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Rupert Hargreaves
Rupert Hargreaves
Articles (710)  | Author's Website |

Using Michael Porter to Find Better Businesses

The father of business strategy's book is a good guide for investors looking for companies with solid business models

February 05, 2019 | About:

Michael Porter is considered to be the father of business strategy. His ideas are still widely used in management consulting and taught in MBA programs today. His book, "Understanding," is a one-stop handbook for creating unique business models.

Understanding companies

"Understanding" is about how companies can compete effectively in the global market space. Rather than concentrating on tactics to grow market share, Porter focuses on profit growth, providing a framework for companies to create unique value, building an interconnected web of activities to reinforce and compliment each other.

From an investor perspective, we can flip this on its head. As investors, we are looking for unique businesses that have a definite competitive advantage and devoted customers that will continue to return year after year and pay the price no matter what the company charges.

Porter favors return on invested capital as an indicator of how well a company is using resources. Unlike other metrics that are open to manipulation, return on invested capital gives a rough estimate of how much profit a company is producing for every dollar invested in the business. For example, return on sales ignores the capital invested in the business.

If the company has a sustainable competitive advantage, return on invested capital will be sustainable and above the industry average. It's not just about sales growth; it is about profitable sales growth.

Quality over quantity

Companies that pursue market share are often able to grow their sales, but at the cost of profitability. It is a common refrain among management that growing sales to achieve scale will ultimately result in profitability. However, Porter notes that more often than not, scale may be illusory and returns from scale may not materialize. Unfortunately, by the time the company realizes this, it has already wasted funds chasing market share.

In his book, Porter notes there are two inputs to the profit equation: relative price and relative cost. You can improve profits by either increasing the relative price, decreasing the relative cost or both at the same time.

A company's ability to increase the cost of its products depends on the customer base. For example, Porter comments that business customers often place orders after a rational and reasoned discussion, where relative value can be quantified. Consumers, on the other hand, tend to purchase based on more emotional desires, rarely do they figure out what they are paying for the convenience they are acquiring.

Apple Inc. (NASDAQ:AAPL) products are a fantastic example. Today, there are plenty of different smartphone models on the market, some of which offer a similar experience and specification to those manufactured by Apple. However, consumers will still choose Apple over its competitors because of its software ecosystem and the brand association. The company has added value through an interconnected web of activities that reinforce and complement each other. Even though it charges a higher than average price, this unique competitive advantage has helped it gain market share.

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The other side of the profit equation is reducing relative costs. There are two ways you can reduce costs, Porter's book explains. You can either simply cut costs or you can use capital more efficiently. He explains that sustainable cost advantages involve many parts of a company, not just one function. The whole business has to be operating as one to keep costs low.

On the other hand, there are low-cost producers, whose only cost advantages come from cheap production. The two business models may seem to have a similar goal, but they are ultimately very different. A low-cost producer can be offset by factors outside of its control, such as increasing wages or input costs. Meanwhile, a business with an ingrained culture of keeping costs low is more likely to keep costs low over the market cycle and not get carried away in the good times and have to cut back aggressively in the bad.

Conclusion

The book may have been designed to help managers improve their business models, but it is also helpful for investors who want to seek out the best business models. It's worth considering if companies have a unique product advantage, or if they are just the lowest-cost operator.

Disclosure: The author owns no stocks mentioned.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website


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