The Investment Checklist

by Michael Shearn

  6. Bary, Andrew. “Kings of the Jungle.” Barron’s, March 23, 2009.

  7. Ibid.

  8. Southwest Airlines. “Checked Baggage.” http://www.southwest.com/html/customer-service/baggage/checked-bags-pol.html. Accessed May 11, 2011.

  9. Hart, Christopher. “Beating the Market with Customer Satisfaction.” Harvard Business Review, March 2007.

  10. Cabela, David. Cabela’s: World’s Foremost Outfitter, a History. Middlebury, VT: Paul S. Eriksson, 2001.

  11. Shambora, Jessica. “Williams-Sonoma’s Secret Sauce.” Fortune, July 26, 2010.

  12. Rust, Roland T., Christine Moorman, and Gaurav Bhalla. “Rethinking Marketing.” Harvard Business Review, January–February 2010.

  13. Meyer, Christopher, and Andre Schwager. “Understanding Customer Experience.” Harvard Business Review, February 2007.

  CHAPTER 4

  Evaluating the Strengths and Weaknesses of a Business and Industry

  In addition to understanding a business from the perspective of its customers, it’s also extremely important for you to analyze the strengths and weaknesses of a business in the context of its competitive environment. The stronger the business’s competitive position, the higher the probability that it will be able to sustain its current earnings as well as grow them in the future. After all, a competitive advantage represents long-term protection from a company’s competitors. Think of it as being in a wrestling match when you’re 50 pounds heavier than your opponent.

  Once you have established whether the company has a competitive advantage, you want to know if the industry is a good one. In some industries, it’s relatively easy for a business to get a good return on its investment, but in other industries, the historical returns are negative. If the industry is difficult or unprofitable, you’ll find it harder to make money on your investment, even if you manage to pick the best company out of tens or hundreds of others in that industry.

  Finally, you want to understand how industry supply chains work. Good supplier relations can improve efficiency and reliability of source goods, so I’ll walk you through how to evaluate supplier relationships, supply chain efficiency, and sources of supply chain risk.

  Let’s begin by evaluating whether a business has a sustainable competitive advantage.

  15. Does the business have a sustainable competitive advantage and what is its source?

  It is critical to determine whether a business has long-term protection from competitors, also called a sustainable competitive advantage. What’s critical to long-term success and the ability of a business to grow and remain profitable is if that advantage is sustainable, such as when a business is protected by government regulation. If you are unable to determine whether a business has a sustainable competitive advantage, then it is difficult for you to commit to a long-term investment in a business.

  When you do find an advantaged business, it is critical for you to determine the strength and staying power of its competitive advantage. Therefore, when you’re analyzing a business, you should always ask these two questions:

  How easily can someone else copy or replace this advantage?

  How quickly might they do it?

  The more sustainable the advantage, the more a company is worth because the company can protect its profitability over a longer period of time. Pat Dorsey, former director of research at Morningstar and author of The Little Book that Builds Wealth states:

  The way I think about the linkage between moats (competitive advantages) and intrinsic value is that moats add the most value to businesses that have lots of reinvestment opportunities within their moats. A business that has a large set of investment opportunities “inside the moat” has a much higher intrinsic value than a business without competitively advantaged reinvestment opportunities because the former compounds cash flow at a very high rate, whereas the latter is forced to use cash for sub-optimal opportunities.

  Microsoft’s moat, for example, may give an investor a reasonable degree of confidence that the return on capital of the core business will persist, but it adds very little value due to the maturity of the company’s core business—cash that is generated just sits on the balance sheet, or is invested “outside the moat” in areas like search (i.e. Bing). By contrast, the moats around businesses like Fastenal or C.H. Robinson—both of which operate in fragmented industries—add tremendous intrinsic value because cash can be reinvested in the core business at a very high incremental rate of return. This relationship between growth, moats, and intrinsic value is central to understanding when it’s truly worth paying up for a business.1

  This section helps you identify the sources of competitive advantage and gives you real-world examples of competitive advantages that are either expanding or deteriorating. Let’s start by identifying common sources of competitive advantages.

  Common Sources of Competitive Advantages

  To help you identify the sources of competitive advantage, I’ve borrowed several concepts from financial-services company Morningstar, which uses these concepts as the foundation of its stock analysis. Dorsey distills the sources of competitive advantage into four categories (Dorsey combines brand loyalty, patents, and regulatory licenses into one category titled intangible assets) which I have broken down into six categories:

  1. Network economics

  2. Brand loyalty

  3. Patents

  4. Regulatory licenses

  5. Switching costs

  6. Cost advantages stemming from scale, location, or access to a unique asset

  Let’s take a closer look at each source.

  Source #1: Network Economics

  One of the strongest sources of competitive advantage is network economics. If a product or service becomes more valuable if more customers use it, then the business benefits from network economics. When telephones first came out, not everyone had one, but as more people acquired telephones, the network became more valuable. The customer was part of the service itself (another node on the network), which meant an increased ability to connect to more people.

