Notes on Brian Gaines of Springhouse Capital Management

Brian Gaines is an investor who runs an investment firm known as Springhouse Capital Management. His background includes experience in distressed debt on the banking side and also on an investment basis. His firm was founded in 2002 with seed capital from Joel Greenblatt who wrote You Can Be a Stock Market Genius and The Little Book That Still Beats the Market. Brian’s initial agreement with Joel Greenblatt allowed him to focus solely on investment research and to outsource all other aspects of the role to Gotham Capital. He has once said his view’s with Gotham Capital are well aligned and that they both look for “great ideas and focus on how you can get hurt.” My reason for writing about Brian is mostly personal interest which was sparked by reading two interviews’ he has completed in the past one was with Manual of Ideas in September 2009 and the other with Value Investor Insight in May 2006.

In short, his investment philosophy focuses on asymmetric investment opportunities where upside needs to be 50% while downside needs to be in the range of 20%. If a stock has 50% upside and 50% downside, why not just flip a coin and save the transaction fees. He has mentioned that he doesn’t believe in limiting himself to value or growth stories as upside can come from many different avenues. Brian likes to avoid situations where stocks are well covered, well known and where the bets you end up making are on whether the business is getting moderately better or staying better for a period of time. He has highlighted that this has generally driven him to invest in small-caps to micro caps but will still invest in large caps if an opportunity presents itself. His mandate seems to be all about being opportunistic, adaptable and flexible. I think he’s doing a lot of things right.

When evaluating a company he’s pursued the usual avenues that are required ie) reading 10-K’s/10-Q’s, speaking with management, reading transcripts and studying competitors. Brian also likes to look for differences between competitors, what each is pursuing and why it could be a good opportunity for the company. Multiples that he likes focus on include enterprise value over EBITDA less capital expenditure. Furthermore, he also likes to see returns on invested capital of at least 20% or ideally in excess of 30%. In a future post I’ll comb through his 13-F filing which updates his holdings each quarter.

Brian adheres to a concentrated portfolio management style where the top 10 positions can often make up 80% of his portfolio. As Howard Marks says “you can’t take the same actions as everyone else and expect to outperform.” To outperform any sort of passive investment portfolio you need to invest in assets that aren’t in that portfolio and you also need to weight them differently. In the manual of ideas interview he says “I know concentrated investing is out of style today as some high profile investors have had tough times, but it seems more appropriate than ever to wait for great situations and take oversized positions.” I think these words are as true as they were when he said them back in September 2009.

The most common theme from I had caught from his interviews was that managing emotions and impacts from market movements is a big challenge. If the market’s perception on an investment changes by +/- 50% it’s uncommon not to feel at least some pleasure or pain. In particular, losses tend to impact our egos more because having something then losing it is painful, especially if it’s not our choice. It’s been commonly quoted that that losses are twice as powerful as equivalent gains. Perhaps there is some logic to his 50% upside and 20% downside requirement for an investment.

His investment philosophy just seems very sound to me. Invests where there is little professional competition. Limit investments to what you can understand. Do the work yourself and be a perpetual student. Bet heavily when an opportunity arises. One that that was absent that some investors have tended to focus on lately is he doesn’t require catalysts to unlock value. Brian mentioned that often if there is a catalyst you have to pay for it. If an event is that clear to you why isn’t it clear to everyone else? Another element I think that was valuable within the interviews was how investors often draw circular conclusions from data or are impacted by halo effects. If a company is “bad” it doesn’t necessarily mean an investment is “bad.”

I’ll close with a brief quote from Brian Gaines he was asked about key lessons from working with Gotham Capital. “Don’t limit yourself in where you look for cheap stocks. Don’t be paralyzed by the fear of making a mistake. Understand the best opportunities usually carry more perceived risks, and distinguish carefully between the risks that matter most and those you can live with.”


Notes on Brian Gaines of Springhouse Capital Management

The Global View With Mohnish Pabrai And Guy Spier

Here are my notes from a recent interview on ET NOW with Mohnish Pabrai and Guy Spier. Link here for people who are looking to watch the full interview.

