Tuesday, September 19, 2006

Entering Treacherous Waters

For its reputation as a group of technocrats, the People's Action Party has been rather slow to embrace the internet.

These last couple of weeks, BG George Yeo made his first foray into the internet by making a few posts at ephraim loy's blog. These posts have drawn much attention, yet the response from the internet has been largely disappointing, since Yeo's posts have little to do with substantive issues facing Singapore, but are rather just an account of various events in his life.

Other attempts by PAP MPs to engage the internet community are now either defunct or benign. MP Penny Low set up a blog to cover the NDP 2005, but that blog is now devoid of activity. Dr Teo Ho Pin also set up a blog, but most of the posts seem to be short replies on relatively mundane issues.

On the other hand, other political parties have long since jumped on the internet bandwagon and have been vocal and explicit on politics. Goh Meng Seng's blog is about his 'political struggle', James Gomez has written extensively on his thoughts, and Chee Soon Juan relentlessly publishes fiercely political content.

Indeed, the rise of the internet as a major media platform for the future points towards serious challenges to the PAP's political hegemony. The free-for-all, democratic nature of the world wide web means that censorship of criticism on this medium is virtually impossible, and the kind of power that the ruling party is able to exert on the main stream media evaporates into insignificance on the internet.

Strong critics of the establishment not only abound in cyberspace, they also dominate the digital discourse. Bloggers and blogs such as Mr Wang, Gayle Goh, Yawning Bread and Singabloodypore all command a high readership and are unabashedly critical of policies and the press. Yet all three PAP bloggers have yet to engage any of the criticisms of the government in any meaningful way.

The recent acknowledgement of the impact of 'The Digital Age' by PM Lee Hsien Loong during his latest rally speech is a tacit admission that the playing field of the future will not be newspapers or television, which the incumbents currently have a stranglehold over. Rather, it will be the internet, where opinions can be published in an instant, at no cost, to everybody and anybody in cyberspace. And with the 'Intelligent Nation 2015' goal of getting 90% of all households on broadband, that means virtually the whole nation will be exposed not only to the opinions of detractors, but also to audio podcasts and videos which may portray the government in a less than favourable light.

But perhaps the PAP's lack of significant presence on the internet foreshadows the beginning of its decline. For years the state has dominated the press and broadcast media, disseminating messages favourable to its regime and censoring all that would threaten its power. And yet, as the Prime Minister calls for more engagement of Singaporeans, particularly in New Media, the PAP seems to lack bite and is clumsy, at best.

Without the ability to censor or control the internet, the PAP will be forced to engage its critics to remain credible in the eyes of Singaporean netizens. Meanwhile, a continued avoidance of substantive issues does no favour to improve its image. The internet is a new, levelling playing field, where authoritarian censorship no longer works.

As the Digital Age unfolds, it will be interesting to watch how the incumbents behave, as the tools for maintaining their dominance slowly slip from their hands, and as they enter the new treacherous waters of the internet.

Blackmores - A Strategic Analysis (Part 4)

Distinctive Resources/Capabilities Analysis

It is Blackmores’ less recognisable distinctive resources and capabilities that mould the organization into an “industry leader in Australia for more than 70 years.” (Blackmores, 2006). The more significant resources and capabilities that can be identified which provide Blackmores with a sustainable competitive advantage are as follows:
  1. Guaranteed quality
  2. Thriving internal culture, expertly trained staff and industry savvy CEO.
  3. Purchasing power and extensive product range.
  4. Research and Development of existing and new products.
  5. Reputation, brand image and awareness.
(i) Guaranteed quality

It is Blackmores’ primary policy to ensure high quality products, with “ingredients sourced from around the world.” (Blackmores, 2006) Marcus Blackmore, following in his father’s legacy has demonstrated that he has “not been interested in pursuing growth at the expense of quality or control.” (Quinlivan, 2006) This uncompromising effort to be a firm recognised for quality healthcare products was rewarded in 2003, when Pan Pharmaceuticals was closed down. Blackmores never did business with Pan Pharmaceuticals, as Blackmores’ “extremely capable audit team” (Quinlivan, 2006) did not recognise Pan’s products as superior in quality or control. This unflinching standard of quality has filtered through into Blackmores’ reputation as a whole.

(ii) Thriving internal culture, expertly trained staff and industry savvy CEO.

Blackmores has a company culture that has built great relationships amongst both employees and senior management. It is a culture in which effort and quality is recognised with both tangible and intangible rewards, Blackmores recently awarded “50 free shares to all permanent staff.” (ASX, 2006) In addition, the firm lives by the philosophy that “it’s impossible to be an effective organization without satisfied and engaged staff.” (Blackmores, 2006) Furthermore, empowering staff and allowing them to work in teams, has provided Blackmores with a further distinctive capability, “At Blackmores, very little gets done without teamwork and staff taking ownership of projects.” The firm’s expertly trained staff, working together, ‘keep the wheel in motion.’