  The same has been true for Facebook: When it was just for college students, it had less value to non-students. As it has grown to include non-students, it has become more valuable to older adults. More customers (of the right type) again resulted in more connection and access, and more value.

  Timeshare exchange company Interval Leisure is another example of a company that benefits from network economics. When someone buys a timeshare, that person usually wants to be able to trade his or her specific week of vacation for other times and locations. Interval provides a network to timeshare owners for these trades. Owners pay an upfront fee to join Interval, and then they have access to all other timeshare traders in the network. More customers means more places and times to choose from. Interval’s network benefit is also important to another of its customers, the timeshare developer, who knows that it is much easier to sell a timeshare (and retain its own customers) if it is part of such a network.

  To monitor network advantages, you need to closely track the number and quality of users. If you see the number of users increasing but more valuable users moving to another network, this might indicate a deteriorating advantage.

  Example of an Expanding Advantage

  Money-transfer business Western Union has been increasing the number of locations in its network. In 2002, Western Union had 151,000 locations, but by the end of 2009, it had grown to 410,000 locations. More important, it is not so much the quantity of locations but the quality of those locations. Western Union has been able to sign exclusive five-year agreements with some of the world’s most desirable agents—(i.e., supermarkets, convenience store chains, postal systems, or banks). The most desirable agents are, of course, those that generate the most traffic. This makes Western Union’s network more valuable to customers who want to send or receive money, because there are more locations where they can do this. The more customers Western Union has, the more valuable Western Union is to its ag
ents, because Western Union is able to deliver more customers to agents, compared to its competitors.

  In contrast, Western Union’s closest competitor is MoneyGram International, which has 200,000 locations (less than half of Western Union’s 410,000 locations), and it processes only one-fourth of the total customer dollars that Western Union does. Its network is weaker because it offers its agents fewer customer dollars, and it offers its customers fewer quality locations.2

  Example of a Deteriorating Advantage

  A network effect is not always sustainable. Can you guess which was the first third-party charge card developed in the United States? Most of you will answer American Express, Discover, Visa, or MasterCard, which together represent the majority of current spending on credit cards. However, the correct answer is Diners Club, which spawned a new industry when it launched the third-party charge-card business in the 1950s. It possessed the highest number of both merchants and users; in fact, it was so successful that at one time, American Express even considered selling its charge-card business to Diners Club!3

  However, an influx of competitors in the following decades relegated Diners Club to only a small corner of the market. Diners Club rivals focused successfully on building their networks by signing up new merchants and customers. Diners Club stuck to its traditional roots as a charge card, whereas bankcards that extended credit offered more appeal and utility to the masses. Competitors seized this opportunity by increasing the number of customers (offering them free cards), which then allowed them to attract the best merchants. If you had closely monitored the numbers of cardholders, merchants, and transaction volume as competitors battled Diners Club, you would have been able to see the deterioration in Diners Club’s network, beginning as early as a couple of years after its first major competitor jumped in.

  Other examples of deteriorating networks might include social-networking website MySpace. Although it was the most popular social networking site in the United States, it was quickly surpassed by late-entrant Facebook. In December 2008, Facebook had fewer than 60 million users, whereas MySpace had close to 80 million users. Yet only a year later, in December 2009, Facebook had more than 100 million users (a gain of 40 million), whereas MySpace had close to 60 million users (a loss of 20 million).4

  Source #2: Brand Loyalty

  A brand can give a business tremendous advantage over competitors when customers remain loyal to the brand and when a business can charge a premium price for the brand. This often results in pricing power for the business. The degree to which brand strength will lead to a competitive advantage varies by the type of product or service. For example, bath and shower accessories have less brand loyalty than beverages.

  Start by asking what the brand stands for with customers. Certain brand names are synonymous with user experience—for example:

  Four Seasons Hotels’ brand means that the customer will receive unrivaled service. As a result, it can charge a higher rate for its hotels.

  Nordstrom is also well known for its unparalleled customer service such as its return policy, which lets customers return any item at any store.

  Starbucks is best known for supplying premium coffees in an inviting atmosphere.

  To build a brand, businesses must continually strengthen the brand in the minds of consumers. Once a business stops investing in its brand, it is likely the value of the brand will decline. You can start to see this when management begins to cut development, marketing, and promotion to save expenses. This causes the brand’s long-term identity to suffer at the expense of these short-term savings.

