BUSINESS MODELS


Investing In Companies and Sectors with Strong Competitive Advantage 

Part 1 Chapters 1 to 3.

By DAVID WATSON

Produced in Association with The Serious Investor Groups network

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Extracts from the book Business Models can be accessed:

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‘David Watson's writing is exceptionally clear.’

Sir John Templeton, author, philanthropist, Founder of the Templeton Growth Fund and John Templeton Foundation.

‘Business Models arms investors with an unmatched and comprehensive set of weapons. Essential reading.’

John Lander, Chairman of The Serious Investor Groups network.

Buy this book at:

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for USA/worldwide customers www.amazon.com/Business-Models-D-Watson/dp/1897597584/sr=1-1/qid=1157620988/ref=sr_1_1/002-3169678-1307266?ie=UTF8&s=books

 

 

Synopsis of Business Models

Different

Business Models is different from other investment books because it breaks new ground. It deploys 129 business models to empower an outside investor to analyse the internal competitive advantage of companies and sectors.

Competitive advantage

Strong competitive advantage is only achieved by having low costs and/or doing something different from the competition. This must add value to the customer, who then pays a premium price. He is glued to the company, which will earn dependable revenue streams and be in the profit zone.

Key features

·        64 company business models are scored for competitive advantage. They include moats, recurring revenues, product differentiation, bolt-on acquisitions and bargaining power.

·        65 sector business models are scored for competitive advantage. They include recession resistance, must-have products, sticky customers, toll bridges and megatrends.

·        The economic cycle is the ultimate arbiter of investment success or failure.

·        Other important tools are growth at a reasonable price, technical analysis, scuttlebutting, accounting for growth and investment axioms.

·        Conclusion Business Models unearths the best companies to outperform in a bull or bear market, giving investors a real advantage. They can correctly evaluate a company or sector in 15 minutes and emulate Warren Buffett, who uses business models to invest in companies with strong competitive advantage.

 

Publisher

HARRIMAN HOUSE LTD

43 Chapel Street

Petersfield

Hampshire

GU32 3DY

GREAT BRITAIN

Tel: +44 (0)1730 233870

Fax: +44 (0)1730 233880

email: enquiries@harriman-house.com

web site: www.harriman-house.com

 

First published in Great Britain in 2005

 

Copyright Harriman House Ltd

 

The right of David Watson to be identified as the author of this work has been asserted in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, copying, recording, or otherwise, under any circumstances. © 2004.

ISBN 1-897-59758-4

Stock market investments can go down as well as up and the past is not a guide to future performance. Securities or shares mentioned in this book are for illustration purposes only and are not a recommendation. Prices, valuations, analysis, business models and competitive advantages were at the time of writing.  They are no longer up to date because prices, profit forecasts and business models continually change. What may be attractive today can be unattractive tomorrow and vice versa. Seek your own professional advice before dealing in securities. Neither the Publisher nor the Author accepts any legal responsibility for the contents of this book or for any errors, inaccuracies or omissions. The liquidity of some securities may be poor and this should be evaluated before making any investment, particularly in smaller companies.

No responsibility for loss occasioned to any person or corporate body acting or refraining to act as a result of reading material in this book can be accepted by the Publisher, by the Author, or by the employer of the Author.

 
Contents                                                              Page

About the author                                                                     v

Acknowledgements                                                                  v

Foreword                                                                                vii

Glossary                                                                                  ix

Introduction                                                                            xiii

Summary of this book                                                             xiv

 

1. Business models: investing in companies                         1

with strong competitive advantage

1. Competitors                                                                         10

2 Customers                                                                             18

3. Economics                                                                            30

4. Management                                                                         44

5. Products                                                                               56

6. Suppliers                                                                              72

 

2. Business models: investing in sectors                              75

with strong competitive advantage

1. Competitors                                                                         80

2. Customers                                                                            84

3. Economics                                                                            89

4. Management                                                                         100

5. Products                                                                               102

6. Suppliers                                                                              116

7. Sectors to avoid                                                                   118

 

3. Shifting deck chairs on the Titanic                                    125

1. The economic cycle                                                  126

2. The cycle of opportunity                                                       136

 

4. Which sectors to buy and sell during the              139

economic cycle

 

5. Growth at a reasonable price                                            181

1. Growth statistics                                                                   182

2. Value statistics                                                                      185

3. Further considerations                                                           187

4. Trading                                                                                 189

 

6. Technical analysis                                                  191

1. A useful tool to improve performance                                    192

2. A chartist’s view                                                                   193

 

7. First-hand experience of the product:                               207

scuttlebutting

 

8. Accounting for growth                                                        219

1. Broker forecasts                                                                   221

2. Cash flow                                                                             224

3. Dividends                                                                             227

4. Goodwill                                                                              231

5. Share options                                                                       236

 

9. Investment axioms                                                             239

Conclusion                                                                              259
Appendix                                                                                263

1. Example of a company’s business model: Radstone   264

Technology

2. How Microsoft triumphed because of its business model        272

Further information                                                                   282

Index                                                                                       285
Index of tables

Chapter 1. Company business models                                7

Chapter 2. Sector business models                                               77

Chapter 4. The economic cycle of opportunity                144

Conclusion Company scoring using all six tools               260

Appendix 1. Company business model                           270

Appendix 2. Company business model                           279

About the author

 

David Watson read a bachelor’s and master’s degree in economics and finance at Manchester University. He is a Fellow of the Institute of Chartered Accountants, qualifying with Price Waterhouse in London. He has extensive UK and international business experience, principally in financial services and media, and was Deputy Editor of Investing for Growth, an investment newsletter first edited by Jim Slater, author of The Zulu Principle. He welcomes comment and feedback and can be e-mailed at businessmodels@gmail.com.

 

Glossary

 

Beta

Beta measures how much a share price movement correlates with a movement in the stock market. A high beta share has a value over 1.0 and its price has historically increased or decreased more than that of the market. A low beta share has a value under 1.0 and its price has historically increased or decreased less than the market. Betas are shown in Yahoo Finance under each company’s details, as well as in REFS (Really Essential Financial Statistics).

 

Business model of a company

A business model describes a company’s operations, including all of its components, functions and processes, which result in costs for itself and value for the customer. Its goal is to achieve low cost and differentiate itself from the competition. This depends on having good economics, management and products, plus power over customers, competitors and suppliers, which result in strong competitive advantage.

 

Business model of a sector

A business model describes a sector’s competitive advantage and is derived from a set of factors or capabilities that allows consistent outperformance. This depends on having good economics, management and products plus power over customers, competitors and suppliers, which result in strong competitive advantage.

 

CEO

Chief Executive Officer.

 

Commodity product

Commodity products, such as sugar and steel, lack differentiation. Price is the single most important factor determining a purchase and competition is intense.  The low-cost producer triumphs and the quality of management is crucial.

 

Contrarian

An investor who does the opposite of what most investors are doing at any particular time.

 

Dead cat bounce

A quick, moderate rise in the price of a share following a precipitous decline.

 

Defensive

A defensive company has inelastic demand and is recession resistant.

 

Differentiation

One of the two ways to achieve competitive advantage is for the company to do something different from the competition that adds value to the customer and can take place anywhere in its value chain. It is most obvious in the end product but could be in logistics, management, quality of inputs, delivery times, etc.

 

EPS

Earnings per share, after tax, are the amount attributable to the shareholder to pay as dividends or retained in the company.

 

Factors of production

The four factors of production are land, labour, capital and enterprise, and contribute to the production of a product or service.

 

Gearing

Debt financing, and is another word for leverage.

 

Goodwill

Goodwill is an intangible asset that cannot be touched or counted. It may provide a competitive advantage, such as a strong brand, reputation and expertise.  Purchased goodwill is the difference between the cost of buying a company and the book value of its net assets.

 

Gorilla

A gorilla is a dominant company, usually a blue chip, and is typically overvalued with modest growth prospects.

 

He

For purposes of brevity, ‘he’ includes ‘she’.

 

KISS

Keep It Simple, Stupid.

 

Leverage

Debt financing, and is another word for gearing.

 

Long

Being long means investing in a share or market. The opposite is being short, as explained below.

 

Low-cost activities

One of the two ways of achieving competitive advantage is for the company to have low-cost activities in its value chain. Differentiation is the other way.

 

Low-ticket items

Low-ticket items are products or services that sell at a low price.

 

PER

Price earnings ratio.

 

Player

A player is a company in a sector.

 

Product

A product is not just a physical good but can also include a service.

 

Reach

Reach is the ability of a company or sector to operate nationally or globally.

 

Scalable

A scalable business can easily and quickly expand to meet increased demand.

 

Scuttlebutt

Scuttlebutt means assessing a product or company by testing it for yourself through empirical observation.

 

Short

Short means selling shares that an investor, or ‘shorter’, does not own. The expectation is that the share price will have fallen below the investor’s agreed selling price when the contract is settled. He can then buy the shares to cover the contract and make a profit.

 

Sticky customer

A sticky customer tends to continue to buy from a company because of factors such as habits, inertia, switching cost or lack of knowledge.