Training and development of a highly skilled labour force is imperative to Blackmores’ mission. Blackmores is committed to employing “high quality staff… [often] qualified health experts.” Blackmores provides the community with trusted information by not only training their own staff, but by “educating [their] retailers [ensuring that their] consumers are provided with superior information on the Blackmores product.” (Blackmores, 2006)

Finally, it may be argued that it is Blackmores CEO, Marcus Blackmore that is the firm’s most valuable distinctive resource. It is he and his father, Maurice who “had ideas about health way ahead of his time,” (Blackmores, 2006) that have provided the firm with the tacit knowledge of not only how to run this complex organization as a business, but also an unparalleled understanding and passion for complimentary healthcare. It is Marcus’ strong political ties that enable him to spend up to 2 days a week lobbying the government for legislative reform, “we’ve moved over the past six months from a largely confrontational approach to industry to one of collaboration and consultation.” (Quinlivan, 2006) “Blackmores and the CHC (complimentary healthcare council) are currently working to oppose the proposed increase in TGA fees and charges and to have GST removed from complimentary medicines.” (ASX, 2006)

(iii) Purchasing power and extensive range.

With an exceptionally large market share within Australia, and growing market share in the Asian markets, Blackmores continues to grow its leadership strength in buying power. This unique bargaining power enables the brand to maintain its superior standard of quality, while becoming more cost effective.

Blackmores produces products servicing in excess of 20 different matters of health, ranging from weight loss and muscular pain to infections. This extensive range of products allows Blackmores to extend its brand equity into the various nooks and crannies of the industry.

(iv) Research and Development Capabilities

Blackmores is an undisputed leader in complementary healthcare research and development. It continues to refine its seasoned products and develop new ones. Blackmores’ joint venture with a research team at the Southern Cross University places it at the forefront of research and development. The recent appointment of a research manager provides the firm with a further distinctive resource and substantial tacit knowledge not available to competing firms. This innovation has been one of the key factors providing Blackmores with a sustainable competitive advantage.

(v) Reputation, brand image and awareness.

Brand image and reputation is critical to a firm’s success within the complementary healthcare industry. Particularly after the Pan Pharmaceutical debacle, there has been a heightened awareness of the need for quality when it comes to medicines and supplements.

Market research has established that “Blackmores is the most trusted natural healthcare brand in the market place.” (Blackmores, 2006) This brand equity has been established over decades and is extremely difficult for competitors to replicate. It forms perhaps the most important distinctive resource for the firm, and is the result of decades of hard work and is the result of the combination of its unique corporate culture, first-class operations, research and development capabilities, and all the other distinctive attributes of the firm.

In a market that demands the highest quality, Blackmores’ brand gives it a strong, sustainable competitive advantage over its competitors.


Strategic summary

The external market is favourable for Blackmores’ industry, with many growth markets in the Asia-Pacific region. The aging population of baby boomers will also contribute greatly to the demand of complimentary pharmaceutical products.

The company has a strong brand reputation and an established market position in the industry, with strong links to industry suppliers and distributors. Its capabilities in research and development give it valuable intellectual capital and tacit knowledge that is hard for other firms to replicate.

Implications for future strategy

Blackmores has a bright future ahead of it. If it can continue to execute the strategies it has been pursuing and continue to strengthen its branding and relationships with suppliers and retailers, it can expect to see its share price continue to grow as it rides the Asian economic boom.

Blackmores - A Strategic Analysis (Part 3)


Value Chain Analysis: Primary Activities

Inbound Logistics
  • Extensive supplier checks means that Blackmores only receives the highest quality materials from its suppliers.
  • All warehouse employees are given extensive training to ensure the most efficient use of human resources possible.

  • Blackmores is moving its headquarters to a central location at Warriewood in order to more efficiently handle its operations.
  • “Everything we do in our Operations area is dedicated to delivering a quality product.” (Blackmores, 2006)

Outbound Logistics/Distribution Channels

  • Blackmores has various distribution arrangements depending in the country it is operating in. For instance, it has an extensive distribution network in New Zealand, with 1700 distribution outlets. In Hong Kong, however, it only distributes through one pharmacy chain store, as competition is highly intense in that market.
Marketing and Sales
  • Great reputation for quality.
  • Blackmores has the highest brand awareness in its category and is the most trusted. (Blackmores 2006 annual report)
  • Effective use of TV commercials to support the debut of new product lines, including Blackmores expansion into the arthritis segment with its Glucosamine product in 05/06.
  • Changes in the Therapeutic Advertising Code have allowed Blackmores to use health professionals in its advertising.
  • Use of the popular Blackmores website to actively communicate with consumers, including 164,000 active subscribers.
  • Blackmores is committed to becoming a source of information regarding health issues:
  • Effective use of the Blackmores website to communicate with its customers. The website won the Hitwise Top Site in the Health and Pharmaceutical category, and has 164,000 active subscribers who receive a fortnightly newsletter of health news.
  • Blackmores Naturopathic Advisory Service fielded 55,000 calls over the past year, providing alternative health information to consumers and professionals.
Value Chain: Support Activities

