Transcript Capitalizing Rent Expense

Strategy & Investing
Chris Argyrople, CFA
Concentric
Corporate Strategy & Investing
1
Competitve Strategy
What is more important?
•
•
•
•
•
Price
Financial Performance (growth)
Corporate Strategy
Industry Factors
Implementation
Answer: They are All Important
Finance and Strategy must be analyzed
together.
2
Industry Analysis (Hooke: Security
Analysis on Wall Street)
• Serious research starts at industry level
• In-depth industry study is prerequisite for a
proper security analysis
• Chosen industries don’t have to be stellar
performers, they just have to be
reasonable
• Don’t be afraid to have a contrary opinion.
If you want different results than others,
you must invest in different securities
3
Competitive Strategy: The Core
Concepts (Michael Porter)
• Competition is the core to success or
failure
• Two key questions:
– Industry Attractiveness
– Firm’s Position within Industry
• Creating Competitive Advantage:
– Create value for buyers that exceed the cost
of creating it
– Either provide lower prices or more benefit @
same price
4
Structural Analysis of Industries
• Industry attractiveness is the fundamental
determinant of any firm’s profitability
• Goal of Strategy: Change the Rules in
Firm’s Favor
• Product sexiness does not drive
profitability – industry structure does
– Many high-tech industries like PC hardware
are not profitable for all participants (Compaq,
Packard Bell)
– Low-tech businesses can be very profitable:
5
Postage Meters
Affecting Industry Structure
• Most important for firms to alter industry
structure in their favor
• Not all 5 forces will be equally important
for each firm in any industry
• Each industry has unique structure
• Firms can easily destroy industry structure
(as easy as they can improve it) by
reducing entry barriers (through new
designs), or extended price cutting
6
Reaction by Competition
• Whenever firms make a move, they must
consider the competitive reactions. If
competitors imitate your price cut,
everyone could be worse off
• “Industry destroyers” are often 2nd tier
firms stretching to overcome competitive
disadvantages
• Leading firms usually dictate structure, but
anything they do usually affects all firms
7
Value to Buyer is Source of
Value
• Satisfying buyer needs is core of success
in any business
• Happy customers are necessary but not
sufficient for profitability
• Industry structure determines who
captures the value
• If buyers have lots of power, they keep the
value for themselves – leaving little for the
firms (same concept for suppliers)
8
Capturing Value
• If an industry’s product creates minimal
value – small profits for industry
• If value created for buyers, structure is
crucial:
– Autos – lots of value but small profits
– Medical Services – value and higher profits
9
Porter 5 Forces Model
Buyers
Substitutes
Industry
Rivalry
Potential
Entrants
Suppliers
10
Competition
Industry = Group of firms that produce
products which are close substitutes
** Industry factors are often more important
than firm specific issues
Example:
Highly
Profitable
Pharmaceuticals
Software
Less
Profitable
Grocers
Retailing
11
6 Major Entry Barriers
• SCALE ECONOMIES
– Can be present everywhere: Manufacturing,
Design, Purchasing, Sales, Service, etc.
• PRODUCT Differentation / Technology
• CAPITAL
• SWITCHING COSTS
– Capital PLUS Training
• DISTRIBUTION CHANNELS
• GOVT. POLICY / REGULATION
12
Advantages Independent of
Scale
•
•
•
•
PROPRIETARY TECHNOLOGY
FAVORABLE RAW MATERIAL ACCESS
GOOD LOCATIONS
GOVT. SUBSIDIES, LICENSES,
PATENTS
• LEARNING CURVE
• FIRST MOVER ADVANTAGE
13
Warning Signs
RIVALRY
Price competition usually hurts everyone
(unless it successfully drives out
competition). Beware of price competition.
It is usually very bad news for a stock.
EXIT BARRIERS - perpetuate Overcapacity
Types: Labor, no buyers for assets, govt.
restrictions, emotional exit barriers.
14
Buyer Power
• Number of Customers.