Discussion in the interview begins with the hosts concerns on how far the market has moved and if that is a concern for either of the guests. Pabrai doesn’t think those are really important data points to follow and that they can be more distracting rather than helpful. He recommends focusing on business fundamentals and limiting your opportunity set to companies you are able to understand well. If the market moves substantially higher or lower it isn’t really going to impact a valuation of individual business. Often the incentives of people discussing broader market movements are not aligned for the reader or viewer. They are often looking to get your attention for advertisement revenue, page views or likes. What people think will happen next quarter or next year on a macro basis just isn’t all that useful in my view.

The host then dug into the duo’s views on Trump. Spier started discussion with highlighting how it’s both difficult interpret political information and to also understand how markets will react. In the United States if you knew what trumps policies were going to be it would still have been difficult to understand all the second and third order impacts it would have on markets. One change to policy has implications in many places where people don’t initially think of but can still be important. Trump had recently tore up the Trans-Pacific Partnership and many people who are pro-trade were very outraged and really concerned about the direction the government was going. It turned out there was a very valuable silver lining because as a result of the USA removing itself as a trade leader of the world it opened an opportunity for others like China and India to lead. So to re-hash, optics were quite bad but resulted in a valuable rebalancing of power among the economic powerhouses of the world.

This followed with the ongoing passive vs active management discussion which appears to re-surface daily. Pabrai highlighted that for most people index funds are a great way to go. He agreed with Buffett’s recent writing on the topic as well. When you pay more in fees either to people who help you allocate the capital or from additional middlemen you will simply earn less of the underlying asset returns. The basic formula to be very wealthy is to save early in your life time, continue saving over a lifetime and continue to dollar cost average.  It’s a shame that some active managers make money off their investors rather than with them. I’m all for high fees where performance justifies it. Perhaps that means only using active managers where the competition is weak or non-existent. You need to play in games where it’s easy to win. Where are the forced sellers in investing?

The host then asks Pabrai and Spier if they focus on looking for 3-4 baggers in today’s environment or do they focus on a margin of safety for each investment. Pabrai says that if Spier tells him an idea that isn’t at least a 5x it would be waste of time. Pabrai uses an analogy from a Miller Beer commercial where the taste is great but the beer is less filling. Ie) good benefits but less cost. In investing you try to find similar situations where the potential is high and that you also have a built in margin of safety. For an investor to be successful at this they should look to limit risks of capital loss and retain high optionality. What this typically looks like for an investor is long period of inaction and studying followed by brief periods of activity when a mispricing occurs.

Next up was the automotive sector in India given Pabrai & Spier has made similar investments outside of the country. Pabrai said he had only purchased Fiat-Chrysler because of its very undemanding valuation at a P/E 1x in 2019 and that he hasn’t been able to find similar opportunities elsewhere. If Pabrai was an investor today in India he would spend all of his time on small publicly listed businesses and keep tearing them apart and trying to understand it all. What about airlines in India? There are some notable similarities and differences about the sector in India. The major difference was that fuel costs represent a higher proportion of total costs compared to the USA. Since oil isn’t very likely to move higher above $50-60/bbl a major component of costs for the sector are going to be relatively capped. Frackers have become the new swing producer in the world. Overall, the airlines in India aren’t as cheap and don’t have a similar opportunity in his view. That said they both discussed how the opportunity set is much larger in India than in developed markets. There are ~4,000 publicly traded businesses and over 90% of them aren’t covered well by sell-side analysts. This results in a wider dispersion of returns. That is what you want if you believe you have good judgement and an edge over your competitors. There is more of a chance for your head to get cut off but also to outperform meaningfully.

How do you evaluate commodity companies? Spier says to always focus on companies with the lowest cost of production as this increases odds that they will survive through the cycle. If this relative advantage is in place then you have an implied margin of safety. P/E’s of 1x are possible to find but only if you believe you can find them. Below a $100 million in market capitalization is a great place to start looking for these opportunities.

