The Investment Checklist

by Michael Shearn

  For instance, Pillowtex (a manufacturer of pillows, comforters, and towels) had $500 million in sales in 1995. In 1994, the United States began to phase out quotas on imports. Its competitors knew they would face extreme price competition from foreign markets, and they immediately began to outsource their manufacturing to developing countries. Pillowtex, however, acquired more businesses, hoping to capture a cost advantage through economies of scale; in fact, in its 1998 10-K, Pillowtex reported that it had spent $240 million on new machinery at its U.S. plants. By 2003, Pillowtex was liquidated as foreign competitors destroyed pricing within the industry.23 Investors had eight years to exit their investment in Pillowtex before it went bankrupt. They should have seen that Pillowtex could not compete with countries with lower-cost labor.

  Which Competitor Sets the Industry Standard?

  Making comparisons is a valuable tool to help you understand the differences between competitors. Always try to locate the best business in the industry by finding the businesses with the highest operating margins, highest returns on capital, and lowest cash-conversion cycle. Create a spreadsheet comparing the financial and operating metrics of the various publicly traded competitors to help guide you. If a business is a subsidiary of another business, you might be able to get only the revenues and operating income information for that business in the Segments section of the 10-K. Also, you will not be able to get information from private competitors, but you can often turn to industry trade associations, which might compile a range of profit margins for an industry. Note the differences in the financial metrics between competitors. You can often learn more about the reasons for these differences in the Management, Discussion, and Analysis (MD&A) section found in the 10-K.

  For example, Table 4.2 compares the net income margin of various freight forwarders.

  Table 4.2 Comparison of Net Income Margin for Several Freight-Forwarding Companies

  As you can see, UTi Worldwide has historically earned an average net income margin of 2 percent since 2005.24 By comparison, Expeditors International has earned net income margins between 4 and 5 percent since 2005.25 By reading the MD&A section for both these competitors, you will learn that the main reason for the difference in margins is due to UTi’s historical growth-through-acquisitions model, compared to Expeditor’s more efficient practice of growing organically or building new offices from the ground up. You can conclude that growing organically will create more value than acquiring competitors for growth within the freight-forwarding industry.

  As you learn more about each competitor’s strengths and weaknesses, you can begin to construct an ideal business using each competitor’s strengths. You can then use this ideal business to make comparisons to help you understand the differences between the business you are analyzing and the ideal business. For example, when my firm was researching a refinery business, we identified three factors that combine to create the ideal refining business:

  1. First, protected wholesale and retail markets are important because they ensure that demand for refined products will continue to exceed supply. In a high-demand/low-supply wholesale market, it is easier to pass along costs and protect margins. Generally speaking, in the United States, the east coast is highly competitive. By comparison, the west coast has more demand in relation to supply. One reason for this is that refineries in California are protected by stringent environmental policies that restrict new refineries being built. This means that gas prices will tend to be higher on the west coast compared to the east coast.

  2. Second, the biggest cost component in producing gasoline or heating oil or refined products is the cost of crude oil. The ability to process multiple types of crude oil generally lowers costs. Compare the average price paid per barrel of crude oil across different refineries to identify those refineries with low crude costs.

  3. Third, plant size is important because the larger the refining plant is, the more it can spread out its fixed costs. Labor is mostly a fixed cost in a refinery because it takes only a few employees to run the refinery, and generally speaking, you need the same number of employees whether the plant is large or small or running at minimal or optimal capacity. Therefore, the larger the refinery, the more profitable it will be.

  Once you have constructed the ideal refinery, you can then compare the refinery you are evaluating to the ideal refinery and learn where its strengths and weaknesses lie. For example, it may highlight that the refinery you are interested in cannot process multiple types of crude oil, so you know that it is at a competitive disadvantage to refineries that can.

  Why Have Competitors Failed in an Industry?

  Search for articles written about why competitors have failed in the industry. You will gain great insights into flawed strategies or operational missteps.

  For example, in 2005, a refinery owned by British Petroleum (BP) exploded, killing 15 workers and injuring more than 170 others. Cost cutting and a lax safety culture were to blame for the explosion at Texas City, according to a report issued by the Chemical Safety and Hazard Investigation Board, a federal agency. “I don’t think I’ve ever seen anything that bad,” said Carolyn Merritt, former chairwoman of the board. British Petroleum also had oil spills from BP’s pipelines on Alaska’s North Slope, which cost it billions of dollars in profits.26

  Fast forward a few years later, and BP was once again involved in an accident, the largest marine oil spill in history at one of its offshore oil wells in the Gulf of Mexico. Because BP had continually cut costs and did not comply with environmental and safety regulations, it was only a matter of time until a new accident occurred. By studying oil-industry failures, you would have learned that one of the biggest risks to an oil and gas firm comes from having lax safety standards.