– An industry is powerful when there are many
small customers. No customer has significant
impact.
• Uniqueness of Product.
– If no substitute readily exists, then an industry
has power over customers.
• Brand Preferences.
– Buyers who prefer a certain brand (cigarettes,
15
for example) have lower power.
Buyer Power
• Size of Purchase.
– If cash outlay is low, customers do not have
power. For large purchases like automobiles,
buyers can exert power because their demand is
very price elastic.
• Switching Costs.
– High switching costs give the industry strength.
• Significance of Product Quality.
– If industry’s quality is not important (to the quality
16
of the buyer’s product), the customer will minimize
Buyer Power
• Threat of Vertical Integration.
– If a buyer has a credible threat of vertical
integration, he exerts more power.
• Information Available to Buyers.
– Lack of information about capacity, markups,
etc. put buyers at a disadvantage.
• Low Profits
17
Supplier Power
• Product Substitutes.
– Industry has power over vendors if substitutes to
the supplier’s product exist.
• Number of Suppliers.
– A large number of suppliers can’t exert influence.
• Entry Barriers in the Supplier’s business.
– If the entry barriers are low, companies can
squeeze out suppliers through vertical integration.
• Ability to Delay Purchase of Vendor’s
Product.
18
Supplier Power
• Existence of Unions.
– A unionized industry may discourage new
entrants, thus giving existing suppliers power.
• Industry Capacity Relative to Demand.
– Excess capacity in a supplier’s product line
diminishes vendor strength
• Product Differentiation or Brand Loyalty.
– Undifferentiated products with low brand
allegiance can’t exert power.
19
Supplier Power
• Importance of Supplier’s Product to
Industry’s Product.
– If the supplier’s product is unimportant to
industry quality, then suppliers have less
power.
• Industry small % of Supplier’s Sales
– Sometimes a product is too small to waste
time on
• Supplier’s Ability to Forward Integrate
into Industry’s Business
20
Product Substitutes
• Existence of Substitutes.
– How close are substitutes to your company’s
products?
• Price / Quality advantage of Substitutes.
• Advent of New Technologies.
– Usually the biggest risk – often can blindside a
slow-moving, large beauracracy.
• Switching Costs.
– Often a product is designed as a system input.
Switching requires product redesign and Re- 21
Industry Rivalry
• Industry Growth Rate is the fundamental
determinant of an industry’s
competitiveness.
– Growth: firms expand without price
competition.
• Industry Cost Structure.
– High fixed costs provide incentives to fill
incremental excess capacity at below market
prices. This is bad.
• Scale Economies.
22
Industry Rivalry
• Exit Barriers. (can increase
competitiveness) Examples:
– Government restrictions
– Emotional attachment (management,
entrepreneur)
– Unique Assets. Difficult to sell.
– Costs to close plant & layoff employees.
• Brand Loyalty and Product Differentiation.
• Switching Costs.
23
• Number of Competitors.
Industry Rivalry
• AMOUNT OF PRICE COMPETITION.
• BEWARE OF PRICE COMPETITION.
• Strategic Importance. If the business is
of strategic importance to competitors,
then rivalry will be strong. Conversely,
if some competitors have vertically
integrated into the business, they will
not be as fierce.
24
Types of Generic Strategies
1) COST LEADERSHIP
2) DIFFERENTIATION
3) FOCUS (Niche)
Cost or Differentiation Focus
Stuck in the Middle
Guaranteed Low Profitability
Firms that Switch Strategies too Often
25
Generic Strategies:
Low Cost, Differentiation, Focus
Lower
Cost
Differentiation
Broad
Target
Cost
Leadership
Differentiation
Narrow
Target
Cost
Focus
Differentiation
Focus
26
Cost Leadership
• There can only be one – don’t want to be
one of several firms vying for the spot.
• Must convince others to abandon this
strategy, depends on preemption
• Low cost producer guaranteed a good
position – at equivalent prices, the low
cost producer has higher margins
• Sources of advantage: scale economies,
low-cost designs, proprietary technology,
better access to raw materials etc.