Pabrai then begins to talk about how patient Munger really is. He read Barron’s magazine for ~50 years and in most cases each issue had at least about 10 investment recommendations which means he read over ~26,000 recommendations without acting once. Then an opportunity presented itself with an obscure auto parts company which he made a $10 million investment. Based on Pabrai’s twitter account the company is Tenneco. The investment turns into $80-$90 million and Li-Lu turns it into even more. What Pabrai thinks you can learn from this is that you need extreme patience, like really just be able to watch the paint dry and keep looking for anomalies. If you study ~4,000 businesses in India for the next few years and eventually make 3-4 bets you are likely to end up with way more money than you can consume. Spier says there are two types of bears some that chase all the salmon in the stream while others just wait on shore ready to strike at what falls into their lap.

Then discussion about the insurance sector comes up, was there a similar opportunity in India? Spier talked about how he would really want to be comfortable understanding the management teams and their actions for a long period of time before he would invest money in the sector. It would only be clear over a long cycle which teams are taking appropriate risks and are well managed. Pabrai thinks the better question is “Where are the no brainer investments in India?” The insurance sector has grown at a very high rate over the past few years in India and as a result investor focus seems to already be on the sector. Pabrai thinks there could be opportunities looking back over time but they just aren’t that clear to him today. Up next was the technology sector which includes companies like Infosys. Pabrai thinks they could be reasonable investments but they don’t fall into the category of no brainers. He thinks changes to regulations make it too hard to tell where the company will be in 5 or 10 years’ time. There are also some headwinds as Trump is exploring changing the H1 Visa program and in some ways these technology companies are abusing the regulations. He thinks optimal policy in the United States would be to retain the best talent in the country. If the United States wants to be very competitive long term one lever they can pull is to dramatically increase the amount of immigrants they allow into the country from today’s 65-80 thousand cap today and make it up to half a million. If these individuals are well educated, and able to contribute it could do wonders for the economy there. Pabrai thinks the American government should tighten regulations and limit what could be done elsewhere. Other places in the world such as Canada are working on building similar hubs to service US businesses, the example he used was Vancouver, Canada.

The conversation closed with the two guests highlighting again of the world of opportunity in India for investing and that competition in Western Europe and USA is just disproportionately higher.

If you are looking to learn more about Mohnish Pabrai or Guy Spier i’d recommend both of their books. Click here to purchase The Dhandho Investor  and The Education of a Value Investor: My Transformative Quest for Wealth, Wisdom, and Enlightenment

Hope this helps, let me know if you have any feedback or commentary

The Global View With Mohnish Pabrai And Guy Spier

Notes From Nate Tobik’s interview on Planet Microcap Podcast

Notes From Nate Tobik’s interview on Planet Microcap Podcast

I made some brief notes on a recent podcast Nate Tobik had on the Planet Microcap Podcast. Nate runs the “” blog which I love to read and he also runs “”. I’ve enjoyed his writing for some time and hope you find some value in the notes below.

Nate’s background is in computer science but has managed to self-learn the most important things in investing. He highlighted he hasn’t taken formal economics, finance or banking course but from what I may have read elsewhere has completed 1 or 2 levels of the CFA program. He also mentioned that his investing style has evolved over time and at points in time included a focus on spinoffs, net nets and compounders.

Later on he recommended the investment classics. I can’t recall which books if any he recommended but when I think of investment classics I think of Security Analysis, Common Stocks and Uncommon Profits and You Can Be a Stock Market Genius. Books should be re-read in an attempt to absorb what you may not have understood the first read or what may not have initially spoken to you. Shane at Farnam Street also recommends this and is also a big fan of the Feynman Technique. I agree with both of them, the more active of a reader you are the more you have the potential to retain and understand. Without retention or understanding what’s the point of reading anyways. Writing about what have read could be helpful as well.