 

Stop loss

An order to a broker to sell when the price of a security falls to a designated level. This locks in a profit or stops further losses being incurred.

 

Transactional

Transactional customers are one-off, as compared to repeat customers.

 

TMT mania

TMT was the technology, media and telecommunications mania that ended in 2000.

 

Value added

Value added means that the company has combined its inputs in a way that creates demand from the customer and results in profit. It can be created anywhere in its value chain.

 

Value chain

The value chain is all the activities and costs of a firm in the entire production process from the initial receipt of inputs, then processing and resulting in the final output.

 

Page xii

Introduction

 

129 business models

‘Between every individual and his tomorrow a veil is drawn. There are ways by which this veil can be penetrated to some extent.’

Laurence Sloan, author of Everyman and his Common Stocks.

Mankind has three main goals in life: seeing the future, amassing wealth and living forever. They are recurring themes in novels and films, as well as in people’s private lives and thoughts. This book occupies the space of the first two of these, as it should enable an investor to see the future performance of a company and, in doing so, increase his wealth. Living forever is left to others.  This book is different from other investment books because it breaks new ground by assessing the business models of companies and sectors. It provides critical tools that enable an investor to assess whether a company’s business model leads to strong competitive advantage and if it is in a sector that, in turn, also has strong competitive advantage. It casts a keen eye on the economic cycle, the ultimate arbiter of an investor’s success or failure. Other important tools are growth at a reasonable price, technical analysis, scuttlebutting, accounting for growth and investment axioms. The 129 business models are used to analyse companies and sectors. For example, a company may be in a favourable sector but has frittered away this tailwind through incompetence. Likewise, it may be superbly run and very profitable in spite of being in a dreary sector. These tools are designed to unearth the very best companies to outperform in a bull market. They should also thrive in a bear market and minimise the chance of a profit warning. Thus, the investor has a real advantage over those who lack this knowledge.

Summary of this book

The first four chapters are the most important.

Chapter 1. Business models: investing in companies with strong competitive advantage

This chapter is the core of the book and examines 64 business models. The aim is to choose companies that have sound business models. This is achieved by having low costs and/or doing something different that adds value to the customer. The result is strong competitive advantage, leading to superior profits. 

Chapter 2. Business models: investing in sectors with strong competitive advantage

Having selected companies with sound business models, the next step is to ensure that they are in attractive sectors by examining 65 business models leading to strong competitive advantage. Both the company and the sector should have the ability to mould the economic world their way rather than being under the power of others. We also examine companies and sectors that should be avoided. If a company does not have a sound business model in a sector with strong competitive advantage then it can be readily dismissed. If it does pass the test, then further consideration can be justified, as discussed in the remaining chapters.

Chapter 3. Shifting deck chairs on The Titanic

The company’s attractions are further strengthened by being in a favourable place in the economic cycle. Buying and selling at the right stage of the cycle and moving between different asset classes is a prime determinant of investment success. Ignoring the economic cycle is like pointlessly shifting deck chairs on The Titanic to obtain a better position, oblivious of the iceberg ahead. 

Chapter 4. Which sectors to buy and sell during the economic cycle

Each of the sectors is scored according to its recession resistance and competitive advantage. Having identified those that offer the greatest investment opportunity, they are then assessed according to when they should be bought and sold during the economic cycle.

Chapter 5. Growth at a reasonable price

The share must offer growth at a reasonable price. Seek to invest in established companies that have a reasonable PER combined with profits growing strongly and at a sustainable rate.

Chapter 6. Technical analysis of the company and sector

The trend in the price graph is your friend, so aim to buy shares that are rising and sell those that are falling. The relative strength of the share is a proxy for technical analysis and is a very important tool.

Chapter 7. First-hand experience of the product or scuttlebutting

First-hand experience of the product or ‘scuttlebutting’ can be very useful in detecting early warning or success signs that the City has not spotted.

Chapter 8. Accounting for growth

In a world of spin and declining financial morality, it is important to understand what the financial results really mean and how to avoid companies which ‘account for growth’ in order to mislead the unwary.

Chapter 9. Investment axioms

The investment axioms, or rules, summarise a total of 1,000 years of trading experience from 35 of the greatest investment gurus. These valuable lessons should enable you to avoid pitfalls and enhance your gains.

Conclusion

This book sets out six tools to help investors choose shares that outperform.  These tools are wrapped up in a simple table to rate a company’s attractiveness overall.

Summary

This methodology may seem a tall order in choosing to buy and sell shares but a familiarity with these tools is invaluable in asking the right sort of questions. For example, if you rely on a professional advisor, such as a broker, ask him the next time he recommends a share: what is the business model of the company and sector and do they have strong competitive advantage? Is this share well positioned in the economic cycle? Does it offer growth at a reasonable price? Is the share price in an up trend? Is there any accounting for growth? Do not be surprised if there is deathly silence at the other end of the phone, in which case you should go elsewhere.

A moderate grasp of this methodology should enable the private or professional investor to correctly evaluate a company in 15 minutes and dismiss the vast majority in much less time. This is how long an evaluation can take Warren Buffett, who uses business model analysis to avoid commodity businesses and invest in companies with strong competitive advantage.

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CHAPTER 1

Business models: investing in companies with strong competitive advantage

Page 1

What is a business model?

‘Competitive advantage is based not on doing what others already do well but on doing what others cannot do as well.’

John Kay, economist.

A business model describes a company’s operations, including all of its components, functions and processes, which result in costs for itself and value for the customer. Therefore, it is how the engine of the business actually works. The objective is to have low cost and high value and thus maximise profit. All attractive business models will have some magical secret or ‘pixie dust’ and the investor’s task is to find it. More importantly, it is to discover the pixie dust that others cannot see. A company’s strategy of combining the four factors of production, namely land, labour, capital and enterprise, will determine its unique business model, the superiority of which over the competition is a crucial determinant of sustainable, competitive advantage. The ability of a company to achieve this is largely determined by the competitive advantage of the sector, which is discussed in chapters 2 and 4.

Business models are not a new phenomenon. They have existed since time immemorial, whether it was the success of the Roman Empire, Christopher Columbus’ discovery of the New World or the advent of the industrial revolution.  For example, an excellent and simple business model was the monasteries in Britain. They usually received a free grant of land from a pious king and set up shop. The land was expanded by gifts from local landowners, such as knights, who had an eye on the afterlife. It was grazed by sheep that added great value just by eating what nature provided free. All that was needed was to cut white gold off their backs. This enabled fabulous monasteries to be built and furthered their expansion and power. This virtuous circle continued for centuries until eventually these tycoons owned two million acres or a fifth of all cultivated land. There were 600 establishments with 40,000 people, enjoying a mouth-watering income, given their strong competitive advantage. Then Henry VIII and rapacious politicians decided to confiscate them and sell the assets to private individuals in an early form of privatisation.

Why are business models so important?

An attractive business model (also called a franchise by some people, like Warren Buffett) is of crucial importance in choosing winners. It can only be achieved in two ways, both of which management must comprehend and sustain:

Page 2

 

a. Low cost

If a company has the same costs as competitors, then it will have the same profits.  Superior profits will, however, be earned if costs are lower and bite less into revenues. Therefore, the strategy is to have the lowest-cost business model compared to the competition. This can be done in a variety of different ways, such as by being number one in the sector, having excellent management, a modest head office, power over suppliers, and superior raw materials, buying skills, technology and quality control. There are trade-offs, so, for example, cost savings on quality of inputs may lead to more product rejects, thus increasing overall cost. Value is added to the customer if his costs are lowered and this can be achieved through a variety of means, such as increased reliability, being easier to use and therefore needing less training, an extended free warranty or insurance, cheap financing and just-in-time delivery.

 

b. Different

A company should strive to do something different from the competitors in its ‘value chain’, which is all the activities and costs in the entire production process from the initial receipt of inputs, then processing and resulting in the final output.  If it does the same as competitors, then customers have no reason to prefer it and it will earn the same, rather than superior, profits. The value the company captures from differentiation depends on the price charged and profit margin earned, rather than the cost borne by the customer. Thus, if a company succeeds in erecting high barriers to entry then it could charge a premium price and earn a high profit margin. However, the cost borne by the customer would be higher than if the barriers did not exist.

Companies often focus on creating differentiation in their product, but it can be done anywhere in the value chain, which encompasses competitors, customers, economics, management and suppliers. However, product differentiation is singled out because of its prime importance to the customer. It must be valuable to him, either by lowering his cost and/or increasing the utility of the product.  Either way, if it offers better value it will be bought instead of the competition’s product. The differentiation must be both real and understood by the customer.  For example, there could be a wonderful product but the customer may be oblivious of its benefits. There are trade-offs, so, for example, a firm may focus on improving reliability but also cut back on the length of the guarantee.  Consequently, the product is better but the customer may be unaware of this and choose a substitute with a longer guarantee.

Page 3

Sources of product differentiation include advertising, customer care, management, delivery time, guarantee, quality, reliability, reputation and service.  One example of a differentiated product is the BBC. It does not have irritating advertisements and has two terrestrial channels so it can readily cater for minority audiences.