27
Differentiation
• Be unique on some dimension that is
valued by buyers
• Get Premium Pricing for differentiation
• Differentiation can be based on product,
delivery system, marketing approach etc.
• Price Premium must exceed added cost of
differentiation to add value
28
Focus:
Cost & Differentiation Focus
• Focuser selects a target segment (or
niche) and tries to get competitive
advantage in the segment (even though
no overall advantage)
• Exploit cost advantage in certain
segments
• Differentiation focus = exploit buyers’
special needs in those segments
• Narrow focus is not sufficient for good
performance
29
Example of Focus
• Craft beer like Sam Adams –
differentiation focus
• Low cost – Royal Crown cola
30
Stuck in the Middle
• Stuck in the Middle – try to be everything
to everybody
• Firms often try to get competitive
advantage through all strategies and
achieves none
• Firm stuck in the middle can still be
profitable if other competitors are stuck or
if the industry itself is highly profitable
31
3 Conditions for being both
Cost Leader & Differentiation
•
Can simultaneously achieve both cost
leadership & differentiation if:
1. Competitors are stuck in the middle
2. Cost is affected by share or
interrelationships
3. Firm pioneers a major innovation
32
Risks of Cost Leadership
•
•
•
•
Competitors Imitate
Technology Changes
Other bases for cost leadership erode
Cost focusers achieve even lower costs in
target segments
• Proximity in differentiation is lost
33
Risks of Differentiation
• Competitors Imitate
• Bases for differentiation become less
important to buyers
• Differentiation focusers achieve greater
differentiation in target segments
• Cost proximity is lost
34
Risks of Focus
• Target Segment becomes structurally
unattractive:
– Structure Erodes
– Demand Decreases
– Segment’s differences narrow (& thus broad
competitors enter space)
– Advantages of a broad line increase
– New Focusers in sub-segment industry
35
Other Points
• Build / Hold / Harvest – this is not strategy,
these are results of strategy
• Acquisitions are not strategy – they are a
means of achieving a strategy
• Market share does not describe
competitive position. Share is not a cause
of competitive advantage but a result of it.
36
Product Life Cycle
SALES
Intro or
Startup
Growth
Maturity
Decline
Transition Phase
TIME
37
Changes in Growth
• DEMOGRAPHICS
• TRENDS (Social)
• CHANGES IN SUBSTITUTES (Cost &
Qual)
• CHANGES IN COMPLEMENTS
• PENETRATION
• TECHNOLOGY / PRODUCT CHANGE
38
Model Industry Analysis
• Industry Classification
– Life Cycle Position, Business Cycle
• External Factors
– Technology, Govt., Social, Demographic, Foreign
• Demand Analysis
– End Users, Growth, Trends & Cyclicality around
trends
• Supply Analysis
– Concentration, Ease of Entry, Industry Capacity
• Profitability
– Supply/Demand Analysis, Cost Factors, Pricing
• International Competition & Markets
39
Business Cycle
• Three Types of Industries:
– GROWTH, DEFENSIVE, CYCLICAL
• Growth Industry: above average growth
independent of the business cycle
• Defensive Industry: Stable (mostly
upward: slight dip in downturns)
performance throughout business cycle
(food, utilities etc.)
• Cyclical Industry: Earnings track the
business cycle
40
Issues in Industry Classification
• Self-deception is a key problem: once an
industry is classified as a “growth”
industry, analysts often miss its move out
of the category
• Don’t paint all industry participants with the
same brush – not all firms in mature
industry are mature
41
External Factors
Technology: What is obsolescence risk?
Government: Policy can create industries
(i.e. auto airbags)
Social Changes: Lifestyle can affect
industries (trend toward fast food etc.)
Demographics: “Greying” of America
(healthcare, golf industry)
Foreign Influences: Foreign steel & auto are
good examples
42
Demand Analysis
• Top-Down Analysis: Look for correlation
between economy & sales (example: cement
industry correlated to GNP )
• Industry Life Cycle: Where is the industry
within its life cycle?