Then Nate and the host get into his views on banks. This was one of my favorite parts of the interview. To start they discuss how accounting for banks is quite different compared to industrial or brick and mortar businesses. In simple terms banks take deposits and loan proceeds to businesses and individuals at a higher rate. Since US disclosure requirements are very standardized it’s very easy to compare particular details from each bank. One of the unique aspects of a bank is that it can give you specific regional exposure and the exposure that you do obtain is driven by the success of small businesses in the area. Let’s say you are looking for exposure to central Omaha, it just might be possible. Banks are leveraged institutions so it is important that the managers have good skill and/or systems in place to manage risk and lend prudently. The majority of the businesses in the world are private and as a result banks are one of the few ways to obtain indirect exposure to these assets. When evaluating a bank you want Net Interest Margins (NIM) to be positive and relatively low non-interest expenses compared to revenue (Efficiency Ratio). A 1% return on assets is a good anchor to keep in mind when evaluating the quality of a bank’s assets. Take the ROA * Assets / Equity to arrive at an ROE. Return on Equity target of ~10% is reasonable in Nate’s view. If banks have a significant amount of assets from businesses this may be a good sign because commercial deposits usually require little to no interest which results in an attractive funding base. The next higher cost accounts are chequing and then savings accounts for individuals. In today’s low rate environment banks that do not understand how to lend prudently have made very long term loans and results in significant yield curve risk. Overall, Nate recommends that people own a basket of banks rather than just one “perfect” bank.

On screening – He likes it and uses various tools to help him screen. Nate stated that everyone uses a screen of some sort to find ideas whether it’s a news article, podcasts, Wikipedia or Bloomberg machine. Nate likes when people he admires as an investor already own a stock despite the potential risks of confirmation bias and group think. He thinks watch lists are misused by investors at times because only few investors need to be invested at all times. Taking a more patient view and attempting to evaluate how a business has changed is probably more worth the effort in my view.

Nate’s favorite “dead money” stock idea is Hanover Foods. It’s a frozen food supplier to grocers and other businesses. They trade at 0.3x book value and a low single digit multiple of current earnings. Management has paid itself lavishly for a long period of time while there are also some issues with the controlling family. Despite the very high compensation book value is still growing and the business is still profitable. They already own a jet and he doesn’t think compensation can go substantially higher than today. He thinks it’s a reasonably good investment but the enemy of this type of investment is boredom. You just have to wait. No other way to approach it.

To close the conversation ended with Nate saying that when you know the least, is typically when you think you know the most. It’s over time that many people see how little they used to know and they begin to expand their understanding how truly little they understand today. Keep reading, thinking and trying to figure it all out.


Notes From Nate Tobik’s interview on Planet Microcap Podcast

Markel Q4/16 Conference Call Excerpt

“First, we earned 13% on our equity investments during the year, which exceeded the S&P 500 return of 12% by 100 basis points. More important than any one year though is the longer-term record. With the 2016 results on the books, we now enjoy a 27-year record of excellent equity investment returns with that 100-basis-point advantage in place for 27 years now.”

  • Over 27 years 100 basis points is quite a big difference but I bet most people would underestimate the power compounding can have on an investment. Using a 10% vs 11% return over 27 years results in a 28% difference in the ending sum. Small changes add up to very big things. I recently watched a Chuck Akre interview on Wealthfront in which he highlighted his own focus on investing in businesses which have an ability to reinvest free cash and capitalize on internal tax efficient compounding opportunities.
Markel Q4/16 Conference Call Excerpt

Jeff Ptak

In Late 2016, Jeff Ptak of Morningstar was recently interviewed by Patrick O’Shaugnessy to talk about Active investment management. I enjoyed the conversation and thought Patrick had a number of good questions. If you are interested in learning more about Jeff you can find some of his additional work which is published on the Morningstar website here. These are my notes from the podcast hopefully these are of some help to you. If you have any feedback please send my way.

  1. When evaluating investment products never overlook the associated fees. Choose low cost over high cost in most cases. Passive ETF’s and mutual funds have been winning market share over the past few years owing to increasing investor allocation to lower cost products. As a result you have seen mutual fund fees drop from large investment managers such as RBC Asset Management, and Investors Group.
  2. Look for investment managers who have low portfolio turnover. High portfolio turnover implies more of your own capital will be paid in fees all else equal. In my view, managers who don’t trade often have higher conviction when they do trade and are potentially doing more in depth research when allocating capital. Perhaps they are looking for the right opportunity each time they allocate rather than just today’s opportunity.
  3. Look for investment managers who are meaningfully invested in the products themselves. Alignment in incentives between any Principal and Agent is required for an agreement to work. If anyone is aware on how to find out easily how much a manager owns of a particular mutual fund I would be interested in seeing the data.