General Administration

  • Stable leadership over 30 years: Marcus Blackmore retains a 31% stake in the company.
  • Strong commitment to core values which are reflected in all aspects of Blackmores’ business. These core values are: Trust, Leadership, Superior Performance, A More Natural Approach to Health
  • Ability to successfully lobby for regulatory reforms.
  • Strong professional ties with other healthcare professional bodies such as the Pharmacy Guild of Australia, the Pharmaceutical Society of Australia, and the National Pharmacy Students Association.
  • Extremely strong commitment to quality at all costs creates a culture equally obsessed with quality.
  • Strong commitment to social responsibility, with substantial donations to charity and a focus on environmental sustainability, provides an ethical culture and helps enhance the brand image.
HR Management
  • Places great importance on recruiting, training, and retaining high quality staff, and this is reflected in the fact that Blackmores one of 12 Hewitt Best Employers awards for 05/06. This helps Blackmores in attracting new employees, important as the company expands its business into Asia.
  • Blackmores has a profit share arrangement where 10% of its Australian profit is shared between all permanent staff, and recently it gave each of its employees 50 shares in the company to reflect the value it places upon them.
  • Training provided for Blackmores employees through the Senior Consultant Training course is recognised and in some cases interchangeable with the Pharmacy Guild’s National Training Course.

Technology Development, R & D

  • Blackmores sends large contingents of staff to the main pharmaceutical and healthcare trade conventions around the world in order to stay in touch with the latest trends in healthcare.
  • Blackmores regularly funds research into new alternative healthcares, a recent example being a study into the immune benefits of the milk protein lactoferrin, which culminated in a new Blackmores’ product, Immunodefence.
  • Blackmores has relationships with several universities around Australia to ensure it stays on top of the latest research relevant to the industry. One of these universities, Southern Cross University, is the base for the Blackmores Research Centre, and the combined effect of all this research is to help Blackmores regularly produce new products.
  • Focus on procuring from quality suppliers over cheaper ones has meant Blackmores has a greater reputation for quality than many competitors, and allowed it to dominate in the wake of the Pan Pharmaceuticals collapse of 2003.
  • Extremely strong commitment to only procuring quality materials from suppliers:
  • Use of quality control teams to ensure that suppliers are of the highest quality.
  • Extensive product testing.
  • Regulatory compliance.

Blackmores - A Strategic Analysis (Part 2)

Porter’s Five Forces Analysis

The intensity of rivalry among competitors in the industry:
  • The industry structure is mainly that of monopolistic competition, with multiple firms competing for the consumer’s dollar. In the supermarket, 4-6 brands can be found selling relatively homogenous products.
  • The high industry growth should help offset battle for market share, as competitors don’t need to steal one another’s customers. Market growth is increasing due to recent pushes towards complementary healthcare, for instance the work of the Complementary Healthcare Association lobbying the government and surveys undertaken by industry help to spread awareness of complementary healthcare among the aging baby-boomer population.
  • The impact of regulatory bodies. E.g. if the Therapeutics Goods Administration tightens quality constraints, may erode profit margins of smaller firms, lead to push for economies of scale
  • There are low switching costs between brands for consumers, though the Pan Pharmaceuticals debacle highlighted the importance of strong brand equity to maintain customer patronage. Also, if the healthcare products are viewed as commodities, buyers will focus upon price and service as their differentiators.
One of the biggest competitors to Blackmores continues to be lower priced alternative complementary medicines. Bio-Organics and Herron are two brands that are competing directly with Blackmores and given their lower price products are sharing much of the market share with Blackmores. Additionally, there are added incentives to purchase Guardian products, such as Guardian loyalty cards. These factors help to boost Guardian owned products. Therefore, a possible improvement in the future for Blackmores is to introduce a loyalty scheme that will help retain their customers.

The bargaining power of buyers:
  • Bargaining power of buyers is moderate to weak.
  • Many buyers mostly accounting for a small proportion of total sales. The complementary healthcare industry utilizes 3 major distribution channels - Chemists, grocery stores and healthcare stores to access a wide range of consumers who generally all purchase relatively low volumes (ASMI, 2006).
  • Blackmores has sought to differentiate its product via a quality focus and some competitors have a cost-focus. This Differentiation strategy helps to develop brand loyalty and is aimed at nullifying the impact of higher prices on consumer demand.
  • No real threat of backward integration – given the diversity of customers.
  • The customers are end-users, so there are no resale issues
  • The absence of any real switching costs favorably influences buyer power, as it allows dissatisfied customers to change readily within the healthcare brands. Again, the focus on brand image and service helps to offset this lack of switching costs.
  • The retail stores and distributors, however, have some bargaining power because they are able to influence the amount of shelf space given to Blackmores. However, Blackmores has a good working relationship with distributors and has a good share of shelf space amongst retail outlets.
The bargaining power of suppliers
  • Generally quite weak, as there are many supplier companies selling relatively homogenous raw materials and commodity products – price, quality and service are the only real differentiators.
  • That said, suppliers don’t need to contend with substitute products, except for advances made in specific healthcare products.
  • The industry is a very important customer of the supplier group (Industry worth more than $1billion). It is a growth industry that suppliers would want to remain on good terms with.
  • Supplier products are vital to the industry’s business, which gives them some power over the industry. However the push for quality and the high number of suppliers means it is difficult for them to utilize this as leverage.
  • No real switching costs between suppliers, only real logistical issues. So again industry has the power to shop between suppliers.
  • Suppliers do not pose much of a threat of forward integration – they manage a diverse portfolio of clients so it is unlikely to be cost effective to develop them within the niche healthcare industry. Furthermore, it would be difficult produce the diverse raw-inputs that are necessary to manufacture healthcare products.
Threat of Substitute Products
  • Synthetic medicines prescribed by professional doctors act as a substitute for the natural medication that Blackmores sells. However, the trend suggests a growingacceptance of natural healthcare products, such as those produced byBlackmores.
  • Within the Asian markets that it is competing in, Blackmores will face intense competition from companies selling traditional Chinese medicines (e.g. Eu Yan Sang). Blackmores will have to work around cultural preferences for these products in countries like Taiwan, Hong Kong and Singapore.
Threat from Potential Entrants into the Industry
  • No major legal barriers to enter the market
  • Few secrets to manufacturing of health supplements
  • Main barriers to entry are the existing supplier/buyer relationships, and the brand name and reputation of Blackmores.
  • Threat of entry by global multi-level marketing firms (e.g. Amway, Nu Skin, Unicity) which often sell nutraceutical supplements
  • Another threat that could possibly undermine the success of Blackmores in Australia is the potential arrival of an international company with intact infrastructure taking over local businesses in Australia. Already there is an abundance of companies competing for a segment in the complementary pharmaceutical industry and therefore separating oneself from the rest is an issue Blackmores must attend to.