Companies that do something different in their value chain are attractive investments and are contrasted with commodity products and commodity-type businesses. Commodity products, such as sugar and steel, are indistinguishable from one another and so lack differentiation. Price is the single most important factor determining a purchase and competition is intense. The low-cost producer triumphs and the quality of management is crucial. Companies can have commodity-type businesses where little value is added and price competition is paramount, such as box-shifting distributors. Such activities are unattractive and should be avoided as they have poor competitive advantage. The future belongs to those companies that have products containing less material and more thought.  This combination is often difficult but it frustrates the competition and is more highly prized by customers.

The holy grail

‘When I was young I used to think that wealth and power would bring me happiness. I was right.’

Gahan Wilson, cartoonist.

Competitive advantage stems from low cost and/or differentiation. The holy grail is for the extra cost of being different to be less than the premium price charged to customers. If the extra cost is higher than the premium price, then profits will be less than those of competitors. For example, a restaurant chef may want to use top quality ingredients to produce superb food but the extra cost may exceed the higher price charged, thus leading to lower profits.

There can be trade-offs between lower costs and being different. A bar may serve cheap, unbranded drinks to lower costs but customers might reject the taste or image, thus reducing the ability of the firm to differentiate itself. Firms should concentrate on finding out what really matters to customers and satisfy those wants that cost little or nothing to provide. Thus, a software company may discover that customers really want technical support and this could be satisfied by a trouble-shooting page on the internet at minimal cost, rather than a telephone support centre.

Page 4

All-weather shares not share price killers

The combination of low cost and motivated customers choosing to buy from a company, rather than a competitor, and at a premium price means it will have strong competitive advantage. This results in superior, sustainable and growing profits. The operating risk of the company will also tend to be low and the predictability of profits should be greatly enhanced. The strong control over revenues means that the share should be resilient throughout the economic cycle and, as such, will be more suitable for ‘all-weather’ not just ‘fair-weather’ stock markets. This minimises the chance of profit warnings, which are share price killers. Companies with no competitive advantage are hammered in a bear market, whereas those with strong competitive advantage tend to be de-rated much less and are quick to recover. Note that competitive advantage stems from what companies do, rather than from such ‘advantages’ as being a ‘gorilla’ (blue chip company) or having a leading market share. This is a common misconception, although these advantages could be important if the companies had a low-cost or differentiated business model.

A strong business model also means that if the share price weakens then an investor should be confident that the setback is likely to be temporary because the company is sound. He will be less worried about selling at the first whiff of a falling share price. This is because buyers will be tempted back and thus push up the low share price. It is also a buying opportunity for contrarians, who are investors that do the opposite of what most investors are doing at any particular time. Some companies have better business models than others within a sector, just as some sectors have greater competitive advantage than others. Both are subject to constant change and this can happen swiftly. The mission is to find companies with excellent business models in the best sectors, which are likely to be comprised of many profitable companies that have low costs and/or different activities that add value to the customer. However, there can be profitable companies in unattractive sectors and vice versa.

64 company business models

Sixty-four company business models are now examined in detail and, although this list is not exhaustive, it is designed to cover the main points. Six factors determine the strength of a business model that gives a company its competitive advantage, which is achieved through low cost or differentiation. These factors are: having good economics, management and products, plus power over customers, competitors and suppliers. This format is also used to analyse the Sixty-four company business models are now examined in detail and, although this list is not exhaustive, it is designed to cover the main points. Six factors determine the strength of a business model that gives a company its competitive advantage, which is achieved through low cost or differentiation. These factors are: having good economics, management and products, plus power over customers, competitors and suppliers. This format is also used to analyse the

Page 5

competitive advantage of sectors in the next chapter. A summary is provided in the table below, for ease of reference, that can be a useful checklist for investors to evaluate any company. Some companies feature several times and the aim is for candidates to score well in numerous business models, not just one or two. A worked example, Radstone Technology, illustrates this point in appendix 1. Business models, prices and valuations are in a constant state of change, given the fluctuations in the economy and unfolding events. Therefore, examples of companies and sectors given are illustrations of the points being made and are not recommendations. Indeed, it is the test of a company that its business model does change over the medium term, which is about five years. This ensures it moves to where the profit zone has shifted. Otherwise, it will become marooned in a profitless zone as competitors encroach. For example, it may be necessary to enter a new sector, as South Staffordshire did when it moved from the water to the support services sector.

All business models are not equal

‘Look for companies that have high returns on capital, strong balance sheets, sustainable competitive advantages and shareholder-oriented management.’

Joe Mansueto, founder of investment information provider Morningstar.

All business models are not equal, as some are more powerful than others.  Consequently, the company business models table overleaf scores them on a rating of 1, being the highest, to 5, being the lowest. These ratings are inevitably subjective and some could arguably be moved up or down to an extent but a top rated business model would unlikely to be relegated to the bottom or vice versa.

Page 6

Company business models table

 

The Company Business Model table can be viewed on the following link 

Companybuusinessmodelstable.pdf

Or on page 7 here:

http://www.harriman-house.com/businessmodels/extracts/Chapter_1.pdf

 

Page 9

The competitive advantage points from 1 to 5 in the table above are awarded according to the business model’s power to achieve low cost and/or differentiate itself from the competition. Above all, it is crucial for a company to be able to control its revenue streams. Consequently, those that score the maximum 1 are: moats, longterm contracts, recurring revenues, focus on competitive advantage, owning the standard, product differentiation and bargaining power over suppliers. Medium scorers include selling directly and lean manufacturing. At the bottom of the pile are those that do not have a major impact on revenue streams or have limited applicability, such as supported by a famous personality and changing sector and index. This same scoring is used for the sector table in the next chapter and includes business models to avoid.

As noted above, a company should have multiple business models and be scoring well throughout to be highly-rated, as this strengthens their overall competitive advantage. For example, Radstone Technology has erected barriers to entry, put a moat around its business and does not have intense competition. JVC owns the VHS industry standard and is also a brand. Diageo is five times bigger than the number two gorilla in beverages, SABMiller, and thus dominates the sector, owns the customer and has some of the best brands in the world. Microsoft owns the standard, it piggybacks on the work and growth of others and is a brand.

1. Competitors

‘I read the annual report of the company I’m looking at and I read the annual reports of competitors – that is the main source of material.’

Warren Buffett, CEO of Berkshire Hathaway.

Companies with sound business models will be able to compete. This section examines some ways that this can be achieved and is also a guide to analysing the threat from competitors.

1a. Barriers to entry and exit: competitive advantage rated 2

A company’s business model is attractive if it has erected high barriers to entry.  An example is Microsoft which has largely locked out the competition by owning the industry standard in computer operating systems with its Windows product.

The barrier stops new companies entering the market, which would otherwise increase capacity and put pressure on prices. Avoid companies that seek to diversify into sectors where such barriers exist, as it is likely to be an uphill

 

Page 10

 

struggle. There are many forms of barriers to entry. A classic barrier is the pyramid, where companies have cheap and cheerful products at the base and high margin products at the top. The base is protected by a firewall of low prices and brands to stop competition from attacking it and working their way up the pyramid to the top where the pot of gold lies. Japanese car makers penetrated such a barrier in Western markets by starting with building British motorbikes and cars under licence and steadily moving up the value chain to compete in the luxury market with brands like Lexus. Sheer size can be an important barrier, such as in steel and mining which need large economies of scale to operate efficiently. Life insurance companies and banks need national coverage with the attendant branches and marketing organisation. The cost of complying with the formidable regulations is significant with HSBC, for example, having to contend with over 350 bodies worldwide. Establishing a brand name may be very difficult in a crowded market where consumers are reassured by an existing brand they trust.

Licences are effective in stopping new entrants. For instance, the number of black cabs in London or commercial television stations is controlled by the authorities.  Know-how and proprietary products provide effective barriers, as in the case of Radstone Technology with its made-to-order, rugged computer boards. Large international professional firms, such as accountants and lawyers, win multinational accounts because they provide worldwide service, which is not feasible with smaller competitors who are locked out of the bidding. A professional recruitment company like Michael Page can often be the first port of call, as it has a leading database of candidates thus offering more choice. The barrier could be location, as is the case with the few available sites for supermarkets and airports.

The barriers to entry may be low, on the other hand, but the reaction of existing players may still be effective in preventing new entrants from establishing a foothold, for example, by threatening a price war. The existing players may dominate the available distribution channels, such as in newspapers, with the likes of John Menzies and WHSmith. Another illustration is the restriction on the location of dispensing pharmacies near doctors’ surgeries, where the demand for fulfilling subscriptions is high. A new entrant is locked out by being unable to obtain a site. There are low barriers to entry in telecommunications, thanks to the regulator, and a myriad of both large and small resellers provide ferocious competition. Providing office plants has low barriers to entry but Rentokil Initial has been adept at winning new customers before some of the competition was even aware of the opportunity.

 

Page 11

 

Conversely, an attractive company should have low exit barriers so it can easily leave the sector should the need arise. For example, a struggling holiday operator can easily leave that sector and cut its losses. By contrast, heavy industry, such as aluminium, coal or nuclear power, may face crippling exit costs and it may be cheaper to carry on. This creates a profitless zone for all players.