A few investment managers Jeff highlighted as strong included Sequioa, Capital Research Group and Dodge & Cox. While investment managers who he thinks have more structural problems includes Third Avenue which has faced some issues with generational transfer to the new group of managers and a blow up on its Focused Credit Fund.

The most interesting investment manager he’s worked with was PrimeCap Management, who is led by Theo Kolokotrones and Joel Fried. Jeff mentioned he really enjoyed the conversation between these two and noticed a stark difference in the amount of time they were willing to spend explaining their business and how they think about it. Theo/Joel discussed culture, generational transfer, capacity to invest, how they teach new analysts and optimizing incentives for employees. One unique aspect at PrimeCap appeared to be how analysts get to run a small component of the actual portfolio which was utilized to better incentivize analysts. A short excerpt on the company’s investment philosophy is pasted below.

“Four key principles guide PRIMECAP Management Company’s approach to investment selection: commitment to fundamental research, long-term investment horizon, emphasis on individual decision-making, and focus on value.

First, PRIMECAP Management Company is committed to fundamental research. The primary objective of its research is to develop opinions independent of Wall Street and to understand the companies it follows as well as any industry analyst. The firm looks for stocks where it believes the underlying company’s long-term fundamentals will evolve significantly better than the current Wall Street consensus or valuation suggests. This can be a function of greater expectations it has for new products, new markets, new management, restructuring, a structural shift in demand or supply, or other changes in industry dynamics. The firm’s research involves interacting directly with the companies it is reviewing as well as their competitors, suppliers, and customers.

Second, PRIMECAP Management Company takes a long-term perspective. The firm looks for stocks that it believes will outperform the market over a three- to five-year time horizon. Portfolio managers strive to recognize values early and patiently wait for the market to reach a similar conclusion. Often, the search begins with companies and industries that are currently out of favor among investors. Consequently, PRIMECAP Management Company’s investment ideas are frequently early. However, if the firm believes that the long-term thesis is intact, conviction derived through its research efforts gives portfolio managers the fortitude to stay the course when the near-term fundamentals are challenging.

Third, PRIMECAP Management Company emphasizes individual decision-making. The firm shuns “group think” and committees whenever possible and relies on individual decision-making in its investment process. The firm believes that individuals, not committees, generate the best investment ideas.

Fourth, PRIMECAP Management Company believes the key to successful investment decisions rests in correctly appraising the relationship between the fundamental value of a company and the market price of its stock. In its judgment, a stock has the potential to be a good investment only if it is purchased at the right price.”

The conversation of hedge funds and their associated fees also came up. If you already make 2% on AUM why would you really care about the 20%. Well I think if you are an emerging hedge fund the 20% on relatively small AUM can keep you focused on delivering returns. In a best case scenario, this would engage an investment manager to think about the market opportunity they have to access and would hopefully drive them towards limiting AUM growth.

That’s all folks. If you’ve read something good lately send me a note or drop a link in the comments. Thanks for the time.

Jeff Ptak

Jack Bogle Interview Highlights

JB I glance at anything favorable to indexing; I pore over anything unfavorable. You don’t need people to tell you you’re right all the time. You need people to tell you that you’re wrong. But this was an absurd paper. First, take the simple part. The stock market has nothing—n-o-t-h-i-n-g—to do with the allocation of capital. All it means is that if you’re buying General Motors stock, say, someone else is selling it to you. Capital isn’t allocated—the ownership just changes. I may be an investor, you may be a speculator. But no capital goes anywhere. This is basically a closed system. You have new IPOs and whatnot, but they’re very small compared to this vast thing we call a market, which is now around $24 trillion. The allocation of capital? That’s just nonsense. 

MR And the correlation of stocks?

