Archive for July, 2013

What is left of Porter`s five forces model?

July 27, 2013 2 comments

In November 20th 2012, Eteve Denning wrote an article in Forbes under the title ”What Killed Michael Porter’s Monitor Group? The One Force That Really Matters”.


It was a very critical approach to Porter`s main contribution to the theory of Strategic Management, and was very unfairly supported in the fact that the Monitor Group, (once created by Porter as a consulting firm that applied his theories), had been forced to file for bankruptcy protection.


The five forces model allows firms to protect and preserve in time a situation of above-normal profits, whether through strategic relationships with customers, providers, competitors, potential entrants and substitutes. Firms with above-normal profits were those that were able to introduce some oligopolistic strength to their relationships with those five forces, some kind of barrier to the competing inertia they exert.


What he discovered was a way to determine the structure of the market, so that firms could alter (or use) the way the Harvard Industrial Economics paradigm understood market forces; according to Bain and Mason, in the 1920`s, the structure of a market determined the Conduct of participants, and consequently, certain effects were obtained: price, volume of the market, efficiency, and so on. Somehow Porter discovered that market structures are an endogenous variable, that depended on the conduct of the market agents, so that insofar as they were able to alter the structure, they could also obtain the above-normal profits, and preserve them in time as desired.


Steve Denning remarks the thought that Porter`s recommendation was to avoid competition, so as to preserve the profits, which is slightly unfair. It does not follow from his model that a company could forget about customer`s evolving needs, new technologies, new products and services, (substitutes or not). When talking about emergent industries in which a firm could invest, his proposal was that a decision would be good if the ultimate structure of the market (not the initial one) allowed to obtain above-average profits.


But still Denning and others view Porter as considering the market as a given, where the customers exist and continue to be there for the best strategist to obtain the above-average profits for ever. And he unfairly takes the example of his consulting group, that, briefly said, used the five-forces model, forgot about adding value to its customers, and failed. As Denning puts it, for Porter “Strategy is all about figuring out how to secure excess profits without having to make a better product or deliver a better service”.


Denning nevertheless recognizes Porter tries to correct his failure in 2011 with his article about “Shared Value”, which is defined as “policies and operating practices that enhance the competitiveness of a company while simultaneously advancing the economic and social conditions in the communities in which it operates.” Even tough, Porter is not given too much credit for that.


Another critic by Denning suggests the time in which Porter created his model, was a time of oligopolistic firms, where it was easier to preserve profits in time. But he argues this time is past, as globalization and internet destroyed the capacity by firms to build barriers; new products and entrants constantly redefine markets. Disruptive innovations have a formidable strength to alter the profit capacity of industries, thus to turnaround the players group in each industry through time.


He uses the examples of Zara, Amazon, Salesforce, and some others, as firms that centered their efforts in innovation and adding value to their customers, instead of in protecting whatever profit situation they might have had at a certain moment in time. But at the same time, he states his doubt about the fact that continuous innovation can be sustained.


As I see the answer to that doubt, continuous innovation can be obtained in some cases for some time, but the big amount of resources obtained by those firms might help them avoid innovation by others, whether by purchasing succesful start-ups, by blocking their commercial possibilities, and so on. This has been a normal practice by so-called disruptive firms once they are not the first innovation champion in the industry: take Microsoft, Google, and  many other firms in so many smaller markets and you will still see a lot of this five-forces model battle. All those firms fight for their trademark, in order to build barriers; all of them fight with each other with crossed and multiple patents, more useful against competitors that for the firm itself; they purchase small innovative firms that lack resources to fight with their fantastic financial situation, (what has that to do with customer satisfaction?).


Perhaps the time passed for the model as a single tool, but his place is still well among us, and for long.


