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Porter’s Five Forces Meets Wall Street

February 17, 2012

Porter’s Five Competitive Forces meets the Financial Services Industry.

(If you would like more on Porter’s Five Competitive Forces, please join the conversation on LinkedIn under groups Porter’s Five Competitive Forces)

According to Michael Porter the Five Forces at work within an industry can be evaluated to explain that industry’s potential profitability. As an industry creates industry profits the participants of each of  the five forces will ‘conspire’ to siphon profitability from that industry. Blue Ocean Strategy is a related body of this work and is used to relocate a company from a red ocean (intense rivalries) to a business strategy where the five forces have not matured or may not mature. I want to introduce a new concept, brown ocean. One where the business level differentiation is not based on price, but marginally on the value side (i.e. small and marginal differences in company policy, costs, fees, relationships at the point of consumption, locations, recruiting of talented employees to gain their clients etc.). The perfect industry to illustrate a brown ocean is the financial services industry.

A quick review of those five forces:
1.Threat of new entrants. If there are not enough barriers to restrain entrants, enough new entrants may emerge to lower the profitability from the incumbents.
2.Bargaining power of suppliers. If the suppliers are powerful enough, they may raise their prices, decreasing their customer’s (industry in question) profitability.
3.Bargaining power of buyers. If the buyers are powerful enough they will demand lower prices from the industry and thereby lowering profitability.
4.Threat of substitution. If the industry is not just competing against products and services of their direct competitors, but also industries where the customers can meet their needs.
5.Intensity of rivalry. If there are enough players who are equally resourced for a fight, it could move to cutthroat competition.

Now let’s overlay the five forces on the financial services industry. The players are well known as Bank of AmericaMorgan StanleyWells FargoCitigroup and UBS on the mass-market side. On the niche player side, there are regional companies like Ed Jones, Stifel Financial and Morgan Keegan to name but a few and there are the independent broker dealers, discounters, insurance companies, private banks and trust companies competing for many of the same investors. The five forces look like this:

1.Threat of new entrants. There will not be any new large mass-market players or niche players bursting on the scene, but there will be new independent broker dealer players as well as discounters, banks, insurance companies and credit unions. Count as well the independent shops where a broker can set up shop literally overnight. The costs of self clearing, recruiting, staffing, technology etc. prevent any new mass-market or niche players from coming on the scene. The number of sub-industries developing within the financial services industry has seen dramatic growth over the last couple of decades. With the fall of Glass-Steagall, the barriers to entry fell impressively. Within each sub-industry, there are few barriers to entry to prevent rapid growth. For instance, almost anyone can get a job with an insurance company selling insurance. They can then get licensed to sell securities (mutual funds and variable annuities). Within the banking system, many client facing employees have at least a Series 6. Then within the independent/regional and warehouse industries, the only barrier is the ability to pass the securities exams. Not a barrier really, more like a speed bump.
2.Bargaining power of suppliers. Who are the suppliers to a business based on intangibles? Mutual fund companies, hedge funds, other broker dealers in structured deals, separate account managers, life insurance companies and companies looking to go public, and believe it or not, Advisors fit in this category. Their bargaining power has grown over the last 20 years from not being paid to move, to deals of up to 300% of their trailing 12 months production as well as commission and fee payouts and benefits. Today these mass-market firms must pay their Advisors to stay at work on top of salary, bonuses and benefits. They are called retention bonuses. Mutual funds, insurance companies, money managers can gain access to the various firms, but to be in a preferred list, these entities have to pay a little extra. This is to gain a good spot on the shelf, eye level. Here the heft of the wirehouses can gain the firms more credibility when demanding the shelf space fee (update: WSJ article of firms raising fees to fund companies 4.3.12).
3.Bargaining power of buyers. Shifted dramatically toward the favor of the buyers. Gone are the days when the industry had all the information. I remember in the 80’s the phone would ring at night and the weekends with investors looking for an explanation for the drop in AT&T’s stock. The newspaper was the only place to get a quote then and if AT&T went ex-dividend it used to be enough to create a call. Along comes the internet and now the buyers have access to faster, better and more clear analysis and information than the industry itself provides to Advisors. As if that were enough, now there are multiple sources of information the investor can access. While their Advisor is stuck with being able to only supply the firm’s individual-investor-digestible research.
4.Threat of substitution. What is it the firms in the wealth management industry provide? Wealth transfer, wealth preservation and wealth creation. Wealth Transfer can be handled by insurance companies, and they do a lot! Wealth Preservation by banks, trust companies, life insurance companies. Wealth Creation in this country has always been through the creation of businesses; long, slow disciplined investing; luck with corporate stock options; real estate and other non-financial markets; all of these not the domain of diversified financial services companies. Financial Services firms are not the place where investors go to become wealthier. It is the place wealthy people go in hopes of maintaining their wealth.
5.Intensity of rivalry. These companies raid each other’s local shops offering checks ranging from 200% to 300% of the financial advisor’s trailing 12-month production. One company I worked for had about 6500 Advisors in the 90’s. Recruiting wars were heating up then. Fast forward 13 years, they still have about 6500 Advisors despite 3 acquisitions and 13 years of recruiting. The industry has been completely neutered in the equity research departments since 2003; there was a time when the quality of research was a differentiator and the competition to offer the best advice was furious. There is no competition to be the lowest cost provider, competition on prices is left up the advisor sitting in front of the client for the most part. At the firm level, there is almost no way to distinguish the client experience from one to the other on the mass-market side, other than brand.