JB There is some evidence that the correlation of stocks, which has always been very high—something like 65 percent, maybe 70 percent now—could very well be caused by indexing. But so what? The efficient market theory ignores the fact that for every buyer there’s a seller. I don’t know why we can’t get this through people’s heads. Cliff Asness is the one who got everything right. He’s one of the smartest guys in the business. One of his headlines was, “Indexing Is Capitalism at Its Best.” I’ll let him be the defender of that, but this Bernstein note was just a sensational thing. It’s a bit like asking your barber if you need a haircut: He has a vested interest in this.”

…”MR Is it a problem if indexing gets to 100 percent?

JB It’s 10 to 15 percent now, and it could easily get to 50 percent. The example I use is stock market turnover, which has run between 150 and 250 percent of late. If we went from no indexing in this theoretical thing to half indexing, say, the turnover would be 125 percent. You immobilize half of the market. For decades the turnover was 25 percent a year, not 125 percent. We don’t need all that turnover, but we have a brokerage business in which turnover generates the returns that the brokerage business earns. And, as everybody knows, if a salesman sells nothing in a month, he brings home nothing—so he has to sell something. He has to believe what he’s doing is right. And he may be doing what’s right, but as a rule he can’t be doing what’s right because there’s someone on the other side of every trade. And all that trading means zero until the croupier in the middle puts his rake down on the table and scrapes off his share of the winnings. Wall Street is a casino, that’s a fact.

  • This is on point. It’s not clear that we need all this additional turnover.
Jack Bogle Interview Highlights

Michael Porter #1

Michael Porter is professor at Harvard Business School. He is well-known for creating the five force’s framework. This helps frame the structure that an industry is operating within. The forces include 1) Rivalry within Industry 2) Threat of New Entrants 3) Bargaining Power of Suppliers 4) Bargaining Power of Buyers and lastly 5) Threat of Substitute services or products.

The basic idea is that people generally view competition in too narrow of an lense and helps helps build a more holistic view of what a business is dealing with. Below i’ve transcribed an video which provides a brief summary on his article “The Five Competitive Forces That Shape Strategy.”

THOMAS STEWART: I am Tom Stewart, Editor and Managing Director of the Harvard Business Review. Our guest today is Michael Porter, Professor at Harvard University and Head of the Institute for Strategy and Competitiveness. He is the author of the forthcoming HBR article, “The Five Competitive Forces That Shape Strategy”. A reaffirmation, update, and extension of his ground breaking  article “How Competitive Forces Shape Strategy”. Mike thanks for joining the program. To start, let us remind our viewers of what the five competitive forces are.

MICHAEL PORTER: Well Tom, the basic idea of the competitive forces starts with the notion that competition is often looked at too narrowly by managers, and the five forces say that, yes you are competing with your direct competitors, but you are also in a fight for profits with a broader extended set of competitors, customers who have bargaining powers, suppliers who can have bargaining power, new entrants who might come in and kind of grab a piece of the action, and substitute products or services that essentially place a constraint or a cap on your profitability and growth. So the five forces is kind of a holistic way of looking at any industry and understanding the structural underlying drivers of profitability and competence.

THOMAS STEWART: So I use this to think about my rival makes it difficult for me. The threat of substitutes means I cannot overcharge. The threat of new entrants’ means I cannot overcharge.


THOMAS STEWART: The same thing with the buyers and suppliers.

MICHAEL PORTER: The buyers and suppliers, and there is underlying drivers of each of those forces that the model really sort of unveils and then you can actually apply this. Every industry is different. Every industry will have a different set of economic fundamentals, but the five forces help you hone in on, first of all, what is really causing profitability in the industry. What are the trends that are most likely to be significant in changing the game in the industry? Where are the constraints, which if you can relax, it might allow you to find a really strong competitive position?

THOMAS STEWART: So how would you apply this analysis to an industry? Airlines for example.

MICHAEL PORTER: Airlines is a great industry. Actually you will see in the article or you have seen in the article that there is a chart that compares profitability of industries, and airlines, I think has been on the bottom of that list for decades. It is among the least profitable industries known to man, and the five forces really allow you very quickly to understand why. I mean, let us just go around the chart. The nature of rivalry is incredibly intense and it is almost exclusively unpriced. It has been very hard to differentiate, get the customer to wait even extra two or three minutes for another flight if they can get on the flight with a cheaper price. So there has been a very intense price competition, low barriers to entry. Constant stream of new airlines coming into the industry despite the fact that probability is low. It always puzzles me.