Blackmores - A Strategic Analysis (Part 1)


Company Background
  • Founded in the 1930s by Australia’s pioneering naturopath, Maurice Blackmores.
  • Goal of the company is to shift the focus of the health system away from treating diseases to one that encourages people to accept responsibility for their own wellbeing
  • It is a customer-focused company inspiring people to take control of, and invest in, their health and wellbeing. They are “leaders in developing and marketing products and services that deliver a more natural approach to health, based on our expertise in vitamins, minerals, herbs and other nutrients.”
Industry Definition
  • Blackmores’ industry is defined as the complementary pharmaceutical industry.
  • This includes complementary pharmaceutical products, nutritional and health supplements.
  • Companies in this industry are mainly involved with the purchase of raw materials and the conversion of these raw materials into natural medication products which are then distributed through retail stores, pharmacies and chemists.
  • More established companies like Blackmores also have a strong sales service where qualified naturopaths and health experts provide advice to customers, in addition to established research & development capabilities to develop newer and better complementary healthcare products.


The Macro-Environment

Demographic and Sociocultural Trends

The ageing population of baby boomers in Australia is perhaps the most significant trend driving growth in the complementary pharmaceutical industry. These baby boomers form a large section of the population, and have had the highest median household incomes of any generation. They are increasingly leaning towards non-prescribed medicine to be the greatest form of treatment for their various physical ailments, as well as natural healthcare supplements to be a source of health and wellbeing. This demographic trend will continue to set the consumer agenda for the years ahead, and especially so in the healthcare industry.

Changing health environments on a national level has meant that people are tending to accept over-the-counter (OTC) products more regularly compared to prescribed medicine. Not only is it sometimes cheaper to purchase OTC products but the feedback from several complementary pharmaceutical companies has demonstrated consumers are more than happy with their results.

Growing acceptance of alternative medicine has dominated mainly the muscle/joint segment of the products produced by Blackmores. More and more people are seeking alternative medicines to combat their muscle/joint soreness, and Joint Formula with Glucosamine and Chondroitin (60 Tabs) continues to be one of their best sellers.

Global Economic Trends

In terms of the global arena there is no doubt that Blackmores is looking to further establish itself in the rapidly growing economies of Asia, which present many growth markets and opportunities for the company. In particular, Blackmores has found the Malaysian and Thai markets to be two of the greatest assets to the company. It has already been in Thailand since 1997, and Blackmores’ products are located in over 1,000 stores throughout Thailand.

Blackmores’ greatest form of overseas expansion lies in Thailand. The company has also made in-roads into Singapore, Hong Kong, Malaysia, Indonesia and New Zealand. However Thailand continues to be the best of the international entities. “The Blackmores business in Thailand has experienced an average growth rate of 20% over the past six years whilst the growth rate in the comparable sub-category is 10%” Further welcome news for Blackmores is that overseas it is not only the expatriates that are purchasing their products but also locals. It is this segment that the company is looking to pursue.

Regulatory Climate & Technological Environment

Regulators were previously quite adversarial towards the complementary healthcare industry. Marcus Blackmore has been actively lobbying for better regulatory conditions. The company also engages in extensive research and development activities. These regulatory and technological factors are discussed in more detail in the analysis of the firm’s internal environment.

Monday, September 18, 2006

Do CEOs ever have a responsibility to "talk down" the share price of their company?

Talking down the share price of the company you are responsible for can often invoke an incendiary reaction from incumbent shareholders, especially if you have yet to build up the almost religious cult following that Warren Buffett has. And if you haven’t, doing so either takes

i. a strong sense of moral courage,
ii. a questionable sense of ethics,
iii. questionable business judgment, or
iv. a very good utilitarian reason to do so.

Talking Down in an Efficient Market

Assuming an efficient market, one can consider three main reasons why a CEO would want to talk down his company’s share price.

1. Public information does not reflect inside information

Under the information perspective for decision usefulness, markets respond rapidly and rationally to newly released public information. This means that market value diverges from intrinsic value only if public information does not reflect inside information, and the market has over optimistic expectations of the firm’s performance based on public information that does not give an accurate picture of the company’s inner workings.