In her book “The End of Competitive Advantage: How to Keep Your Strategy Moving as Fast as Your Business”, Rita McGrath takes a more moderate approach than Denning. She admits “sustainable competitive advantage” is not an acceptable unique concept today, and advocates for what she calls “transient competitive advantage”.  Some of the most successful companies have very fast seen their competitive advantage fail, (just think of RIM-Blackberry), so that a firm cannot rely on protecting it, but to keep itself in a continuous process of reconfiguration. And there is also a need to know this is the new environment, so as to avoid sunk costs that are incompatible with the idea of constant reconfiguration.


This is perhaps a more pragmatic approach: keep the above-average profits while you can, but keep always looking for innovation and reconfiguration, so as to have a “transient competitive advantage”.


The Conference Board on Corporate Governance models

In a report published in July 2013 by the Conference Board, Leslie N. Silverman and Julie L. Yip-Williams expose their views about the “Shareholder Value Corporate Governance Model”.


They start by citing Berle`s (1932) statement that the purpose of a corporation is increasing shareholders` wealth.  In a big corporation with no relevant shareholder, power needs to be deposited by them on directors, so that they control the managers`s activities and assure the corporation fulfills its duty. They also cite Prof. Merrick Dodd, who advocated for a corporation looking also for the public good of other constituencies, as a tool created by the government.


In any case, they argue, the Corporation has been successful in providing wealth to both society and shareholders in the last four centuries, and public and academic opinion goes from one model to another from time to time. Since 1930 and until the 60`s, Dodd`s approach was predominant, and managers had a strong independence from shareholders. This was the time of the big conglomerates, as growth was much in connection with the managers` interests. But the view that these conglomerates and managers`discretion somehow destroyed wealth and were too difficult to manage gave way to the shareholder value model of the 80`s, a model that has been dominant until the end of the 20th century.


Nevertheless, the authors outline the existence of certain problems in the model, that is mainly focused on share price as a target:


–         Short-termism

–         Under-investment

–         Pressure by predominant institutional investors,

–         Excessive risk-taking

–         In an academic perspective, some also argue shareholders do not really own the corporation, but they have a contract to supply capital, as any other provider.


So, what are the actual stakeholder-type alternatives to the shareholder value model?


Two examples have been brought forward by stakeholders` model supporters:


First, a German labor-oriented model: it has a two-tier board structure, with a Supervisory Board, (executive body that in big firms has a third of members named by employees), and a Management Board, (composed by senior managers, and in big firms one also nominated by employees, the labor director). In that way there is a kind of co-decision by shareholders and employees, which is supposed to engender better employee training and security efforts, higher commitment by employees, and a longer-term oriented behavior by the firm.

Second, Japan`s state-oriented model. The state is involved in big corporations`businesses, on behalf of stakeholders and public interests. State officials ideally act on behalf of those interests in a long-term perspective.


Academic approaches differ: some support one stakeholder group above others, such as those advocating for a Customer-first model; or those advocating for society`s public good; but others do not prioritize any group: for instance, some argue that contract are not efficient in distributing the income generated by the firm, so that the board (a third independent party) must do it; others support the idea that each group should be represented in the board, so that all interests are considered by this body.


When evaluating actual models, the authors consider them more a result of particular history of each country than a model that can be exported. Models where stakeholder groups are represented are said to be even more problematic, in terms of the internal board malfunction they might entail. In general, those models are difficult to implement in countries where the shareholder value model is and has been predominant, as in the USA.


A new proposal: a Modified Shareholder Value model.


For those countries, a model where directors have the authority to take care of other stakeholders` interests is then proposed by Silverman and Yip-Williams.


The Business Judgement Rule protects directors in doing so, as a Court will not analyze informed decisions by disinterested directors, even if the decision harms the sharehoders` wealth. Directors in fact are generally not legally forced to blindly pursue the maximization of  shareholder value, but the best interest of the corporation, or of all shareholders, and in doing so, they usually consider other constituencies interests.


And the change also involves some other relevant elements, according to Barton (McKinsey): first, Boards would pursue longer-term goals; second, directors should be aware of the fact that stakeholders` interests do not oppose those of shareholders in the long-term; and third,  directors must act like owners, to compensate the rational “absenteism” of retail investors.