THOMAS STEWART: Low barriers to entry because you can rent a plane, you do not have to buy them.

MICHAEL PORTER: You can rent a plane. You can lease a gate. It is all generic technology. You can start with one flight between two city pairs. There is no real need to have a whole network in the beginning, and yet, people keep coming in. I think it is just one of those “sexy” industries. It is a great example of how sexiness or coolness or hotness or cheapness has nothing to do with industry profitability. The underlying structure is what drives profitability. Yeah, the customer is very fickle and price sensitive. Suppliers of aircraft and aircraft engines and even aircraft gates at airports now have a lot of clout. They can bargain away most of the profits. GE, and Rolls-Royce, and Airbus, and Boeing make a lot more money than Airlines. They get most of the profit. And then of course, there is always the substitute of getting on the train or driving your car or shipping your goods by air and that sets kind of kept the consumer.

THOMAS STEWART: You have powerful suppliers of labor too. That is another powerful supplier.

MICHAEL PORTER: Right, exactly. There is a great case where you have unionized labor. Unlike other industries, in this industry particularly with the pilots, the labor can literally shut you down, and there is no way around them. So, it is an industry where there are spurts of what you might call mediocre profitability punctuated by long periods of terrible profitability.

THOMAS STEWART: So everyone of the five forces is very strong in that industry and you could take another industry where the five forces are relatively benign.

MICHAEL PORTER: Right, like soft drinks. I mean, soft drinks have been a license to mint money and again, it is the opposite kind of analysis. When I talk with students, we kind of joke around, there are five-star industries where all the forces are attractive like soft drinks. There are zero-star industries where all the forces are unfavorable like airlines and we are always trying to understand, okay, what is the configuration of underlying economic drivers that is going to really shape the profit potential of this industry and then armed with that insight, what do I do about it? How do I try to relax the constraint that is holding back industry profitability? How can I position myself to kind of insulate from some of the gales, gale winds of those forces? Those implications of the five forces are something that this new article has developed in much more detail.

THOMAS STEWART: You conceived this framework nearly three decades ago and it has been the most extensively used both in management scholarship and management practice of any strategy framework, and it changed the definition of strategy in a lot of ways. In these three decades, what have you learned? What have you learned about the application of these ideas in the real world of business?

MICHAEL PORTER: Well, the wonderful thing of course we learned is that these concepts can be applied to literally any, any industry, to product, to service, high-tech, low-tech, emerging economies, developed economies. Indeed, what one of the powers of the framework is it helps you get avoid getting trapped or tricked by the latest trend or the latest technological sensation, and really allows you to focus on the underlying fundamentals. The internet is a good example. We got very, very confused by the internet because people saw the internet as a force as supposed to really enabling technology that might or might not impact the underlying structure of the industry. So I think one thing I have learned is the framework is very, very robust, but I have also learned that there is a lot of confusion and complexity in actually applying the framework in actual practice and we tried to clear as many of those areas up as we could in this new article. For example, how to think about rivalry? How do we understand when rivalry is really positive-sum, which allows many companies to do well? When does rivalry become really zero-sum, where everybody is kind of dragged down into a destructive battle that you cannot win.

THOMAS STEWART: Well, I can understand zero-sum. I mean, if we get in a price war, the only one who wins is the consumer, which is nice if you are a consumer.


THOMAS STEWART: But what do you mean by positive-sum competition?

MICHAEL PORTER: Well, the trouble with the zero-sum competition is then the consumer gets a little price, but they really got no choice, and a positive-sum competition is where companies can compete on different attributes, services, features, customer support, that is actually relevant to particular groups of customers. The most really positive-sum competition is where companies are really competing on different things in order to meet the needs of different segment.

THOMAS STEWART: So we are growing the pie and there is a piece for each of us.