When this happens, CEOs have an interest in ‘talking down’ their share price and releasing accurate inside information to the public, in order to manage shareholders’ expectations. The risk for the CEO is that the company will report future earnings that are below shareholders’ expectations that were based on faulty information. This could result in adverse consequences for the CEO’s job or compensation. This also allows the public to have better information of the internal state of the company, and avoids an over-allocation of capital to the company’s shares by the capital market.

2. The CEO wants to reduce expectations to make future performance seem better than it really is

Assuming public information more or less reflects the inner workings of the company, a CEO might be motivated to talk down the share price by making the company appear to be in worse condition than it really is, in order to make future earnings results seem abnormally high. A CEO stands to benefit financially from this practice when earnings performance is higher than expected, but doing so is ethically questionable, since it essentially involves deceiving shareholders and the market.

3. The CEO’s judgment is inaccurate

If public information is congruent with inside information, then a third reason why an honest CEO might want to talk down his company’s share price is because he has an overly pessimistic assessment of the company’s prospects. The converse is true if he tries to talk up share price in an efficient market with little information asymmetry – the CEO may be over estimating the prospects of his company. This is probably much more prevalent in practice.

Talking Down in an Inefficient Market

If, however, public information does accurately reflect inside information, and if a CEO is not prone to questionable ethical behaviour, then one has to consider relaxing the efficient market assumption in order to find reason to talk down the share price. With the advent of new fields of study like behavioural finance and comments of ‘irrational exuberance’ by such luminaries as Alan Greenspan, this may not be such an outrageous relaxation of assumptions after all. In fact, assuming that the market may not be efficient relaxes the need to assume that either:

a. information asymmetry exists,
b. a CEO is behaving unethically, or
c. a CEO’s judgment is inaccurate,

or any combination or permutation of the three.

Assuming public information reflects inside information, a CEO is honest and behaves with integrity, and the CEO accurately understands the value of his company, a CEO would be motivated to talk down the share price of his company if he noticed that the stock of his company was trading at a price significantly above its intrinsic value.

Doing so would:

i.Protect current shareholders from having an inflated sense of their wealth.
ii.Prevent a transfer of wealth, rather than a creation of wealth, from those buying the shares at the inflated price to those selling the shares at the inflated price. This is particularly important if we hold that prices eventually correct to reflect a company’s intrinsic value. When that happens, many retirement funds and children’s college funds can be destroyed overnight when share prices fall from lofty heights.
iii.Prevent the CEO & management team from being the victim of unrealistic expectations that are imputed into an inflated share price.
iv. Encourage efficient allocation of capital in the stock markets.

The very idea of an inefficient market, however, suggests that efforts by a CEO to persuade the market to 'rationalise' its pricing may well be unsuccessful. There is a significant chance that an inefficient market with irrational participants will ignore the talking down of the CEO, since the market has already ignored the public information available and has mispriced the company's stock.


Whether or not one believes the market is efficient, there are times when a CEO is rightfully motivated to talk down the share price of a company. And none other than Warren Buffet and Charles Munger "like the stocks of both Berkshire and Wesco to trade within hailing distance of what [they] think of as intrinsic value. When it runs up, [they] try to talk it down. That's not at all common in Corporate America, but that's the way [they] act." And if shareholders can suspend their immediate reactions of unhappiness towards such a move, they might well find that the CEO's actions are in the long run interests of the company as a whole.



Kerin, Paul (2006), "Tactical Retreat," Business Review Weekly
Scott, William R. (2006), Financial Accounting Theory, Person Prentice Hall
Tilson, Whitney (2003), "Charlie Munger's Worldly Wisdom," The Motley Fool

Saturday, September 09, 2006

Competitive Strategy: The Five Forces (Part 1)

When pursuing a qualitative analysis of a business, one of the key components of an analysis is the competitive dynamics of the industry the business is in. Michael Porter, in his book, competitive strategy, outlined the five key forces that determine the profitability of an industry. And while these five forces are not exhaustive, they form a useful guide to analysing a firm's competitive environment.

Force 1: Internal Rivalry Within the Industry

Internal rivalry refers to the state of competition between companies in the industry itself. A company in an industry characterised by low competition is likely to exhibit high amounts of abnormal profits. For example, Microsoft competes in the operating system industry, and has very little competition in this area. For all practical purposes, the company has a monopoly in the desktop operating system market, and faces very little competition. This enables it to raise prices and maximise profit, without having to worry about competitors undercutting its prices to compete away market share. A company such as Microsoft is said to be a price maker, since it has much power to set the prices of its Windows products.

Conversely, a business that is in an industry with a highly competitive market structure is likely to be a price taker. This means that it is forced to take the price that is set by the market. For example, the average soybean farmer's produce, with his few acres of farmland, only constitutes a drop in the ocean amongst the global soybean market. As an individual producer, the farmer has no say on the price of soybeans, since any attempt to sell his produce above the market rate will fail (nobody will buy his soybeans since they can get the same product at a cheaper price), and besides, he has no incentive to sell below the market rate when he can clear his barns at the going rate.

It therefore follows that companies that are within a competitive industry should seek to shape the competitive landscape so as to minimise competition, and derive competitive advantage. This, however, is the subject of another essay.