Jesse Fried and Nitzan Shilon, in an article published in 2011, analyze the efficiency of clawback policies both under the Sarbanes-Oxley and Dodd-Frank regulation, and recommend several improvements to current legislation.

Many other countries are also deploying these policies, at least in certain sectors, (investment and commercial banks, for instance), and could benefit from this contribution.

1.- The problem of Excess Pay

After Dodd-Frank becomes enforceable, companies need to have a policy to recover payments done on the base of results that have been considered false and restated.

This article suggests the policy leads to at least some firm value generation.

a)      Equity and bonuses are paid in connection with the company`s performance, measured by certain metrics. Errors in metrics, if bonus banks are not used until the metric value is completely certain –or retirement, in the case of equity-, may end in excess payments to executives and directors. It may involve misconduct, (inflated accounting measures), or not, (errors, mainly). The cost for shareholders arises from (i) the value transfer to managers, and (ii) the efficiency costs stemming from mismanagement, (reduction of pay sensitivity to performance, reputation damages that can even lead to bankruptcy, the costs of restatements, and so on).

b)      Managers ability to keep the payments: (i) under Sarbanes-Oxley the Sec could force managers to pay back excess pay, but it rarely did it, because of costs of procedures, and difficulties to prove misconduct; (ii) directors are reluctant to require those payments, for the cost of doing so is high when compared to their personal benefit. The costs arise from the dependency of directors towards current managers, or from litigation against managers having left the firm.

2.- Clawback policies before Dodd-Frank

Approximately 50% of firms did not have clear clawback policies. Of those having them, 81% left the decision to give back excess amounts on directors` hands; for the rest, 86% did not allow executives to pay them back if a “misconduct” estatement hadn`t been issued. Only 2% of firms forced directors to pay back.

Why didn`t firms voluntarily adopt robust policies? Fried and Shilon argue as follows:


a)      What`s the problem with the board`s discretion? Under discretion, the executive will likely defend itself in Court, (in the hope the board abandons the claim if costs rise);  also, without discretion, there is a deterrent effect in the policy.

b)      And in cases where misconduct is required for the board to ask for the clawback, (i) there is still a discretionary power to determine whether misconduct existed; (ii) or simply, it may be difficult to find.

Why haven`t firms adopted robust policies? There are two main reasons according to the authors:


a)      Managerial power and opposition to adopt them.

b)      Short-termism on the side of directors, who eventually may think such clauses prevent managers from decisions that would raise the stock price in the short-term, (misconduct included or not).

3.- Dodd-Frank

Dodd-Frank requires the Sec to regulate that Stock Exchanges issue a rule that forces companies to have clawback policies for restatement cases, even if no misconduct is found. Those policies include:

–         Current and former executive managers,

–         Any incentive-based compensation having

i.      Involved erroneous data

ii.      Been paid in the three prior years to the requirement of restatement,

iii.      In excess of what would have been paid with restated figures or metrics.

There are nevertheless two defects in the new rule, Fried and Shilon say:

–         First: Not every mistake leads to a restatement:

i.      There can be small errors not requiring restatement,

ii.      There can be non-financial metrics used to determine incentives,

iii.      Also the company can reject to restate the books, even if it is generally agreed that it is required.

–         Second: Not all pay excesses can be called back; for example, stock sales proceeds obtained at high prices after manipulations. In this case several improvements could be introduced:

i.      To let executives sell their stocks but at an average price that avoids inflated temporary values,

ii.      Executives can be prevented from selling their stock when they decide,

iii.      Or they can be forced to announce their decision with a certain advance, so the market can anticipate the “hidden” problems.

Other situations that SHOULD require directors to pay some amounts back:

  • Insolvency situations that arise, without any restatement.
  • Unethical behavior or violation of the duty of loyalty.

Based on Excess-Pay Clawbacks, by Jesse Fried and Nitzan Shilon.