Asmoreinvestorswalkawayfromfundamentalinvesting,theneedandtheopportunitygrowsforvalue
investorswhofocusonunderstandingcompanies,industriesandcompetition.Suchinvestorscandowell
forthemselves,fortheirowninvestors,andforsociety.Thisiscreatingsharedvalue.Idliketoseemore
investorswiththatsenseofpurpose,andmorerules,regulationsandincentivesputinplacethatlead
investinginthesedirectionsratherthanthosethatcreatelimitedsocietalreturns.

ToreadtheentirenewissueofValueInvestorInsight,whichalsoincludesindepthinterviewswith
marketbeatinginvestorsTimHartchofBrownBrothersHarriman&Co.andMarioCibelliofCibelliAsset
Management,signupnowforanoobligationfreetrialat
http://www.valueinvestorinsight.com/freetrial.





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