  20. What type of relationship does the business have with its suppliers?

  You need to determine the type of relationship a business has with its suppliers. Does the business have a hostile relationship, in which it is constantly finding ways to pay suppliers lower prices for their goods or services? Or does it have a good relationship, where it helps suppliers innovate new products and services for the benefit of the business’s customers?

  Investors often believe that a business needs to constantly negotiate lower prices from its suppliers in order to increase earnings. They fail to recognize that if these businesses continually take advantage of their suppliers, the suppliers will eventually go out of business. The business will then need to find new suppliers, disrupting its supply chain, and ultimately decreasing earnings. Instead, if there is trust between the suppliers and the business, then this is often a competitive strength, because good supplier relationships facilitate the flow of goods.

  J.C. Penney thinks long term about its vendors and negotiates contract terms that are favorable to both itself and its suppliers. The Wall Street Journal quoted Darcie Brossart of J.C. Penney, “We don’t view squeezing our vendors to protect our bottom line as a viable long-term strategy.” In the same article, representatives from Macy’s and Dillard’s did not want to comment about their dealings with vendors.27 It seems likely that if Macy’s and Dillard’s had good vendor relations, they would have communicated openly about that, in order to encourage more suppliers to work with them.

  Similarly, dollar-store retailer 99 Cent Only Stores maintains good relations with its suppliers, because management believes this makes for good business. The retailer pays its suppliers quickly and has never cancelled a purchase order in the history of the company. It treats suppliers as if their roles were reversed, and 99 Cent Only Stores were the ones doing the delivering. By treating its suppliers fairly, the retailer is able to build a lot of goodwill with its suppliers. As a result, manufacturers of products prefer to sell their excess inventory to 99 Cent Only Stores, rather than to other retailers. This gives 99 Cent Only Stores a competitive advantage and allows it to sell products at lower prices.

  The following questions should help you learn more about the suppliers of a business a
nd whether a business has good supplier relationships.

  Does the business have reliable sources of supply?

  Does the business help the suppliers innovate by providing them with customer feedback?

  Is the business dependent on only a few suppliers?

  Is the business dependent on commodity resources, and to what degree?

  Does the Business Have Reliable Sources of Supply?

  If a business does not have reliable sources of supply, then it will generate more volatile earnings. You need to determine how a business is creating reliable sources of supply and the risks to those sources.

  One of Nestlé S.A.’s fastest-growing divisions is Nespresso, which has grown 30 percent annually since 2000. The Nespresso system combines single-use coffee capsules with an espresso machine, which makes the specialty coffee easy to prepare. The biggest problem Nestlé S.A. encountered was in obtaining reliable sources of specialized coffees because most coffees are grown by small farmers in impoverished rural areas. To ensure a steady source of supply from what was an unreliable source, Nestlé S.A. worked with these small farmers, providing them with tools and advice (e.g., on farming practices, helping them obtain pesticides and fertilizers) to help them create more successful crops. As the production quality from these small farmers improved, this increased the reliable supply of specialized coffee beans for Nestlé.28

  Supply Chain Management

  Supply chain management is the process of matching demand for products with supply. This includes determining the amount of inventory to carry, handling product returns, and distributing products. If you are evaluating a business, such as a fashion or online retailer (e.g., Amazon.com), it is imperative that you learn how it manages its supply chain. You need to determine if the sources of supply are stable and if the quality is consistent. For example, in the late 2000s, there have been several prominent toy recalls related to the safety and quality of supplier products.

  Ideally, you want to know how quickly a supply chain can adapt to changing business conditions. For example, what if a supplier runs out of product? What does the business do? You can often find articles written about the supply chain of a business or interviews written about supply chain managers in trade journals. For example, here are a few trade publications for operations and logistics management professionals:

  DC Velocity

  Commercial Carrier Journal

  Supply & Demand Chain Executive

  Supply Chain Digest

  World Trade Logistics Journal

  Logistics Today

  Supply Chain Management Review

  Logistics Management

  There are many articles in these publications that have been written about Li & Fung, Toyota, Starbucks, Nike, and Wal-Mart—all of which have strong supply chains.

  As you study a business’s supply chain, consider how efficient it is. One way to do this is to calculate inventory turnover, which measures the number of times inventory is sold in a year. To calculate it, take cost of goods sold and divide it by average inventory for the year.

  For example, from 1995 to 2010, Wal-Mart improved its inventory turns from 5.23 times to eight times. This meant it was able to turn its inventory over faster.29 In contrast, the inventory turns for its competitor Sears Holdings went from 3.2 times in 1995 to 2.9 times in 2010,a indicating deterioration in their inventory-turnover and supply chain capabilities.

  Does the Business Help the Suppliers Innovate by Providing Them with Customer Feedback?

