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Biologist Julian Huxley’s idea that  “Life is just one damn relatedness after another” is a great way to understand life and business. As a long term investor, when one analyses a business it’s important to consider it’s present and future prospects.

In his book Guns, Germs & Steel, author Jared Diamond has highlighted the importance of geographical factors in the evolution of human societies and to the ultimate rise of western civilization. The point Mr. Diamond makes is that the factors that made some societies superior to others were geographic and climatic and not the intelligence of members of these societies.

Michael E. Porter in his popular HBR article “How Competitive Forces Shape Strategy” presents a holistic approach to business analysis and strategy. The premise of his article centers on the fact that business are beneficiaries or victims of the “industry structure” in which they operate. He highlights five forces  that shapes the profitability and it’s sustenance over the long run.

When one visits a site like Yahoo finance or Google finance to gather data about a public company one also finds information about it’s competitors. Usually the list of competitors include existing rivals operating in the industry.

As Michael E. Porter  argues in his HBR article, existing rivals in an industry are just one among the five forces that influences the future prospects and profitability of a company. Mr. Porter writes.

image credits - www.hbr.org

Industry structure, as manifested in the strength of the five competitive forces, determines the industry’s long-run profit potential because it determines how the economic value created by the industry is divided—how much is retained by companies in the industry versus bargained away by customers and suppliers, limited by substitutes, or constrained by potential new entrants. By considering all five forces, a strategist keeps overall structure in mind instead of gravitating to any one element.

One of the common misconception among investors and entrepreneur is that fast growing industries are always attractive. In reality growth rate does not always translate into profitability.Warren Buffet  had the following to say when asked about his decision to abstain from investing in high-tech or internet/”social” companies.

It’s important for investors and managers to know the average profitability of an industry and how that has been changing over time.The Porter’s five forces reveal why industry profitability is what it is. The following chart lists some of the popular industries by their profitability (i.e. ROIC ).

image credits - www.hbr.org   

As an investor it’s critical to understand the industry structure in which a business operates before evaluating the business for potential investment. Michael E. Porter writes in his HBR article.

Understanding industry structure is equally important for investors as for managers. The five competitive forces reveal whether an industry is truly attractive, and they help investors anticipate positive or negative shifts in industry structure before they are obvious. The five forces distinguish short-term blips from structural changes and allow investors to take advantage of undue pessimism or optimism. Those companies whose strategies have industry-transforming potential become far clearer. This deeper thinking about competition is a more powerful way to achieve genuine investment success than the financial projections and trend extrapolation that dominate today’s investment analysis.

In conclusion if investors look at business in a systematic way and understand that the future of any business is shaped by multiple forces, they will avoid falling for latest trends which promises poor returns or value traps which are headed towards profit destroying revelries. So next time you hear about a attractive hyper growth company in a cocktail party, think about the industry structure in which it operates before you hit the “Buy” button.