The Investment Checklist

by Michael Shearn

  Interestingly, the large advertising agencies continued to acquire other advertising agencies. Curious about this, I asked managers what the benefit of size was for an agency during a time where markets were becoming more fragmented. The management teams of the large agencies explained that they were continuing to make acquisitions because customers would benefit from being able to use a single agency to run a global campaign: For example, Nike would be able to run a global campaign without having to hire 10 separate agencies. These managers claimed they had created synergies by combining agencies: With more distribution power under one roof, they believed they would enjoy the benefit of efficiencies on the cost side.

  However, because I had studied the way that ad-agency industry consolidation had taken place in the past, I knew that consolidation didn’t result in large cohesive agencies being able to offer seamless global advertising campaigns; I also knew that consolidation didn’t result in efficiencies. In fact, as large agencies made acquisitions, the acquired agency was not absorbed; instead it often competed with other agencies in the same umbrella or conglomerate agency. Each agency within the conglomerate ran its own profit and loss statement and had few incentives to work with other agencies under the same roof. I followed up with additional research and found that the industry still operated in a similar fashion. So even though acquisitions resulted in increased revenue on paper, they weren’t going to create cost efficiencies or synergies.

  Studying the advertising industry over time allowed me to conclude that ad agency consolidation worked differently than consolidation in other industries. I concluded that margins would not grow in this new environment, and I passed on the investment. By knowing how the entire industry evolved, I was able to see the fallacy in management’s claims of cost synergies and better customer service, and I sidestepped a poor investment opportunity.

  A great source to help you understand how an industry has evolved is the collection of Standard & Poor’s (S&P) Industry Surveys. S&P publishes surveys on many industries, including real estate investment trusts (REITs), chemicals, publishing, restaurants, and homebuilding, to name just a few. The reports are typically broken down into sections on how the industry operates, industry trends, key industry ratios and statistics, and a section titled “How to Analyze” a particular industry, such as a REIT. There is also a section on industry references, which can give you valuable leads for trade journals, industry associations, and other sources. There is a comparative-company analysis in the appendix, which will give you useful competitor information and a list of other companies in the industry. You can access these reports through a university or local library.

  19. What is the competitive landscape, and how intense is the competition?

  You can better understand what the competitive landscape is for a business by answering the following questions:

  Does the business have limited competition?

  Does the industry change often?

  How do the competitors compete within an industry, and how could that change?

  How fiercely do businesses compete?

  What risks does the business face from substitute products?

  Can competition from low-cost countries impact the business?

  Which competitor sets the industry standard?

  Why have competitors failed in an industry?

  Let’s take a closer look at each of these questions.

  Does the Business Have Limited Competition?

  Competition does not increase the value of a business. Generally, more competition means more customer choice and less profitability. In addition, a business with limited competition is easier to analyze than one that has lots of competitors.

  For example, think about the competition in a supermarket aisle. There is limited shelf space on each aisle that name brands and private-label products compete for. If you are analyzing a name-brand food company, you can easily assess how a certain food brand is doing against a private-label brand or other brands by monitoring shelf space in various national supermarkets. In addition, there are many market-research organizations that can provide you with valuable information regarding market share, such as global information and measurement company A.C. Nielsen. In contrast, it is far more difficult to understand the competitive position of a business such as a check-cashing store, where there are thousands of direct and indirect competitors.

  To begin your assessment, view the Competition section in the 10-K. If a business lists its competitors by name, the company has limited competition. For example, the 2009 10-K for bond-rating agency Moody’s lists the following competitors:

  Standard & Poor’s

  Fitch

  Dominion Bond Rating Service Ltd. of Canada

  A.M. Best Company Inc.

  Japan Credit Rating Agency Ltd.

  Rating and Investment Information Inc. of Japan

  Egan-Jones Ratings Company

  LACE Financial Corp.

  Realpoint LLC

  In contrast, in such businesses as banking, homebuilding, or restaurants, the company will not list its competition but will simply disclose that it has many competitors. For example, the 10-K from June 30, 2010 for Dollar Financial (a check-cashing business and consumer loan provider) states:

  In the United States, our industry is highly fragmented. According to Financial Service Centers of America, Inc., there are approximately 7,000 neighborhood check cashing stores and, according to published equity research estimates by Stephens Inc., there are approximately 22,000 short-term lending stores.

  Does the Industry Change Often?

  If the industry is one that is constantly changing, then it will be even more difficult to evaluate the competitive position of a business. For example, if you are evaluating competitors individually in the technology industry, by the time you have analyzed most of those companies, the technology may change, which of course opens the door to a new crop of competitors you never considered.