MICHAEL PORTER: There is a piece for each of us. In fact, one of the things we talked about in the new article, one of the things I did in the new article that we really probably did not have the experience to do so many years ago was really talk a lot about the implications. If this is the way competition works, what do you do about it? One of them is might be in some industries rather than go for market share against your rivals, you might be much better off just really expanding the pie, expanding the whole profit pool of the industry. That may be the best way for a market leader to actually improve their circumstances rather than to trigger a destructive battle with their head-to-head rival.

THOMAS STEWART: How should a company get started using the five forces framework? You are working your strategy and you decide, “This really works for me.” How do you begin?

MICHAEL PORTER: Well, I think industry analysis and looking at the competitive environment is of course, probably the starting basic discipline of any strategy formulation process. If you do not know what your industry looks like, if you do not know how it is changing, if you do not know what the drivers or competition are, strategy is going to be marginally useful, if not destructive. So we got to start with industry analysis figuring out what your industry is and drawing the right boundaries.

THOMAS STEWART: That is not always easy.

MICHAEL PORTER: It is not always easy. We have added a box in this new article, which really addresses that question because I encountered so many companies that struggled with industry definition, identifying really what the industry structure is in your particular industry. And then there is another thing that a lot of managers do. They kind of go through the industry analysis and they say, “Okay. This is good, this is bad. This is good, this is bad.” So this is an attractive industry or unattractive industry, but of course the real question is how is that industry changing? Some have believed and taken the five forces as really a static snapshot, but of course the five forces give you the tools for understanding the dynamics and where is that industry structure changing? How are buyers and suppliers and substitutes and potential entry evolving? And then what implications does that hold for your strategy? How do you position yourself to find that spot within the industry where you can command a really good profit given the five forces? How can you maybe reshape the nature of the industry structure? We have got some great new examples that are very, very contemporary in this article that I think will help the manager community and the investor community really understand the application of this.

THOMAS STEWART: Sometimes when people think about strategy, they think about a group of people, maybe from a management consulting firm or maybe on the 3rd floor of the building, whatever it is, but it is sort of elite strategy priesthood that goes in and does this. They are almost divorced from the rest of the management of the company, the % of the other people working in the company. How can a strategy become part of the day-to-day life of a working stiff manager in a company? How do you apply this framework, this thinking? How do you use it?

MICHAEL PORTER: Well, we think that this way of looking at an industry needs to be very, very broadly understood in the organization. The thing about it is that managers, even rank and file employees, it is intuitive. People understand. We have these customers, we have these suppliers, we are struggling with them everyday. They are trying to get a better deal, we are trying to get a better deal.

So intuitively, I think this is a way of helping people sort of step back from all the excruciating little details that characterize any business and say, “What is really important here?” And then of course we have learned that strategy is completely useless, again, unless the results of the strategy process, the position that you choose to occupy, the way you are going to drive your company is well understood quite broadly because the number one purpose of strategy is alignment. It is really to get all the people in the organization, making good choices, reinforcing each other’s choices because everybody is pursuing a common value proposition or common way of gaining competitive advantage.

I remember when I wrote this article, there were many people who believed that strategy documents should be locked in the safe at night and should not be made available to the rank and file. There was a concern that some competitor would find some secret. Well, we have actually learned now that it is the opposite. Your employees got to know your strategy, your channels have to know your strategy, your suppliers have to know your strategy.

THOMAS STEWART: Your competitors probably knew it already.

MICHAEL PORTER: Well, and frankly, again the competition is not zero-sum. If every company finds a unique need that it can set out to meet, if it tries to deliver something different than its rivals, multiple rivals can be successful. If your competitors can understand what you stand for and what you are committed to, maybe they will make a different choice, rather than get dragged into this kind of mindless price wars that we see in so many industries.

THOMAS STEWART: The five forces that shape strategy have been around for  years, they are going to be around for, well, they have been around long before you wrote about it.

MICHAEL PORTER: That is right.

THOMAS STEWART: They have been around as long as business has been around. They are going to be around as long as business is around. The new article is just fabulous. Thank you so much.

MICHAEL PORTER: Thank you. Well, I am looking forward to kind of getting another surge of feedback from the practitioners and we will keep learning.



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Michael Porter #1