Just as you would expect from behaviors predicted by the Sheth Model, the large mass-market participants compete for market share at the expense of financial performance following and sometimes leap-frogging the leader. The niche players, those whose plan is to play for a small niche can do so far more profitably. Compare the stock performance, ROE, ROA, etc. of UBS (UBS), Wells Fargo (WFC), Morgan Stanley (MS), Bank of America (BAC), and Citigroup (C) to Stifel Financial Group (SF).

Between these two industry participant groups lies the “ditch.” This is the place where the companies who are too big to be a niche player and too small to take on the mass-market find themselves sliding. “The Ditch” is a place where many never return. A question to ask, will the market reward innovation? A review of an article and the associated research from an MIT Sloan Review, The Business Models Investors Prefer provides insight. Also, those firms who have not built strategy and executed it to combat the 5 competitive forces, will be found in the ditch.

The only real differentiator for investors to choose firms is the individual advisor. Any investor can go into a single branch office and find a different experience for every Advisor in that particular branch. The choice for investors is not based on the capabilities of the firms, yet really and almost always based on the relationship with their Advisor. The time has come for the financial services firms to innovate. The last real game changing innovation was Merrill Lynch’s rollout of the CMA account. Since then the ‘innovations’ have been self serving to the firms. The names on the tombstones of offerings and product failures stretches back past the recent real estate bubble. With the differentiation coming down to each individual Advisor, all competing against each other (also within the same branches and firms) without the ability to compete on a unique product or service offering, the ocean is a brown hue through and through.

From this brown ocean who is poised to break out into a bluer ocean? Again, look to the Sheth Model to predict who is the best positioned to make the innovative move? It would be the one closest to the ditch (for fear of slipping into it) with the most resources. In this case it’s UBS. If there is a chance to innovate profitably it is their’s for the taking. But it will require a competitive strategy built to combat the competitive forces and innovation. WIthout those, the future is certain it is only a matter of when.

I have a client who has over 30 years experience in the construction industry. Very competitive and not a very profitable industry. This client moved to a blue ocean. Needless to say, his results have been outstanding versus his peers for the last 18 years. Here is a chart of the differences in the five forces in the two industries, the one he created and the financial services industry. The wider one is the more profitable one.

The financial services industry will need to make decisions like this client. The only thing lacking is a clear strategy.

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