  Therefore, to evaluate competitors in a fast-changing industry, view them from the customer perspective. You will need to locate and maintain close contact with customers to understand if they are switching to other products and services.

  For example, when I first began analyzing the online travel industry, which was in its infancy at the time (in 2001), I attended several online travel-industry conferences (such as The PhoCusWright Conference) to look for potential investments. I knew that online travel was a growing industry, but I did not know which businesses to invest in. Most of the industry players—such as Expedia, Travelocity, and priceline.com (and many others that no longer exist)—were in their early stages of development. Because the industry was changing so quickly, I searched for customers and travel providers (i.e., hotels, airlines) who used these services. I wanted to find out which services they preferred and why.

  When I first studied priceline.com, I personally did not like the business model because customers could only choose to bid on hotels with a certain star rating, and they could not choose the specific hotel where they would be staying. I thought this business model had limited potential, and many of its competitors agreed. However, the customers and travel providers kept telling me that because priceline.com was a differentiated service, it could represent a great investment. The travel providers and hotels liked this business model because they did not have to advertise discounted hotel rates, which could damage their pricing power.

  The customers and travel providers ended up choosing the best investment in this industry: priceline.com has been one of the highest-returning stocks in the online travel industry, increasing from $8 per share toward the end of 2000 to more than $400 per share at the end of 2010.18 Had I not viewed competitors from the customer perspective, I would have come to the wrong conclusion as to which business would be most successful.

  How Do the Competitors Compete within an Industry, and How Could That Change?

  Competition may be based on capital, service, or price. Determine whether the com
petitive dynamics can change, and then construct different downside scenarios for the business based on those dynamics. Let’s look at each of these factors individually:

  Competing on capital

  If the businesses compete based on capital, then the advantage will always reside with the well-funded competitors. For example, BHP Billiton (a global resources and mining company) has an advantage over smaller mining operators because it has more capital that it can use to develop large mines. Competitors with less capital are limited in the types of mines they can develop.

  Competing on service

  If companies compete based on service, the company with a stronger, more ingrained customer service culture will have an advantage. Therefore, you should focus on understanding the reasons why one business has better customer service than another and whether that can change. For example, if a new management team takes over a company that has poor customer service and if they make improvements, they may be able to gain market share from a dominant competitor.

  Competing on price

  You need to determine if the competitors within an industry have to constantly match each other based on price. If so, the business may have a difficult time increasing its margins or earnings, as increases in margins will need to come from cost cuts which become more and more difficult to achieve.

  Competing by copying

  Be cautious investing in businesses whose management teams attempt to replicate the success of a competitor’s breakthrough products or profitable business lines. Whenever competitors attempt to meet a competitor head on by entering the same business line where a competitor has an advantage, there is risk.

  For example, Stanley O’Neal, former head of Merrill Lynch, was known to be obsessed with his competitors and made derivative trading a priority because it was generating so much profit for his competitors, including Goldman Sachs. O’Neal’s goal was to increase profits through these exotic products; however, he did not understand the risks involved, which eventually destroyed Merrill Lynch.19, 20

  In contrast, John McFarland, CEO of electric-motor manufacturer Baldor Electric Company, once told me he did not worry about his competitors, nor did he attempt to track them or copy them. Instead, he asked his customers which products they liked. He explained that if he spent his time tracking competitors, he might be tempted to incorporate some of their changes into his motor designs, and then later learn that the customers did not value these changes. It was better to let customer input drive his decision making, instead of competitor input.

  How Fiercely Do Businesses Compete?

  The degree of competition, or how fiercely competitors compete, can depend on such factors as whether the competitors are roughly equal in size or whether the industry is growing or mature. If competitors are numerous and roughly equal in size, then it will be an intensely competitive industry, such as the check-cashing industry. In these environments, there is typically no industry leader.

  In contrast, for industries with only a few strong players controlling the market, these market leaders hold an advantage, simply because of their size. For example:

  Home Depot can offer lower prices on its products to customers because it often represents a large percentage of the sales for its suppliers.

  Philip Morris, maker of Marlboro cigarettes, is able to get more shelf space compared to its competitors.

  The Coca-Cola Company can invest more in advertising to increase brand awareness.

  Amazon.com has the resources to invest in more efficient distribution and Web page design.

  In growing industries, competition is generally less fierce. When industry growth begins to slow, competitors fight for market share and, in some instances, will change the way they compete. There have been many instances in which two large, dominant competitors have entered into price wars.