  In other situations, management will discount the price of its products in order to sell its excess inventory, which can cause the value of a brand to deteriorate in the minds of customers. For example, luxury handbag maker Louis Vuitton is able to consistently charge a higher price for its handbags compared to its competitor Gucci because Louis Vuitton will destroy overruns rather than sell them through discount channels.5 In contrast, Gucci discounts its inventory more frequently. Yves Carcelle, chief executive officer (CEO) of Louis Vuitton, says, “We’re never on sale. All the rest discount. Us, never. When a customer invests in one of our products, they don’t expect to see it discounted three weeks later, so we don’t do it.”6

  Tommy Hilfiger is another company that suffered when it diluted its brand. For many years, Tommy Hilfiger had crafted an upscale image in its red, white, and blue flag and crest logo. But the brand became diluted when the company made it widely accessible to middle-class consumers (whereas before it had been accessible to that market only on an occasional basis). This caused it to lose its status as an aspirational brand. It also began to move from its traditional preppy style to a hip-hop image, which helped increase sales from $847 million in fiscal year 1998 to $1.9 billion in fiscal 2000 but eventually alienated many of its customers. The stock price peaked on July 1999 at $40 per share but dropped to $16.60 per share by the time the company was taken private on May 10, 2006.7

  Recently, private-label products (PLs) have proven to be an enormous threat to previously strong national brands in groceries, household goods, and over-the-counter drug segments. According to the Private Label Manufacturers Association, “store brands now account for nearly one of every four items sold in U.S. supermarkets, drug chains, and mass merchandisers.” In the United States and many other countries, labeling requirements allow for easy comparison of certain items, such as food and drugs. The cost of production, marketing, and promotion is often less for these private-label items, and retailers benefit because they get higher margins from selling them. In some cases, national brands have had to lower prices to stay competitive.

  Many PLs are not just cheaper, lower-quality versions. With the introduction of PLs at several price points and quality levels (especially premium levels), these multiple-tiered products have gained substantial market share: In fact, a 2010 Nielsen study showed private label store brands had captured 17 percent of the market share in the United States.8 Private labels now sell more mouthwash and dishwasher soap than Colgate and more food wrap and trash bags than Clorox (which makes Glad).9 However, some products are less affected than others. The same 2010 Nielsen study also found that private-label market share ranged from a high of 40 percent in dairy to less than 1 percent for alcoholic beverages.

  Source #3: Patents

  Patents can be a source of protection because they legally protect the products or services of a business from competitors over a 17- to 20-year period. The best way to determine whether a patent is valuable is to understand if it has any commercial value, as evidenced by any product or licensing revenues. Not surprisingly, drug companies have extremely valuable patents: For example, Pfizer’s set of patents for Lipitor is the basis for a quarter of its sales, about $11 billion. Almost all of chipset designer Qualcomm’s $10.9 billion in 2009 revenues are related to its patents on code-division multiple access (CDMA) and 3G cell phone network technology.10

  The easier patents to research and understand are those in the pharmaceutical industry, because there is a lot of information as to the potential market size of a drug. The more difficult patents to evaluate are those based on technology. For example, Tessera Technologies has patented a technology that enables devices such as laptops and mobile phones to pack more silicon inside their products. It is difficult to analyze how many of these devices will be manufactured in the future and which ones will employ Tessera’s technology.

  Although they provide protection, patents have a finite life, and you need to be cautious not to assign too much value to them. Paul Bobrowski, dean at the College of Business at Auburn University, once joked that a patent was as valuable as his patent leather shoes. David Freedman, a reporter for Inc. magazine, explains, “The problem is that a long period of patent protection is not useful because a newer technology will displace it. Therefore, the more innovation there is or more technological changes there are in an industry, the less value a patent will have as a source of protection
[of a sustainable competitive advantage].”11

  Source #4: Regulatory Licenses

  Regulatory licenses and approvals can also create sustainable competitive advantages by limiting competition. For example, Western Union benefits from laws and restrictions designed to inhibit money laundering.

  If the source of advantage is regulatory, spend your time closely monitoring legislative threats from the entity that regulates it, whether it is in Washington or in state or local government offices. Closely monitor lobbyists who influence legislation by visiting the websites of groups that either generally support or oppose the industry or by reading articles written about what impact new laws or legislative changes have on an industry.

  First, determine whether the license or approval is regulated by the state, local, or federal government or a combination. Next, determine what types of power each regulatory entity exerts on the business, such as the ability to regulate the price charged for goods or services or the number of units a business can sell. The competitive advantage’s strength depends on how much power the regulatory entity has over pricing. If the regulatory entity controls the prices a business can charge customers, then the competitive advantage is weaker. Dorsey uses the example of a utility, which is regulated in the price it can charge customers. He then contrasts this to a pharmaceutical company where the Food and Drug Administration (FDA) concerns itself with the safety of drugs it regulates, but it does not control the prices that a business can charge for them.

  Regional casino Penn National Gaming is regulated by each state in which it operates. To evaluate the competitive threats to Penn National Gaming, you would need to watch legislative trends by state. The state legislature typically approves gaming for each state, then the licensing of casinos is monitored by each state through gaming boards (such as the Ohio State Racing Commission, Pennsylvania Gaming Control Board, or Maine Gaming Control Board). These boards approve the total number of slots or table games that are allowed within a certain geographical region of the state. The board also sets the amount of the slot-win percentage (which is the amount it is allowed to win from customers): For example, 6 percent to 10 percent of slot handle. The state also sets the tax rate on gaming revenue that casinos collect. For example, Maryland levies a 67 percent tax on gaming revenue, whereas Nevada levies a 6.5 percent tax. If the state decides to either reduce the amount of slot-win percentage or raise the tax rate, this would decrease the profitability of Penn National Gaming.