1b. Being number one or two in the sector: competitive advantage rated 2

‘We are watching the dinosaurs die but we don’t know what will take their place.’

Lester Thurow, MIT economist.

 

Being number one or two in the sector implies that the company has achieved competitive advantage to reach this position, examples being BP and Royal Bank of Scotland. It can be particularly attractive if the number one company is much bigger than the number two, say by a factor of five times, as it can then reign supreme in the sector. Coca-Cola, for example, has half of the world soft drink market whereas Pepsi has a fifth. The advantages of being the top dog include: economies of scale; tying up suppliers; dominating distribution channels; superior know-how; advertising; and brands. These can be important sources of low cost and differentiation, the two essential ingredients of competitive advantage. However, size is not everything, and gorillas are a list of yesterday’s winners rather than of tomorrow’s. Many with dominant market share face problems, such as intense competition and adding little value. Consequently, profits have been eroding, at the likes of Invensys, BT and ICI. Market share does not translate into a successful business model unless the company has competitive advantage, like Diageo and Tesco who add value and possess strong brands. The single-minded pursuit of market share is a dazzling but flawed strategy for many companies, such as Vodafone, which has been a key ingredient in curbing net profit. It is crucial to think of customers and profit first and then determine an appropriate business model, rather than have preset ideas and strategy and hope that customers and profits emerge at the end. 

 

The problem with a gorilla is what to do next. Its big disadvantage is its very size, because it may not be able to grow by much more than that of the overall market.

The recourse is often to grow via acquisitions, but studies have shown they generally destroy shareholder value. Blue chip companies’ shares tend to be overpriced and bought because they are well known. Although they seem to offer the allure of stability, they can fall dramatically from grace, like British Energy, ICI, Invensys, Marks & Spencer, Railtrack and Royal & Sun Alliance, and are no

 

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panacea for protecting your wealth. Further, once they are troubled, they are like an oil tanker and take considerable time and money to turn around, with no guarantee of success. High exceptional costs can be expected during such restructurings and these destroy shareholders’ wealth. 

A gorilla can dominate the market by setting prices and standards, launching new products and controlling the entrance and exit of competitors. A second division player may be weak and takes what crumbs it can from the table if it lacks strong competitive advantage. It may have to accept the ruling price set by the gorilla if it is unable to lower its price to gain new customers, either for fear of retaliation by the gorilla or because production constraints inhibit increasing output.  Examples of well-known companies that are gorillas include Microsoft, Vodafone, HSBC, Sony and Toyota. Second division companies include mmO2, Bradford & Bingley and Fiat. Buying shares in a company like Microsoft or Vodafone when they are small but have the tenacity and competitive advantage to become the gorilla can be one of the most rewarding plays in the stock market.  A sensible strategy is to sell when growth tails off and look for the next upstart.  One way to spot companies making this transition is to look at those quickly moving up through the ranks from one FTSE index to the next. These movers are published quarterly and this information is widely available. The main FTSE indices are AIM, Fledgling, Small Cap, mid 250 and 100. 

Gorillas are able to attract the top talent, so the management is usually the best around but often excessively paid, judging by the wrath expressed by shareholders. Moreover, they are usually run by ‘employee’ directors on a salary rather than being run with an ‘owner’s eye’ by founders with a substantial stake in the business. Employee directors can also damage the company by empire building using shareholders’ money. They can have conflicts of interest due to share options, which encourage ‘accounting for growth’ and maximising profit in the short-term rather than the long-term.

1c. First and late mover advantage: competitive advantage rated 2

 

‘If you gave me $100 billion and said take away the soft drink leadership from Coca-Cola, I’d give it back to you and say it can’t be done.’

Warren Buffett

 

To be the first mover in a new sector can be a great advantage for a company over the choice of sites, personnel, partners, sector standards, quality of product,

 

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pricing, distribution channels, brands, etc. There have been many examples of this, such as railways, mining, shipping, canals and textiles in the past, and technology and telecommunications in the present. It is more difficult for new entrants to gain market share after first movers are established, whose steep learning curves can be a source of competitive advantage as experience often leads to lower costs.

If the market is growing rapidly then the first mover may not be able to keep up with demand and, for the sake of the health of the sector, may not be too perturbed by new entrants. Usually, however, it will fight to maintain its dominance. Coca-Cola, Ford and McDonald’s are instances of companies with first mover advantage that are still dominant in their sectors. Microsoft was an early mover in operating systems and triumphed over IBM, which was largely the latter’s own fault as it did not insist on owning the rights to the software. In the UK, first mover examples include Shell and Lloyds TSB. 

First mover advantage may be from a new process in an established sector. An example is Telecom plus, with its one database controlling all the services sold to customers and presenting just one bill. This is very hard for the gorillas to replicate because they have separate and cumbersome computer systems. The Japanese have been keen to grab first mover advantage and rush out a rudimentary prototype of a new product, such as automatic cameras and video, and refine them with later versions, as has Microsoft. 

However, there can be advantages in being a late mover. This tends to happen when the new sector is very risky and costly. Many mistakes can be made along the way and a late entrant can avoid them, benefiting from the efforts of the pioneers in establishing the work force, technology and infrastructure, and buying their assets in a fire sale. A classic example is the debris of TMT, which was the technology, media and telecommunications mania, after its collapse in 2000, with companies bombed out and billions wasted. For example, BT was forced to sell off some good businesses cheaply, such as its Yellow Pages, to prop up its battered balance sheet.

1d. Lack of competition: competitive advantage rated 2

Companies are more attractive if they lack competition, a position gained through low cost and/or differentiation. Radstone Technology makes rugged computer products for use in military hardware, such as planes, and does not have intense competition. When it comes to protecting high value assets and operators’ lives, saving a few pounds on components is not high on the priority list. Quality and

 

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delivery are more important so customers are not price sensitive. Its competitive advantage is based on a strongly differentiated, ‘must-have’ product that is very cost effective. The sales contracts are long-term, which secures revenue for years, and helps to shut out the competition. Albemarle & Bond has a chain of 53 pawnshops with a strongly differentiated product. Almost all its customers live within two miles of each outlet, allowing it to dominate the area and achieve a high level of repeat business. Since physical goods are handed over the counter, competitors’ other normal channels to market, such as post or phone, are not a threat. This controlled customer base is cross-sold ancillary products like unsecured loans and pay day advances.

Supermarkets and retailers have intense price competition. Their ‘known value items’, such as milk and bread, are largely commodity products and are easy for price-sensitive consumers to judge. The competition in media is intense, as people are usually short of time, inundated with supply and have many compelling, alternative claims on their disposable income, such as mobile phones and cars. This makes life hard for newspapers, books, television, music and cinemas. The fiercest competition may increasingly be from the internet, where price comparison is but a click away. Some products are free, such as music and films which are swopped by consumers on the internet, and it is difficult for companies to combat this threat to their revenues. Holiday companies regularly have to discount prices to tempt customers, as over-capacity is often prevalent and consumers wait for last minute bargains.

Swap an investment in a company facing strong competition for one that is shielded from it. Incumbent gorilla utility companies, like BT and British Gas, used to have an easy life. Then their sectors were opened to a multitude of competitors. They relied on customer inertia rather than keen pricing to stem the lost sales but it is a strategy of death by a thousand cuts. A nimble, fast growing company like Telecom plus is a more attractive prospect than BT. British Airways is a full cost carrier and is under tremendous pressure from fast growing, no frills airlines like Ryanair and easyJet. Their business models are similar to the very profitable Southwest Airlines that pioneered low-cost airlines in the US. Neither was British Airways successful in trying to emulate the competition by starting its own low-cost carrier. BAA, the national airport operator, may have competition from regional airports but they are small and in remote locations. It earns low risk landing fees and makes money from its monopoly retail outlets.  BAA faces far less competition than British Airways and is more attractive on this score.

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1e. Moats: competitive advantage rated 1

‘Wonderful castles, surrounded by deep, dangerous moats where the leader inside is an honest and decent person. Preferably, the castle gets its strength from the genius inside; the moat is permanent and acts as a powerful deterrent to those considering an attack; and inside, the leader makes gold but doesn’t keep it all for himself. We like great companies with dominant positions, whose franchise is hard to duplicate and has tremendous staying power.’

Warren Buffett

 

A company with a moat around the business can powerfully ward off competitors and has the highest competitive advantage rating of 1. Sometimes the moats are benign and filled with water, whereas others are infested with sharks. One example is Microsoft, which will leave players alone in some areas or collaborate with them, if it so chooses, but will fight fiercely if anyone tries to cross or even approach its moat. Evidence for this was its demolition of Netscape, which has been the subject of court action, as outlined in appendix 2. Warren Buffett’s objective is to widen and deepen the moat round Berkshire Hathaway every year and he reports his progress, or otherwise, in achieving this goal. By any measure, he has been successful.