  For example, when Roger Enrico became PepsiCo’s CEO in 1996, he started a price war with The Coca-Cola Company that lasted until 1998. As he tried to boost volume and increase market share, the price of a two-liter bottle of Coke or Pepsi sold for as little as 59 cents, compared to prices of $1 before the price war began.21 Instead of competing based on marketing, Coke and Pepsi were competing based on price. When the price war ended, volumes at both businesses dropped because consumers, accustomed to the lower prices, decreased consumption.

  Sometimes competitors become irrational in the way they compete with each other, even following strategies that lose money in order to gain market share. You need to determine if this is a temporary phenomenon or a long-lasting trend. If you identify a temporary change in the way businesses are competing, you can often profit.

  For example, in 2007, Blockbuster launched its Total Access (TA) DVD-by-mail program to compete with its rival Netflix. Blockbuster decided to cut the price of its program by several dollars a month to undercut Netflix’s pricing. Blockbuster quickly accumulated more than 2.2 million customers, and Netflix lost 50,000 of its subscribers. The stock price of Netflix dropped to under $17 per share, which was near its IPO price of $15 per share five years earlier, in 2002.

  However, if you had spent some time reviewing Blockbuster’s financial statement, you would have learned that it had a lot of debt and that it was losing money on its stores. The TA program was also losing money because it was designed to gain market share instead of generate profits. You would have learned that Blockbuster’s strategy was not sustainable and that at some point, it would have to stop under-pricing Netflix. When Blockbuster was forced to raise its prices, it quickly lost the advantage it had over Netflix. Netflix’s stock price increased to more than $175 per share at the end of 2010 (from $17 per share when the price war began), whereas Blockbuster’s stock declined from over $6 per share in 2007 to $0.16 per share at the end of 2010.22

  There are also financial metrics you can monitor to understand if an industry is becoming more competitive. This will alert you that future earnings may drop, decreasing the value of the business you are analyzing. Take total costs and divide by the number of customers, transactions, or another metric. Track the resulting ratio of operating cost per customer or operating cost per transaction. Is it decreasing or increasing for most of the competitors in the industry? As markets become more competitive, costs tend to increase.

  For example, the customer-acquisition costs of wireless telecom businesses have gradually increased over the years as more competitors have entered the market and existing competitors try to increase their market share. As a result, many of these wireless telecom carriers have had to invest in customer support, marketing, and increased commissions to sign up new customers and retain existing customers. Therefore, if you had monitored the customer-acquisition costs for competitors in the wireless telecom industry, you would have seen that the wireless telephone business was becoming more competitive.

  To get more insight into the reasons for differences in profitability, read articles about the industry. Search for articles using search terms such as “auto industry profitability” to locate articles that are written about how the profits of an industry or certain businesses are changing over time and, more important, the reasons for these changes.

  What Risks Does the Business Face from Substitute Products?

  Be careful not to define the competition too narrowly by considering only direct competitors. You must also consider the risks from substitute products. A substitute product or service performs the same function as the business’s current product or service but by a different means. For example, plastic is a substitute for aluminum, and e-mail is a substitute for express mail. Sometimes, substitute products can be extremely different from the existing product or service. For example, for a Father’s Day gift, power tools may serve as a substitute for a necktie. The threat of substitute products is high if they can offer the customer an attractive price or performance tradeoff to the current industry product or service. Here are a few examples:

  International calling cards suffered when low-cost Internet-base
d service Skype entered the market.

  Advancements in digital photography replaced the duopoly on traditional film that Kodak and Fuji had. Kodak and Fuji took too long to transition to the new digital medium and therefore lost significant market share.

  There are certain types of businesses that are currently immune from the competitive threats of substitute products. For example, there are not any cost-effective substitute products for cement. You can build a house with steel, but this is not cost effective compared to using cement.

  Some types of products and services are immune from substitute products for long periods of time and others for short periods of time. For example, the U.S. Postal Service dominated the transmission of mail for decades in the United States, but e-mail evolved to become a substitute product. Typically, the more asset-intensive a business is, the less threat it has from substitute products: For example, think of airplane manufacturer Boeing, chemical firm Dow Chemical, and cement producer CEMEX. Although substitutes may be developed in any industry, these businesses have longer periods of immunity.

  Can Competition from Low-Cost Countries Impact the Business?

  As economies become more interconnected, businesses face more competition from foreign competitors. You need to determine if a business is threatened by foreign competition. Generally, items that cannot be shipped long distances are not subject to foreign competition.

  For example, plastic parts for automobiles can’t be shipped long distances because they scratch easily, so there is less foreign competition. Rock quarries also face little or no competition from foreign businesses because it is extremely expensive to ship aggregates overseas. On the other hand, manufacturing firms where labor is a large component of the product cost face threats from foreign competition.