  In the 1990s, General Motors’ warranty costs were higher than its profits. One of the reasons for this is that GM was more concerned with driving down its costs than with seeking improvements from its suppliers. In contrast, Chrysler provided customer feedback to its suppliers to help them develop new features that required fewer repairs and less frequent replacement. By seeking new innovations through its supply chain, Chrysler was able to take market share from GM.30 You can find such information simply by searching for articles that are written about supplier relationships by combining search terms such as “supplier” and “[the company in which you are interested].”

  Is the Business Dependent on Only a Few Suppliers?

  You need to determine the potential risks for a business if it depends on only a few suppliers. If a supplier represents more than 10 percent of net sales for a business, that company will often disclose this risk in the 10-K.

  For example, the 2010 PetSmart 10-K discloses that sales from its two largest vendors approximated 22.4 percent of net sales for 2009. You would need to monitor these two vendors to learn whether they are vulnerable to supply disruptions. Read historical articles to learn more about these two vendors, and monitor articles written about these businesses to learn if they are having any difficulties. For example, one vendor sources most of its raw materials from China, so you would need to understand if there is a risk that it will not be able to obtain these materials. This will alert you to the potential risk that the sales of PetSmart may drop if it is having difficulty obtaining inventory.

  Is the Business Dependent on Commodity Resources, and to What Degree?

  If a business depends on certain commodities to manufacture its products, monitor those commodity prices. This will help you to understand whether rising commodity prices may force the business to increase prices, which can decrease profits if a business is not able to pass along price increases to customers. On the other hand, if the cost of supplies decreases, a business can either earn a higher profit margin or decrease prices to increase sales.

  You need to follow the price of the underlying commodity closely so you can determine whether earnings will increase or decrease. For example, if you are analyzing apparel makers, then you must monitor cotton prices to understand if the costs will increase. If the apparel maker is not able to pass on these higher costs to its customers, then it will result in lower profits.

  Those businesses that are highly dependent on commodity resources—such as oil, steel, or chemicals—are difficult to forecast because you must assume a certain price for the commodity in the future. This increases the risk that you will be wrong in your valuation of the business. You are essentially betting on one direction of the price of the commodity for your investment to work out. Some businesses will hedge their exposure to a commodity price, which can give you greater visibility, but often these hedges are short term.

  For example, Southwest Airlines CEO Gary Kelly talked about how much commodity prices affected the airline industry saying, “Volatility in fuel prices is the industry’s No. 1 challenge. All you have to do is look back at the last decade to see what kind of havoc it wreaks on our industry. It is the single biggest threat to aviation.” When oil prices increased to $145 a barrel, airlines were forced to ground hundreds of planes, drop routes, and cut thousands of jobs.31

  Key Points to Keep in Mind

  Evaluate the Business’s Competitive Advantages

  The more sustainable the competitive advantage, the more a business is worth because it can protect its profitability over a longer period of time.

  Competitive advantages add the most value to a business that has lots of reinvestment opportunities within that advantage.

  Competitive advantages expire. Even when a business appears most formidable and generates the strongest financial metrics, it can be on the verge of failure.

  Competitive advantages are less sustainable when they are affected by changes in technology or if they are in rapidly emerging industries. Changes in technology threaten a competitive advantage when they expand customer choice, whether by offering the same product for less or by offering greater benefits for the same price or less.

  The greatest gains in a stock are usually made as a business is developing its competitive advantage rather than after it already has developed one.

  Do not confuse a competitive strength or a business that is successful because it is in the right place at the right time with having a competitive advantage.

/>   Assess the Business’s Pricing Power

  Businesses that have pricing power typically have several characteristics in common such as high customer-retention rates; their customers spend a small percentage of their budget on the business’s product or service; the customers generate high margins and lots of cash flow; or the quality of the product is more important to the customer than the price.

  One of the best methods for determining whether a business has pricing power is to monitor the reasons for increases or decreases in the gross margin.

  If the business does not disclose price increases, then it is highly probable the business does not have pricing power.

  Price increases add value to the business when they add to operating income, rather than just offsetting new expenses.

  Consider the Health of the Industry as a Whole

  Investing in the right industry is important because a large part of your potential rate of return is often attributable to the industry you are invested in, as opposed to a specific company you are invested in.

  By making comparisons between the best and worst companies in an industry, you will identify the reasons why the industry is good or bad to be in.

  The profitability of a business will eventually trend toward the mean of the industry as it is difficult for any business to outperform the industry for a long period of time.

  Understanding how an industry evolved will help you evaluate the business in the context of its competition, its operating environment, and various other forces that shape it.

  Assess the Business’s Competition

  Competition does not increase the value of a business. Generally, more competition means more customer choice and less profitability.