One classic way to build a moat is to take out the competition by various means, examples being: acquisition (banks and insurance companies); price wars (newspapers); and patents (pharmaceutical companies). Customers themselves can strengthen the company’s moat by increasing their loyalty, turning them from being one-off, or ‘transactional’, into long-term customers. Also, they can shun the competitors, examples being the protests against Shell in Germany and fast food in France. Radstone Technology’s moat is strengthened by sending its technicians to the customer’s site to develop the rugged computer products. The technicians can then inform them of new products and are in pole position to make sales, compared to little known competitors who have to resort to banging on doors. Microsoft shares its computer codes with favoured partners, including Hewlett Packard, Intel and Logitech. This minimises compatibility problems, for example, and gives them an advantage over competitors.

Moats can be made by the ineptitude of competitors, such as that of British car manufacturers in their largely self-inflicted death throes in the 1970s, due to shoddy products and strikes. This handed success to the Japanese and Germans, whose differentiated cars were well made by a motivated workforce and offered value for money. Another example was British Airways’ ‘dirty tricks’ campaign

 

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against Virgin. It was the height of foolishness to alienate its customers, given that British Airways did not compete on price but heavily relied on their loyalty.  It compounded this error with its infamous decision to replace the union flag on its tail wings with what looked like graffiti, incurring the public ire of Margaret Thatcher. Gerald Ratner made a famous speech belittling the jewellery sold in his jewellery chain and said ‘what we sell is crap’. It was a spectacular own goal that should have had its competitors rubbing their hands with glee.

1f. Threat of substitute products: competitive advantage rated 2

Companies have strong business models that suffer little from the threat of substitute products, one example being superior plastic corks supplanting wood corks in wine bottles. A substitute is a potential impediment to the quantity and quality of output and can cap the price a company can charge, given the fear that the customer can shop elsewhere. Remove that fear and the company can do pretty much what it likes. An extreme case was the East German Trabant car that remained unaltered in its appalling state for decades, as every one was sold for a high price and had a long waiting list. Microsoft’s Windows operating system is routinely pre-installed in personal computers and has a 90% market share. There are operating system substitutes from the likes of IBM, Macintosh and Linux, but the consumer lacks knowledge and choice. He does know Microsoft, however, and is very wary about straying from the well-trodden path with such a complicated product. Consequently, Microsoft has an immensely powerful, monopolistic competitive advantage.

The threat of substitution can be low because of a company’s superior product or control over the customer. For example, banks and stockbrokers control customers who are described as being ‘sticky’ because they wish to avoid the hassle or cost of changing the account to another provider, so accept the product on offer. Another reason may be due to customer ignorance. A tourist chooses a busy restaurant in a town square and is unaware of better alternatives in a back street or is unable to make a rational choice through lack of information. A company may have no wish to substitute since it may want return favours from the existing relationship. Examples include beverage companies that need the distribution channels provided by retail chains, such as pubs; investment funds that receive refund commissions from selected stockbrokers; and information technology companies that share information or technical specifications with each other. Substitution may be thwarted because there is ineffective competition at the point of sale. For instance, stores sell warranties when electrical products

 

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are sold and, similarly, travel agents sell insurance with holidays. These warranties can account for 30-50% of profits at retailers like Dixons. The Competition Commission has examined this area and aims to increase choice and reduce prices, thus generally increasing the threat to a company from substitute products.

Long-term contracts can be effective in stopping substitution because, when they are renewed, the incumbent has the relationship, inside knowledge and track record, so is in a prime position to win again. Examples of such contracts are in the support services activities of companies like McAlpine, Mears Group and MITIE Group. Generally, the threat of substitution diminishes if the price of the item is low because the potential cost savings from doing a bit of homework by the customer are much less. Thus, the threat is great when buying a car but very low for buying an ice cream. At the other end of the scale, commodity products are not differentiated and are easy to substitute, like food. When a company that was fairly immune from competition finds its products, like computer chips, are becoming easier to substitute it is undermined, as in the case of ARM, the once high-flying, information technology company. Surfcontrol is a world-leading, internet filtering company with a commanding position in controlling what content can be viewed but now faces substitute products from the US.  Commercial terrestrial television enjoyed a loyal audience up to the 1980s but digital television has been a powerful substitute with hundreds of channels and unique content in some cases, like premier league football.

2. Customers

‘The customer is the appreciating asset.’

Federal Express

 

Customers are the cornerstone of success and, whereas a company can automate the production of goods, it cannot automate the production of customers. Companies with the best business models will have customers glued to them who pay a premium price because their products add great value in a way that is not met by competitors. This section examines what the company can do to configure its value chain to try to achieve that objective. In a world awash with excess capacity, companies need to concentrate on customers rather than products. This turns the normal company on its head because, traditionally, the focus has been on making a product and then figure out how to sell it to customers. Instead,

 

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companies should think how they can satisfy a customer’s wants and then determine how to deliver products which achieve that objective.  Focusing on customers tends to be easier in a small company rather than a large one. This can be partly because the former is entrepreneurial, closer to the customer and hungry for business, but also because the latter’s world can seem to stop outside the career concerns of the employees and management, few of whom may have ever met a customer. Consequently, a gorilla is often an easier competitor to beat than an entrepreneurial firm. If you want to find what the customer wants then ask those who complain rather than those who are satisfied.  Impressively, one CEO had his photograph and contact details in his retail outlets and asked customers to contact him directly, such was his keenness to obtain direct feedback. He had a print out of all complaints and held a weekly meeting with the directors to resolve them.

Successful smaller companies usually operate in a profitable niche. As they grow, they often and unwisely move out of this niche into areas where they do not have strong competitive advantage and where customers are best served by others.  This dilution of the original sound business model undermines profits and the effect continues all the way up the growth path until the company becomes a moribund gorilla. The correct strategy is only to grow into associated business areas that can feed off the initial competitive advantage, such as the banks’ move into mortgages and life insurance years ago. Diversifying, or ‘diworseifying’ as it is called by the guru Peter Lynch, into unrelated areas can be extremely risky, therefore, an example being banks and building societies moving into estate agencies in the late 1980s.

 

End of extract from Chapter 1

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CHAPTER 2

Business models: investing in sectors with strong competitive advantage

Business model of a sector

‘Competitive advantage comes from being different. Increasingly, difference comes from the way people think rather than what organisations make.’

Dr. Kjell Nordstrom, author of Funky Business.

A business model describes a sector’s competitive advantage and depends on factors or capabilities that drive consistent outperformance. This depends on having good economics, management and products plus power over customers, competitors and suppliers, which result in strong competitive advantage. These same headings were used to analyse the company business models in chapter 1. 

The profitability of a company is largely determined by being in a sector with a sound business model. An attractive sector has the ability to mould the world for its benefit, rather than weakly reacting to pushes and shoves over which it has no control. It will contain many companies that are profitable, due to low costs and/or doing something different, examples being banks, oil, tobacco and pharmaceuticals. If a sector has a weak business model then most companies are unprofitable, examples being engineering, automobiles and household goods.  The product itself is but one important ingredient and straightforward products can be attractive investments, e.g. beverages, whereas those that seem exciting can be unattractive, e.g. technology. This chapter looks at these power points in alphabetical order and one of the business models may be applicable to numerous sectors, for example beverages, tobacco and mining. This is followed by some examples of sectors that should be avoided. The merits of individual sectors, such as telecommunications, are analysed in chapter 4.

65 sector business models

The table below lists each of the power points for ease of reference and provides a checklist for investors to score sectors easily. There are 65 business models to assess the competitive advantage of sectors and this list is not exhaustive. These are analysed in detail after the table below. Please note that, in order to provide a comprehensive picture, some aspects in this sector-wide analysis inevitably overlap with those of their underlying companies (chapter 1) and the individual sector analysis (chapter 4), although this has been minimised as much as possible.

 

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All business models are not equal

As explained in chapter 1, all business models are not equal, as some are more powerful than others. Consequently, the table scores them on a rating of 1 to 5, with 1 being the highest and 5 the lowest. These ratings are subjective and could arguably be higher or lower, to an extent, but a top-rated business model would unlikely to be relegated to the bottom or vice versa.

The points are awarded depending on the power of the sector to achieve low cost and/or differentiate itself so that it adds value. Above all, it is crucial to be able to control its revenue streams. Consequently, those that score the maximum 1 are: rivalry; substitutes; value added; recession resistant; addictive or highly compulsive; long-term and opaque pricing; make once and sell many times; and moving up and down the value chain. Medium scorers include consolidation and demographics. At the bottom of the pile are those with poor competitive advantage because they are commodity-type businesses that have serious flaws or do not add value, such as dying sectors.

Sector business models table

 

The Sector Business Model table can be viewed on the following link 

Sectorbusinessmodeltable.pdf 

Or on page 77 here:
http://www.harriman-house.com/businessmodels/extracts/Chapter_2.pdf

 

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We now look at each of the sectors in detail. A sector should enjoy multiple business models and be scoring well on these to be highly-rated, as this strengthens its overall competitive advantage. For example, pharmaceuticals’ competitive advantage is rated 1, as it has a top score in such business models as entry and exit barriers, value added and recession resistant.

1. Competitors

‘A horse never runs so fast as when he has other horses to catch up and outpace.’

Ovid, Roman poet.