Force 2: Potential Entrants/Barriers to Entry

Even though a company might be in an industry with little competition, the competitive landscape of the industry can change rapidly once new competitors enter the industry. Thus, industries are attractive to the extent that there exist barriers to entry into the industry. For instance regional newspapers often operate with high barriers to entry. The large amount of fixed costs involved with purchasing and setting up printing equipment, coupled with the high editorial and administrative costs that are necessary to maintain a newspaper, prevent competitors from entering small regional markets. Customer brand loyalty can also create large barriers to entry, since there is little incentive for a reader to switch newspapers when he or she has been reading it for the last 20 years. High barriers to entry deter competition, and in turn help to maintain abnormal profits associated with lesser amounts of competition.

Conversely, an industry with low barriers to entry will invite competition, and companies in the industry will see any abnormal profits competed away rather quickly. For example, it is easy to set up a lemonade stall along the beach to sell drinks to passers by. Any abnormal profits, however, will quickly attract competitors who will rapidly compete away these profits. The lack of barriers to entry allows other enterprising individuals to quickly enter the lemonade market, and the lemonade stall owner can do little to keep them out.

Competitive Strategy: The Five Forces (Part 2)

Force 3: Threat from Substitute Products

The availability of multiple substitute products can decrease the profitability of an industry. This is because customers have more choice available to them and can switch to other products easily if the products of an industry are priced too highly. However, when a product is very unique in the market and there are few, if any, substitutes, this will mean that there are high switching costs involved for customers and that the company or industry producing the product can raise prices to earn abnormal profits.

One example of an industry with no substitutes is the water industry. There is no substitute for water, and utilities companies, if operating in a monopoly, have the potential to raise prices upwards. The lack of substitutes means that people do not have the choice to switch to other products, and water companies often exhibit strong pricing power. However, because there is a need for the provision of this basic resource to society at large, governments often regulate that water companies are not allowed to raise prices above a certain point, to prevent an abuse of industry power at the expense of society.

On the other hand, the t-shirt industry faces many substitutes. If a customer is looking to buy a new t-shirt, he will be very much spoilt for choice. He has at his disposal the option to purchase collared tees, short sleeved shirts, tank tops, or basically any other garment that clothes his upper body. This availability of multiple substitutes greatly diminishes the pricing power of any t-shirt producer, who often has to provide value in other ways, in the form of designs or brands.

In general, an industry that has few substitutes or potential substitutes is an attractive industry to operate in.

Force 4: Bargaining Power of Suppliers

The third force that determines the profitability of an industry is the bargaining power of the suppliers of inputs into the industry. The more consolidated the suppliers are, the more bargaining power they will have, and the higher the prices the suppliers will be able to charge to companies in the industry. The higher the prices of inputs, the higher the costs for the industry, and the less profitable the industry will be.

An example where a supplier has very strong bargaining power is the personal computer industry. Two of the key suppliers, Intel and Microsoft, dominate their industry and are able to exert strong bargaining power on their customers to push up the prices of their inputs: computer chips and operating system software. Because the PC assemblers are relatively fragmented, they do not collude to exert as much counter-bargaining power as they possibly could.

On the other hand, a global giant like Wal-Mart faces fragmented suppliers and thus is able to exert strong bargaining power on the products it needs to stock its shelves. This allows it to keep costs low and pass these savings on to its customers.

It should thus be apparent that, all other things equal, a favourable industry to be in is one which has suppliers that have relatively weak bargaining power.

Force 5: Bargaining Power of Customers

Just as strong suppliers can eat into an industry’s profits, so can strong customers. Conversely, an industry can exert pricing power against the weak bargaining power of numerous small customers. In this way, the bargaining power of customers relative to suppliers helps to determine the level of profitability of an industry.

A regional newspaper with a monopoly will be able to raise prices relatively easily because its customers are many and fragmented. It will also be able to charge a premium for advertising because it is the only platform available to advertisers to disseminate their messages. The customers of the newspaper have weak bargaining power, and the newspaper is able to profit accordingly.

On the other hand, a regional broadcast station with a monopoly will also be a strong buyer when it comes to negotiating for programming airtime. If the television producers are a fragmented bunch, their industry will have to suffer a loss of profits due to the fact that the customer of their products is in a very strong negotiating position because it is the only customer for the product.

Once again, the weaker the bargaining power of an industry’s customers, the more attractive the industry is.


Before investing in a company, it is necessary to understand the competitive environment it is operating in. A company in an industry that scores poorly on the five forces is likely to be vulnerable to competition and have its profits competed away. Such a company is likely to make an unattractive investment.

The astute investor is always on the look out for a company that is operating in a favourable competitive environment, or which has the ability to shape and mould the competitive dynamics of its industry so that the competitive forces are relatively benign. Such companies stand a much higher chance of not only maintaining their profits, but growing them far into the future.

For an example of an in-depth Five Forces Analysis of a company, peruse Blackmores - A Strategic Analysis (Part 2)

Looking for Opportunities in China

The rapid growth of the Chinese economy has forced investors all around the world to pay attention to it, and there are very few businesses that have not been impacted by the awakening of the Dragon. Yet the opportunities that the Chinese market provides bring risks as well. Here are some things to look out for in a company that is competing in the Chinese market:

The Chinese market is huge, and so is competition. Companies which are unable to articulate a strong competitive advantage will find it difficult to survive the onslaught from counterfeiting, piracy, and sheer will of the Chinese themselves to compete away the profits of others. Any product or service which is not able to differentiate itself adequately will quickly become a commodity. As such, companies with established records in developed markets tend to have a greater chance of doing well in China. Their track records of success in developed economies such as USA, Hong Kong and Singapore show that they have quality managerial expertise, quality products, and/or an established brand name which are more likely to withstand the intense competition that they will face in China.

