“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”
That quotation about the passenger airline industry is used by Stephen Horan, Robert R. Johnson and Thomas Robinson in their 2014 book, “Strategic Value Investing: Practical Techniques of Leading Value Investors.” The point they wanted to make is that no individual stock can be properly analyzed without also checking out its industry and sector (a sector is made up of multiple industries).
In analyzing sectors and industries, the authors reported they were most interested in the ability of individual companies to generate cash flow, determining the industry’s ability to grow in relation to the overall economy, and in knowing the stages of the business cycle.
To assess industries and sectors, the authors pointed to several tools, including Michael Porter’s Competitive Advantage framework, the stages of an industry life cycle and economic moats (sustainable competitive advantages).
Porter’s competitive advantage
Michael Porter became a major figure in economics after publishing an article in the Harvard Business Review in 1979. Titled “How Competitive Forces Shape Strategy,” the article gave investors a framework for assessing industries and a company’s business model. There are five distinct forces, he said, but they should be taken as a group, rather than as separate forces:
- The threat of new competitors, which is a function of how difficult it is to enter some industries. For example, it’s tough to get into the airline industry because of capital requirements and government regulations. On the other hand, it is relatively easy to enter the retail industry, which has few barriers to entry. Note that this is essentially the same as economic moats, which will be discussed later.
- The amount of bargaining power held by suppliers: This includes factors such as supplier concentration, switching costs and the differentiation of inputs. In the airline industry, for example, there are only two suppliers of large aircraft for passenger use.
- The power of buyers: For example, an industry that cannot differentiate its products (commodities) has little pricing power. Once again, the experience of the passenger airline industry illustrates the point; as the authors noted, “The biggest factor dictating which airline a leisure passenger selects is price. In essence, airlines must match the price of their dumbest competitor.”
- The threat of substitutes refers to the likelihood customers can switch easily among suppliers. In this case, the airline industry does have an advantage: The competition for passengers consists of individual automobiles, buses and passenger trains — all much slower than planes and thus not a substitute for passengers who want to get somewhere in a hurry.
- Rivalry among existing competitors is the final force. One important driver of competitiveness is industry growth; if slow, competition is likely to be more intense. Another factor is high exit barriers. To overcome this rivalry, companies need a strong strategy, such as cost leadership or product differentiation. For example, Southwest Airlines (NYSE:LUV) was very successful, and an exception in the industry, because of its low-cost strategy.
The authors emphasized that Porter’s list need not be just a delineation of qualitative factors; each can be translated into numbers and analyzed.
Industry life cycle
Analysts say that industries go through a four-phase life cycle that unfolds over time:
- Pioneer stage, when companies in the industry are using venture capital financing and there are high failure rates. An example is the tech industry during the 1990s, when internet firms were first booming, and then collapsing.
- Growth stage, when the new products and services become established and recognized. In some cases, firms will introduce new products that consumers did not even know they needed. For example, the Global Positioning System industry appeared almost out of nowhere, but has since evolved in dozens of different directions and become essential for many types of consumers.
- Mature stage, when growth eases back to match the growth of the overall economy and once-novel products have become consumer staples. Companies can continue to grow by taking market share from other competitors, or by acquiring or merging with other firms.
- Decline stage, when demand for an industry’s goods and services is declining and some firms are exiting the industry. Profit margins tend to fall, but there may be opportunities for investors and in particular, value investors. For example, Buffett’s Berkshire Hathaway bought the Omaha World Herald Company, which publishes the leading newspaper in Buffett’s hometown.
This refers to the strength and durability of a company’s competitive advantage over its rivals. The moat metaphor comes from Buffett, who stated that he wanted economic castles protected by wide moats.
Morningstar has further developed the concept, and has five primary classifications for competitive advantages:
- Low-cost producer: Think Walmart (NYSE:WMT) and how it built itself from the ground up with a low-cost strategy, a strategy so strong that it dominated retail for many years. That position has been challenged in recent years by Amazon.com (NASDAQ:AMZN) and other ecommerce companies, the new low-cost producers.
- High switching costs: The one-time costs consumers must pay to switch from one provider to another. Think of cell phone companies and their reverse incentives for switching.
- Network effect: Sometimes, products or services get better when more people use them. For example, FedEx (NYSE:FDX) gets stronger as its collection and delivery territory gets wider, and Facebook (NASDAQ:FB) gets stronger as more people participate on its social media platform.
- Efficient scale: These are markets competitors find it difficult to enter because they are already well served by existing providers. This is especially true for niche and limited markets.
- Intangible assets: These include patents and brand names. For example, Coca-Cola (NYSE:KO) has built up such a strong brand and image that new producers find it difficult to gain a foothold in its industry.
Industry analysis can help us understand not only the stocks in which we are interested, but also the context within which they operate.
Using the tools listed here allows you to methodically dissect industry issues, and most importantly, helps you figure out how companies generate their cash flows and maintain (or not) their positions in competitive markets.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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This article first appeared on GuruFocus.