Sectors are attractive where the profitability is captured by the participants and not frittered away by strong competition, which results in low prices. If the latter does happen then the customers capture the profitability instead. Unfortunately, the days of making easy money have gone and now global competition is generally as fierce as it is widespread. This has been due to, inter alia, lowering of trade barriers, free currency movement, competition regulations, technology and rapid industrialisation of some developing economies. This has empowered customers, who are increasingly more demanding, at the expense of companies. The implications are far-reaching and have not yet run their course. It has hollowed out the profitability in those sectors that have poor competitive advantage, examples being textiles, distributors and manufacturing. Others are squeezed by ever more powerful gorillas, such as food producers by supermarkets. Some customers are not wanted because they can no longer be profitably served. Various business models have been abandoned, for instance relying on products rather than services. Clearly, no longer is it relevant to have a mission statement just to ‘increase sales’ or ‘create a bigger empire’, as these are no panaceas for profitability.

Therefore, sectors vary and some have greater intensity of competition than others. A reasonable assumption is that those sectors with the highest profit margins have less intense competition. These are, in order, tobacco, pharmaceuticals and health, and utilities. This concept is more fully explored in chapter 4.

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1a. Collaboration: competitive advantage rated 2

Sector profitability can be enhanced by the collaborative behaviour of the participants, such as choosing not to compete in certain areas and thus avoiding a backlash. Microsoft collaborates by code-sharing with preferred partners who are not competitors, examples being printers and cameras, and are thus outside its sphere of activities. The dominant players may act paternally, like Coca-Cola, and desire a stable and profitable environment for all in the sector and act accordingly, for example, with pricing, expansion policies and setting technical standards. There may be a cartel operating that enables all the participants to earn super profit, e.g. OPEC, or a more informal cosy relationship, e.g. petrol retailing. Companies can collaborate in joint ventures and thus share the risk.  Such partnerships can enhance trust and reasonable behaviour, with ‘milestone’ payments made when progress is made. Joint ventures are not generally very attractive, however, as a company loses some control over its destiny and partners can be unreliable. Joint ventures are evident in oil, aerospace and biotechnology. Generally, fierce competition has weakened collaboration between companies within a sector, an example being clothes retailing, and is the exception rather than the rule.

1b. Consolidation: competitive advantage rated 3

‘Why anybody thinks they will produce a gazelle by mating two dinosaurs is beyond me.’

Tom Peters, author of In Search of Excellence.

 

Consolidation is an ongoing trend in some sectors, driven by their economics.  They may have no choice if they need to reduce capacity and competition or reap economies of scale, such as achieving critical mass. This could be a spur to increased profitability and a re-rating. Consolidation may be due to empire building by CEOs in some cases. Some sectors have not consolidated and have a large number of participants with no one being dominant. 

Consolidation is prevalent in sectors at different times and recent activity has been in stockbroking, oil, banking, food retailing, media and pharmaceuticals. Some undergo consolidation where emergent gorillas grow by bolting-on acquisitions. This may increase competition or not, depending on how the participants behave. For example, the cigarette sector in the US has been threatened by price-cutting by struggling competitors. Increased size is a driving force in banking and life insurance to cope with international competition, or the Chapter 2 – Business models: investing in sectors with strong competitive advantage

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need for global reach. The regulatory burden is a large overhead that cannot be easily afforded by small players. In such an environment, takeovers are inevitable. Supermarket chains are consolidating to achieve economies of scale in order to compete. Utility companies need the critical mass of millions of customers and consolidation quickly helps to achieve this. Commercial terrestrial television is consolidating into a single ITV company, given the merger between Granada and Carlton, so that it can compete with the BBC and British Sky Broadcasting.

Investing in a takeover target is usually a more attractive investment than the gorilla in a consolidating sector because of the takeover premium. It is particularly attractive if the number of targets is small. A bidding war may ensue over who will acquire the limited number of players still left in the market and this drives up the take out price. Thus, a minor company in the life insurance sector like Friends Provident would be more attractive than a gorilla like Prudential, all things being equal. Similarly, in mortgage banking, smaller players like Alliance & Leicester and Bradford & Bingley are targets, as is Gallaher in tobacco. It may be worth thinking of buying a struggling company in the hope of a takeover but be aware that a white knight may take years to come to the rescue, if at all, and a takeover price could be lower than the current price if the target’s fortunes decline further. Therefore, it is sensible to invest in a company because it is attractive on its own merits, with the possibility of a takeover thrown in as a bonus.

1c. Entry and exit barriers: competitive advantage rated 2

Sectors benefit from high barriers to entry because they keep out competitors that may otherwise undermine profitability by increasing capacity and lowering prices. The barriers may be because the existing companies in a sector have locked in the customers, suppliers or distributors, for instance in oil and gas.  Switching costs may be high and incur risk or inconvenience, a feature of information technology. A newcomer may fear retaliation if the companies then overlap sectors, such as media and entertainment. Government can impede newcomers to protect home markets, as the French did by limiting Japanese cars. Brands may be very important and the cost, time and risk are too great for newcomers to build their own, e.g. newspapers and cars. The sector may be dominated by a few gorillas, with propriety products, that put a moat around the business. A newcomer may find it impossible to gain comparable proprietary expertise, let alone exceed it. Some sectors need global reach, huge economies of scale or capital to operate, examples being international advertising agencies and

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pharmaceuticals, and this makes it very difficult for a small company to gain a foothold and grow.

Sectors also benefit by having low barriers to exit so that firms who want to leave can easily do so. This reduces capacity and enhances profitability. Exiting is easier when the costs of doing so are low, for instance in support services or software, where it might mean closing a rented office and firing mainly temporary staff. At the other extreme are sectors where the fixed cost is very high and it might be cheaper to carry on than close down, examples being power generation, car plants, mines, aerospace and defence. Exiting will be easier if the player has other sectors on which to focus, rather than having to face annihilation. 

In conclusion, it should be hard to enter the sector but easy to leave it.  Information technology is a case in point, where know-how and proprietary products can make entry hard but it is straightforward to close down.

1d. Rivalry: competitive advantage rated 1

‘I would rather see a battalion enter the field than him.’

Duke of Wellington’s estimation of Napoleon.

 

Great rivalry tends to undermine profitability and such sectors should generally be avoided. This could stem from low growth or fighting over declining demand.  There could be overcapacity, e.g. telecommunications, or a dominant gorilla that is determined to crush opposition, e.g. British Sky Broadcasting. Some players may see the sector as a loss leader to make profits elsewhere, e.g. holiday companies cut prices but make money in travel insurance. The balance of power may be uneven, so a struggling player with poor competitive advantage may resort to desperate action and thus increase the rivalry. Price wars can develop where competition is intense, with adverse effects on share prices. This occurs frequently in food retailing and has featured in newspapers, tobacco and pubs. 

 

Rivalry can feature when there are large fixed costs and low marginal costs. This structure means that prices can be cut significantly to produce some contribution to the fixed costs. An example is air travel where the cost of filling the seat is minimal but the overheads are enormous. This price-cutting can become an expectation by the consumer, who increasingly becomes resistant to paying the full fare, e.g. last minute holidays. This undermines the long-term health of the sector. Rivalry is very likely in profitless sectors where little value is added. The participants are cornered and panic, with disorder resulting in ruinous competition. This tends to be particularly evident in a recession and sectors include construction, household goods and textiles.

 

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2. Customers

Sectors are preferred where the companies capture the value added rather than customers. This depends on the balance of power and the ability of the sector to add value to customers that induces them to pay a premium price. If the companies have little power and the customer is king, then the sector will be a profitless zone.

2a. Elasticity of demand: competitive advantage rated 2

‘Every time I reduce the charge for our car by one dollar, I get a thousand new customers.’

Henry Ford

 

It is important to have some understanding of elasticity of demand and supply.  We start with elasticity of demand, which shows how demand for products varies according to the price charged. Typically, the demand for a product increases as the price falls and vice versa. Elastic demand means that demand changes more than the change in the price. Unity elasticity means that demand increases by the same percentage as the price change. Inelastic demand means that, as the price changes, there is little change in demand and power generally rests with the companies, not customers.

Sectors with high elasticity of demand are unattractive because customers can be unreliable, such as leisure (health clubs) and retailers (jewellers). Demand falls by a greater percentage than the price increases so turnover drops overall.  Generally, luxury items have high elasticity of demand so sales can fall dramatically in a recession, as survival rather than prestige become uppermost in customers’ minds. Yachts are a good example. However, the demand for some luxury goods, like diamonds and gold, can actually rise as the price rises, since they can become a status symbol.

Sectors with inelastic demand are attractive because customers will be reliable. Demand falls by a lesser percentage than the price increases so turnover rises overall. Tobacco, petrol and alcohol are examples and are subject to swingeing tax that only dents demand, rather than curtailing it seriously. Staples of life, like food and utilities, also have inelastic demand. Customers may lack price sensitivity and thus have inelastic demand. For example, the product may be a low-ticket item, such as sugar, or the customer may be prosperous and not fight to save costs. Another reason for inelastic demand may be that the product may

 

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add great value, for instance a car, or have a powerful brand, like Coca-Cola, that provides a compelling motivation to buy.

The demand for shares and other stores of wealth, like housing, usually increases as the price rises, the opposite of normal economic theory. This peculiarity is covered in chapter 6 on technical analysis.