• External Factors: Qualitative Analysis
Establish a sales forecast, often by
extrapolating trends (look for turning points)
43
Other Issues: Demand Analysis
• Customer study is key – study buying
habits
• Geographical differences
• Growth Industries – measure penetration
• Untested Industries – does product fill a
need?
44
Supply Analysis
• Supply is a function of excess capacity
• Add up capacity of all firms
• Pricing is linked to capacity: overcapacity
indicates lower prices
45
Industry Pricing
• Factors Influencing Pricing:
– Product Segmentation
– Industry Concentration
– Ease of Entry
– Price changes of Supply Inputs
46
Strategy & Investing
• Long Term Perspective
• Augments “The Numbers”
• Analyze
– INDUSTRY
– FIRM’S COMPETITIVE ADVANTAGE
• Pay Attention to:
– Cash Flow, Cyclicality
– Growth Rate & Changes in Growth Rates
– Capacity / Substitutes / Change in Comp.
Position
47
Strategy & Investing
• Great Long Term Investments have
Sustainable Competitive Advantage
• Like to Pay a Reasonable Price for firms
with a Moat around them
• Growth at a Reasonable Price = GARP
• Pay attention to Industry as much as firm
• Who has the best strategy today?
– Microsoft? - GE?
Thoughts ???
- Gillette? 48
Determining Sustainability of
Competitive Advantage
DC Mueller, in Profits in the Long Run, found
that there is incomplete regression to the
mean. Why?
Incomplete Regression to the Mean
High Return Firm
ROA
Low Return Firm
Time
49
Why Might Excess Profits
Persist?
• Maybe the high-profit groups are riskier
(thus the markets require higher returns)
• Some advantages are subtle to detect,
especially in a world where the same
resources are available to all firms.
• Why might resources be immobile?
– Culture, Brand Image, Location,
Relationships, Patents, Scale Economies,
Customer Access, etc.
50
Example of Sustainability:
QWERTY Keyboard
• Sometimes the answer is VERY SIMPLE
• QWERTY is a sub-optimal keyboard
configuration invented in 1873
• QWERTY invented to minimize typebar clashes
(we don’t have typebars anymore)
• All world records for typing have been set on the
Dvorak keyboard, invented in 1932
• Apple IIC computers came with a keyboard that
switched between QWERTY & Dvorak
• TOUGH TO GET PEOPLE TO CHANGE !!!
51
Reputation & Buyer Uncertainty
• People generally go back to the same
place to buy their gasoline etc.
• Habits are tough to break
• Once you are satisfied with a product, it is
difficult to get people to switch !!
• Why do people still buy Intel processors
when AMD might be faster & cheaper?
52
Why Early Movers Fail
• Royal Crown invented diet cola
• Lotus 123, D-Base all lost 90% share
• These firms may not have the
Complimentary Assets necessary for
product leadership
• Early movers often fail to innovate & next
generation products are superior
53
Management is the Key Variable
• Good Companies are run by Good
Management Teams
• Goodwill can be destroyed. This means
that, Long Term, people are a company’s
main assets. Example:
– 1960s, General Motors, PanAm, IBM, AT&T
were like Microsoft, Gillette, Coke, and GE
today.
– Lousy Management ruined GM, it could ruin
Coke too!
54
Evaluating Management
Characteristics of Good Management:
• Ownership interests aligned with
shareholders (i.e. they own lots of shares)
• No empire building. Acts in best interests
of stockholders. Examples:
– Increased Dividends, Stock Buybacks etc.
• Good information systems
• People Focus
• TRACK RECORD
55
Checklist for Management
Evaluation
•
•
•
•
•
How have they done in the past?
Are they buying or selling shares?
Have you listened to the conference call?
Is Mgt. more or less cautious vs. normal?
Do their actions support shareholder value
or empire building?
• Too many options grants to themselves?
• Any recent Changes to the Mgt. Team?
56