Examples that have succeeded include household brands like Mercedes Benz, Starbucks, McDonalds, Las Vegas Sands and OSIM. They all have established brands in developed economies and have proven business models. Conversely, a company which is simply banking on "the huge China market" and "immense opportunities for growth" and does not have a proven business model will find it difficult to survive in the ruthless environment that is characteristic of the Chinese market.

The Chinese economy also has problems with the enforcement of patents and intellectual property. Bill Gates should know: the vast majority of Microsoft software being used in China has not been paid for. Hence, business models which are not dependent on the existing legal framework to enforce property rights will have a better chance to succeed. Examples of sectors which fit into this category are, transport & logistics, natural resources, food & beverage, computer hardware (even this sector faces problems, though) etc. Examples of sectors which will face intense counterfeiting are digital media distribution companies like video, music, computer software etc. One example of a company that is able to circumnavigate the piracy problem is Blizzard (Vivendi Games) - its World of Warcraft game software is based on a subscription basis, which is not subject to piracy.

Another important point about investing in China is that the ability to compete on costs is not enough. Many manufacturing companies have relocated to China citing lower labour costs as their source of competitive advantage. This advantage may exist for a short while, but for most who entered the market on this premise, the cost advantage has disappeared. Intense competition has competed away this advantage; meanwhile, wage rates have begun their ascent. Municipal governments are starting to impose mandatory wage rises. And the businesses which only compete on costs have suffered as a result. An example of this is Creative Master. A company must not only be able to compete on cost, it must be able to compete based on quality and have other differentiating factors, so that it can establish some pricing power. Haier, for instance, has done so, and is now a global player in the white goods market.

In short, the sheer size of the Chinese market makes it a very tempting one to enter. But just being in the market is not enough. When researching a company, one should look for clues that indicate that it will be able to withstand the intense competition that it is bound to face. Only after establishing this should an investment be considered. Many have bePublishen burnt by the China story, and many will be in the future. Let's hope you're not one of them.

The Difference Between Price and Value

Many people think that the value of something is the price that others are willing to pay for it. And to some extent, that is true. However, when investing in stocks, this kind of thinking is very dangerous, and can be extremely damaging to your bank account. It is the investor who knows the difference between price and value who will prosper.

So, what is the difference between price and value?

The price of a stock is quite simple - it is simply the amount at which the stock was last transacted on the stock exchange. You can find it by looking up the financial pages or on a website like finance.yahoo.com

The value of a stock, however, is a different matter altogether. To understand what the value of a stock is, one has to first understand what stock is.

Stocks in a company, or shares in a company, are a piece of property that gives the holder ownership rights to a portion of a company. An owner of stock in a company has a proportionate claim to any future dividends that are paid out by the company as well as any voting rights which give the shareholder to have a proportionate say in matters during shareholder meetings. In the case of a winding up of the company, the shareholder also has a proportionate claim to any residual assets that remain after all other creditors have been paid.

The value, or “intrinsic value”, of a stock is thus the present value of the future cashflows that can be derived from the stock (known as net present value calculated by discounted cash flow analysis) or the net liquidation value that is due to the stockholder in the case of a winding up.

It should thus be obvious that the intrinsic value of a stock can often be a subjective thing - different people will have different estimates of intrinsic value depending on how they foresee the company performing in the future - a person who predicts a strong growing company will have a higher estimate of intrinsic value than a person who believes the company is going to perform poorly.

But one thing is for certain - price is NOT value. Price is simply the amount that two people came to an agreement over which to allow the stock to change hands. Nothing more.

Price can differ from intrinsic value, and often does - and the astute investor tries to buy a stock when its price is trading significantly below its intrinsic value, and sells the stock when the price goes above intrinsic value.

And it is because he understand that price and value are not the same thing, that he is able to profit from this method.

Even Harvard Students Don't Seem to Know Any Better

Research by three academics at Wharton, Yale and Harvard suggests that superior investment judgment is not a function of superior access to information, nor is it a function of superior academic intelligence.

The article: “Today’s Research Question: Why Do Investors Choose High-fee Mutual Funds Despite the Lower Returns?” from Knowledge@Wharton, is about experimental research done on Harvard undergraduates and MBA students.

The students were, for all practical purposes, given equal information about four different index funds, all of which contained the same securities. The only difference between the funds was the management fee structure. Yet, they overwhelmingly failed to make the optimal investment decision: to focus their investment into the index fund with the lowest management fees.

The students were misled by irrelevant information showing “annualised returns” (a moot point since going forward, all the funds had the same securities in the same proportions and would thus perform identically, apart from management fees), and also diversified their investment into several funds, even though there was absolutely no diversification benefit to be gained from investing in more than one fund.