 

End of extract from Chapter 2

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CHAPTER 3

Shifting deck chairs on the Titanic

‘You better start swimming or you’ll sink like a stone, for the times they are a’changin.’

Bob Dylan

 

We have examined in the first two chapters the business models of companies and sectors that result in strong competitive advantage. The next step is to assess how they fare during the course of the economic cycle, as this determines when they should be bought and sold.

The first part of this chapter examines how the economic cycle can seriously enhance or damage your wealth. It is vital to select the appropriate asset class and sector. Investing in the wrong sector at the wrong part of the economic cycle can lead to a catastrophic loss of capital. The second part is to analyse how asset classes behave in a typical economic cycle and identify opportunities.

1. The economic cycle

‘Most other fund managers refuse to believe that the cycle exists any more: they believe that consumers can go on spending indefinitely.’

Peter Webb, Eaglet investment trust.

 

Share selection can be compared to shifting deck chairs on the Titanic. You may have chosen a good spot to sit on the ship but that is not very helpful if it is about to hit an iceberg. Similarly, it is imperative to choose shares that will not sink when the economic cycle changes. Some understanding of this will, in all likelihood, be the most important determinant of success or failure. Sadly, all too many investors and businessmen extrapolate from the past to the future and assume that existing trends will continue. They fail to understand that the trend has a bend in it and even less understanding of when that bend may happen. 

It is vital to recognise the current point of the economic cycle. Once this is understood, the appropriate asset class can then be selected. Essentially, investors should have a good tailwind behind them and this is best and most easily achieved by being in asset classes that are rising in price and avoiding those that are falling. Battling against a strong headwind is futile. Another way of riding the cycle is to be long on assets that are rising and short those that are falling. We will return to this later but first we need to examine what causes the cycle and where we are on it now.

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What causes the economic cycle?

‘Change is the law of life. And those who look only to the past or the present are certain to miss the future.’

John F. Kennedy

 

The economic cycle is a normal part of life. In a typical cycle, the economy starts with equilibrium between supply and demand in the four factors of production, namely land, labour, capital and enterprise. Presently, companies begin to feel confident and anticipate that profits can be improved, so they increase output.  The demand for the four factors of production rises accordingly and their prices rise. Additionally, people foresee continued and increased demand for their labour so they feel confident about spending on consumer goods. Borrowing increases and this fuels the housing market. The economy starts to operate above its long-term growth trend, which is about 3% a year. Inflation, a trade deficit and a falling currency ensue and this threat is met by the central bank with higher interest rates. This increases the cost of capital, one of the four factors of production, and, with more resources earmarked for that purpose, there is less left over for the other factors. The demand for these falls, as companies and people tighten their belts, and recession ensues along with a severe bear market in shares and houses. Inflation is eventually wrung out of the economy and it can once again return to equilibrium. Then the whole process can start all over again.

Alan Greenspan’s view

‘Don’t confuse genius with a bull market.’

Wall Street slogan.

 

Alan Greenspan, chairman of the Federal Reserve, assessed the economic cycle admirably in 1997: ‘There is no evidence, however, that the business cycle has been repealed. Another recession will doubtless occur some day. History demonstrates that participants in financial markets are susceptible to waves of optimism, which can in turn foster a general process of asset-price inflation that can feed through into markets for goods and services. Excessive optimism sows the seeds of its own reversal in the form of imbalances that tend to grow over time. When unwarranted expectations ultimately are not realised, the unwinding of these financial excesses can act to amplify a downturn in economic activity, much as they can amplify the upswing.’

 

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‘Clearly, when people are exposed to long periods of relative economic tranquillity, they seem inevitably prone to complacency about the future. This is understandable. We have had fifteen years of economic expansion interrupted by only one recession and that was six years ago. As the memory of such past events fades, it naturally seems ever less sensible to keep up one’s guard against an adverse event in the future. Thus, it should come as no surprise that, after such a long period of balanced expansion, risk premiums for advancing funds to businesses in virtually all financial markets have declined to near-record lows.’

These words are so apt that they are well worth carefully re-reading, as it could save investors a fortune. There are mini cycles of about three to four years but the whole cycle lasts for about a decade, as evidenced by the recessions in the early 1970s, 1980s and 1990s. On this wave theory reckoning, another recession should be anticipated in the not too distant future. The reason recessions seem to occur every decade may be because it takes that long for those at the sharp end to forget the pain but, once forgotten, the assumption becomes that it will not return. Also, a new generation has not yet felt that pain and naively acts without fear until it is their turn to experience a recession. If people forget the lessons of history, they are doomed to repeat them.

A history lesson

‘Truth is the daughter of time.’

Josephine Tey, author.

 

We should examine what has happened over the last three decades to understand where we are in the economic cycle today. The stock market boom lasted 18 years from 1982 to 2000. The 1987 stock market crash proved to be but a correction in that overall bull market. It is very unusual for a bull market to last so long and it was a response to changed macroeconomic conditions. In the 1970’s there was stagflation, which is a combination of inflation and no growth. This had a number of causes, such as the quadrupling of oil prices, very strong and aggressive unions, high taxation and protected economies that restricted currency movements and propped-up lame duck industries. A new determination to tackle these problems lead to conservative parties coming to power that reinvigorated the economy both in the UK and US. They opened the borders to free trade, in the UK’s case made necessary anyway after joining the EU. Currency controls were swept away and direct taxation was reduced to encourage private enterprise. The behemoths of state industries were privatised en mass. The demise of heavy industry and growth in smaller companies eroded union

 

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membership and the causes of strife evaporated, most notable amongst them being ruinous inflation. The result was that strikes became rare.  On the face of it, the economy today seems to be in fine fettle with continued growth in GNP, unstoppable increases in property prices and ultra low interest rates and unemployment. Yet, scratch below the surface and a different picture emerges. We are past the top of the economic cycle but some of the traditional measures that mark this event have yet to become evident. One that has done so is a lead indicator of trouble ahead, namely the three-year rout in the stock market up to 2003. In 1987, for example, the stock market crashed and the authorities’ rapid response was to ease monetary policy by lowering interest rates. This fed inflation and then interest rates had to be increased sharply, causing the recession in 1991-92. It is not feasible for the stock market, the main yardstick of economic growth, to experience such a bear market and also have ongoing health in the real economy and property prices. Eventually, the latter will have to face up to the reality of the ominous signals that the stock market has forecast.

Greatest bubble in stock market history

‘The hangover may prove to be proportional to the binge.’

Warren Buffett

 

Low inflation broke out in the mid-1990s. This was a puzzle at the time to many, including Alan Greenspan, chairman of the Federal Reserve, because, with the economy booming, inflation would have been expected to increase but it did not.  There were a number of reasons, including a quiescent oil price, intense competition and a strong dollar making imports cheap. Also, inflation was low because most people merely extrapolate from the past. For example, if shares or houses are increasing in value then investors climb on board, as they expect this trend to continue. It seems that a key ingredient in the high inflation from the 1970s to the mid-1990s was the expectation of more inflation. People saw there had been high inflation and pushed for high wage increases to compensate, which itself then caused inflation. When that cycle was eventually broken and low inflation became the expectation, based on current low inflation, then wage claims ratcheted down.

This low inflation allowed central bankers to reduce interest rates steadily since the mid-1990s. In general terms, there is a direct and inverse relationship between interest rates and asset prices. Low interest rates result in increased asset prices and vice versa. If interest rates are low, borrowing is cheap to buy assets,

 

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such as property and shares. Also, the value of a share is the discounted net present value of all dividends that will be paid in the future. If the discount rate is lower, reflecting low interest rates, then the value of a share increases accordingly. The result was a massive increase in borrowing by companies and individuals that culminated in the stock market bubble that ended in the TMT mania in 2000. Low inflation and interest rates proved a curse, not a blessing. The booming stock market was not due to a significant increase in profits, as these had been falling since 1998, but because the PER quadrupled and reached a staggering 43 in the Standard and Poor’s index. It was the greatest bubble in stock market history. The three-year bear market up to 2003 brought the PER down but was still at the same level as when the market crashed in 1929, at around 30. Then the Great Depression ensued and it took 25 years for the market to regain its 1929 heights. The ultimate arbiter of world stock market levels is the US long bond.  Its yield is around 5% and should this rise significantly, to say around 8%, the markets would be in dire straits.

The curse of low inflation

History provides a powerful reminder of the curse of low inflation, as the three biggest stock market bubbles and subsequent busts, which were 1929 in the US, 1989 in Japan and worldwide in 2000, were caused by low inflation. Japan has been in a bear market since 1989 and its stock market level is but a quarter of that peak. It can take a very long time to unwind asset bubbles and it is wisest to prevent them occurring in the first place so that the economy remains in equilibrium. Unfortunately, such common sense is not that common.  Furthermore, there are serious doubts as to whether the PER is based on real numbers after scandals such as WorldCom, the failings of the defunct auditors Arthur Andersen and accounting treatment of items like share options and goodwill. If anything, in a world that has long since lost financial conservatism, a PER of 30 may well, in reality, be even higher if earnings have been overstated, thus making the stock market more overvalued. However, recessions uncover what the auditors do not and reality eventually returns. The corporate backdrop has been bleak in the real economy too. Profits in the US suffered their sharpest fall since 1929 and profits in the UK hit the lowest for 10 years after the TMT crash. The response was to cut costs wherever possible and profits have recovered, at least for now.