This research thus suggests a few important things:

1. Superior investment judgment is not a function of superior academic ability. We can safely assume that the Harvard undergraduates and MBA students represent the cream of America, if not of the world. Yet they overwhelmingly demonstrated inferior business judgment. Hence, If you are evaluating someone as a potential manager of your money, it is irrelevant to look at his or her academic credentials. Superior investment judgment is a function of something else. And that something else is not academic intelligence.

2. One does not need superior information to make superior investment judgments. The notion that one needs to have better information than the next person in order to make a better informed judgment, is a myth. As a result of this research, it seems investing is akin to the game of chess - where the participants in the game both have complete access to all relevant information - the one who wins is the one who has the superior ability to synthesize and evaluate the available information, not the one who has better access to information. Hence, it is wise for investors to avoid any such schemes which claim to have “superior inside information.”

3. Another important implication of this research, and perhaps the most profound of all, is that having complete information does not necessarily lead one to make the optimal investment decision! In other words, markets are not efficient. The efficient markets hypothesis holds that markets adjust rapidly and rationally to take into account available public information, and that market valuations are thus optimal or rational. Yet the research results indicate otherwise: 80% of Harvard students were unable to come to the optimal investment decision, despite them having all relevant information required!

If the vast majority of the intelligent population is unable to make optimal investment judgments given unhindered access to information, how can markets possibly be efficient? The notion that markets are efficient i.e. that securities are always priced rationally, must necessarily be thrown out of the window. This has profound implications for supporters of such theories as the CAPM or MPT (i.e. the vast majority of fund managers) - and provides support, once again, for Graham & Dodd’s theory of intrinsic value i.e. the best way to invest is to purchase securities trading at a substantial discount to their intrinsic value (i.e. when markets are behaving irrationally), and sell them when they are trading above intrinsic value.

In short, this research provides proof that investing is, ultimately, a game of skill, and that those who have superior ability will ultimately outperform those without.

Thursday, September 07, 2006

Using the Internet to Aid Your Investing

The world of investing can be daunting to those who have just begun to learn about the subject, and for those who have yet to begin. Indeed, with the multitude of terms to learn and concepts to understand, a guide to get you started on the basics will certainly be very helpful. Thankfully, there are various resources on the internet to assist you in your quest to invest. Here are a few helpful links:

Wednesday, September 06, 2006

Five Steps to Follow Before Buying a Stock

When analysing company, one should do both a qualitative and quantitative analysis of the company before deciding whether to buy its stock. Here are the things to consider:

A. Qualitative Analysis

1. Market Environment - An ideal company is competing in a market that is growing. This allows the company to participate in sales growth without necessarily having to take away market share from its competitors. Furthermore, in the same way that a rising tide lifts all boats, so a rapidly expanding market is a boon to most companies in the market.

2. Competitive Dynamics - A rapidly growing market is ideal, but a company will have much greater success if it is able to create a competitive environment where it is able to maintain its profits and fend off competitive threats from its suppliers, buyers, substitute products and potential competitors, in addition to dealing with its existing rivals. A favourable competitive environment, coupled with a favourable market environment, often give a company a high chance of success. For more on this, click here.

3. Internal Capabilities - In many ways, a company's own resources, strengths and capabilities help to shape its competitive environment. Companies with strong capabilities in areas such as branding, product development, research & development and human resources can often create very strong barriers to entry in their industry, as well as dimishing supplier and buyer power. The quality of management often plays a big role in determining a company's capabilities, so understanding the key officers of a company can be crucial to analysing a company's prospects.

For an in-depth example of a qualitative analysis of a company, peruse Blackmores - A Strategic Analysis

B. Quantitative Analysis

4. Financial Statement Analysis - This involves breaking down the various components of the balance sheet, income statement, and cash flow statement to determine the various characteristics of the business. Various ratios can be calculated to determine financial strength, asset utilisation, profitability, and the quality of the projects the company is pursuing. These ratios include debt/equity ratio, return on assets ratio, return on equity ratio, asset turnover ratio, and gross and net profit margin ratios. A comparative analysis of a company's ratios with others in the same industry can help to identify who are the market leaders and who are the market laggers.

5. Investment Valuation - Valuation involves using various valuation technologies to decide on how much a stock is worth. These tools include, the dividend discount model, the discounted cash flow models, residual income model and abnormal earnings growth model, amongst others. When valuing a company, one has to bring together the analysis in the preceding four steps to project the future revenues, costs, cash flows and other financial numbers, before inputting these numbers into the valuation tool to arrive at the intrinsic value of the company.

Making the Decision

After one has gone through steps 1-5, the investor compares his valuation of the company with the market price. If the market price is above the intrinsic value, the investor does not purchase the stock. On the other hand, if the market price is significantly below the intrinsic value, then it may be an opportunity to buy the stock. For example, suppose one decides that the intrinsic value of a company is $1 per share, and the market is trading at $0.70 per share, this represents a 30% margin of safety, and looks like an attractive buy. In general, I look for at least a 25% discount to intrinsic value.

Valuation in Practice

Analysing a stock often involves making many subjective judgment calls about the market, the competition and the company. Even after making these subjective judgments, one has to translate this analysis into numbers, which can also involve many estimates and educated guesses. By insisting on a strong margin of safety, one can err on the side of caution, and avoid the cost of expensive mistakes that investing can often bring.