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Followed by the housing bubble

‘When you combine ignorance with leverage, you get some pretty interesting results.’

Warren Buffett

 

The reaction by central banks to the 2000 stock market meltdown was to carry on reducing interest rates to the lowest levels for half a century in a misguided, foolhardy and futile attempt to avoid a recession. Setting interest rates at the lowest level for half a century is, by definition, an extreme and very rare act leading to a hangover that is likely to be equally extreme and unlike anything experienced for half a century. The central banks have rewarded those that borrow at the expense of those that save and this is has produced a false and untenable economy. Spending one’s way to prosperity is a peculiar notion and would not sit easily with Charles Dickens’ Mr. Micawber: ‘Annual income twenty pounds, annual expenditure nineteen, nineteen and six, result happiness.  Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery’. Millions of consumers would laugh at such a notion, at least for now, hooked as they are on debt.

The response to this cheap money was that a mountain of it flowed into property and this led to a second bubble, which is still expanding. This was the last thing the economy needed, when the concentration should have been to unwind the stock market bubble fully. UK house prices more than doubled since 1995, with important implications for the health of the economy. The increased property prices eventually trickle down into the real economy, as wages and prices need to increase to offset the higher cost of one of the four factors of production (labour, capital and enterprise are the other three). The reaction will be to use less of any factor of production that suddenly increases in price and use more of that which is cheaper so there will be substitution, for example by producing in low-cost countries.

Reverting to the norm

‘Whenever you get a wild excess on the upside, the following correction doesn’t just go back to normal; it almost always falls way below normal.’

Sir John Templeton, philanthropist, author and renowned investor.

 

All markets tend to revert to the norm, which is the long-term trend line, and the UK stock market was 40% above its norm in 2000. That anomaly was removed in the

 

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three-year bear market when it again hit the norm. In the previous house price boom of the late 1980s, prices were also 40% above the norm. The subsequent bust meant that prices hit the norm again by 1996 after years of falls.  House prices are now even more exposed than in 1989, as they are a perilous 50% above their norm and, at some point, another bust can be expected so that prices once again hit their long-term trend line. The housing bubble could burst for a variety of reasons. Eventually, all the people and speculators who want to join in will have bought and the lack of such buyers on the margin will lead to falling prices, as confidence evaporates to be replaced by fear. Other factors could be a rise in unemployment and interest rates. The fall in prices will deter further buyers but there will be great selling pressure from speculators rushing for the exit, resulting in a collapse. Looking at how far the price of any asset is above its trend line is a good way of assessing the presence of a bubble, although Alan Greenspan has claimed asset bubbles are hard to identify until they burst, which would be a convenient defence if it were true.

Mega recession in the wings

‘For those properly prepared in advance, a bear market in stocks is not a calamity but an opportunity.’

Sir John Templeton

 

The increase in the unrealised gain in house prices enabled consumers to stripmine this manna from heaven and fuelled a massive increase in spending. This has kept the wheels on the economic bus, at least for now. This spending has been crucial because the consumer accounts for two-thirds of the economy. The snag is that consumers are relying on the unrealised gain being permanent but it will disappear in a housing bust, turning into negative equity. The mortgages will not vanish so miraculously and the pain of repayment if interest rates increase will be extreme, especially if there is a significant rise in unemployment. Add to that the psychological ingredient of a ‘feel-bad’ factor and all the usual suspects are lined up for a recession. It could be the worst in living memory, as, historically, the severest are those resulting from the deadly combination of a stock market bubble and massive over-investment and borrowing, as two bubbles have to be unwound, not just one.

The borrowing can take up to a decade to be repaid or written off and, if low inflation persists, its real value will stubbornly remain intact. By contrast, the Business Models

 

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recessions in the last half-century were not caused by low interest rates but by high interest rates which were imposed to reduce rampant inflation. Thus, we are now sailing into uncharted economic waters and a depression could result, rather than a recession. If low interest rates do persist then the unwinding of the housing bubble may be similar to the Japanese experience since 1989, which has been a long and painful economic squeeze rather than a short, sharp recession. The stock market will be in a crisis either way and this should provide a rare and fantastic buying opportunity. Recall that in 1974 the stock market dividend yield was 12% overall and that the deeply depressed shares could be bought at a further 40% discount by buying investment trusts like Foreign and Colonial.

Conflicts of interest

‘Mr. Greenspan, I always enjoy your presentation because, frankly, I wonder what world you live in.’

Bernie Sanders, Republican Congressman.

The false economy has been egged on by central banks and governments, who have aided and abetted the two bubbles. Why should this be so? Central banks and governments are keen to maintain their reputations and be re-installed into power. This provides a conflict of interest, as the temptation is to try to stimulate unsustainable, short-term growth rather than manage the economy for the longterm good. Alan Greenspan admits that the power rests with the markets but that still does not prevent central banks believing they are powerful and clever enough to control the economy. Indeed, Gordon Brown, the UK Chancellor of the Exchequer, made the unbelievable claim that he had abolished the economic cycle by taking the ‘tough decision’ to give the Bank of England independence in setting interest rates. These words will haunt him when the recession proves him wrong. One problem is that central banks have a narrow brief to control interest rates and have but scant responsibility for borrowing levels. This lack of responsibility is truly astonishing and a solution would be to make central banks responsible for preventing asset bubbles as well as inflation. That way they could stop the bubbles in the first place rather than sorting out the mess afterwards, which is their preferred method. A more sensible attitude would be to recognise the economic realities of life, suffer a mild recession and avoid one later that will be much more severe.

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Deflation

The Federal Reserve, other central banks and the media have expressed fears about deflation. It is a reality in Japan and is a possibility in Germany more than the US. It seems an unlikely scenario in the UK because inflation is a high 5% in services, which accounts for two-thirds of the economy, and their limited substitutability by consumers means that this type of inflation will probably continue. This high rate of inflation in services is offset by deflation of 2% in physical goods, which is due to intense international competition as substitutability of goods is generally easy. There are no prizes for concluding that a company has a rosier future in services than making physical goods. Should deflation in fact transpire, it would increase debt in real terms and exacerbate the unwinding of the debt bubble. The central banks are running out of room to manoeuvre to ‘prevent’ recession, as interest rates are low and they cannot fall below zero.

Perilous US economy

‘There cannot be a crisis next week. My schedule is already full.’

Henry Kissinger, US statesman.

 

The US economy looks perilous as it has massive debt with very low consumer savings. The current account and trade deficits have rocketed to about 5% of GDP and this profligacy is financed by 80% of the world’s savings. This largesse by the rest of the world could be withdrawn at any time and such lack of control is as dangerous as it is uncomfortable. Repatriation of foreigners’ money would be unsurprising, as US interest rates are low. Further, the US stock market has recovered strongly since the three-year bear market to March 2003 but the rally has the hallmarks of being an unsustainable ‘dead cat bounce’ rather than the start of a major bull run. This view is based not only on macro economics but also on technical analysis, such as Elliott Wave theory, and stock market history. The dollar has tumbled and hit an all time low against the euro, with more falls likely.  A weak currency means that imports cost more, so inflation should rise and lead to higher interest rates. This would burst their housing bubble and a worldwide recession would then beckon. However, it would mark the beginning of a sustainable and healthy economy, once the excesses have been eliminated.

Where are we in the cycle?

On an historical basis, we are past the top of the cycle, given the severe bear market and the economy is set for recession, which may yet be postponed by low interest

 

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rates but not cancelled. As explained above, this cycle has not been typical because of the absence of inflation. This has allowed interest rates to be kept low and so bond and property prices are high. Just how long the central banks can forestall the day of reckoning is unknown. It is unlikely that the next recession will follow the same timetable as the last three recessions because the ingredients are dissimilar and so extreme: two bubbles and ultra low interest rates.

How to find out where we are in the cycle

‘Never trust an economic boom fuelled by consumer debt.’

Neal Weintraub, author of Tricks Of The Floor Trader.

 

An investor does not need to be an economist to find out where we are in the cycle. There are many signals given by business and the public. Those signals from business indicating a raging bull market and the time to sell may include:

·        PER ratios and forecast increases in profit are very high

·        institutional cash holdings are very low, stock market indices are beginning to falter and are far above the norm

·        a mania for a sector, investment style, asset or geographical area

·        bad news is dismissed and good news is a catalyst for action

·        new issues are oversubscribed and trade at a premium

·        the stockbroker’s phone is always engaged

·        inflation and interest rates are beginning to increase but are dismissed as blips

·        dividend yields are at record lows

 

Signals from the public indicating a raging bull market and the time to sell may include:

·        media and pundits are overwhelmingly optimistic

·        doomsters are few, ignored or fired

·        consumer and government borrowing and spending are high

·        speculation in shares and housing is rampant

·        advertisements abound for foreign holiday homes

·        dinner party talk is boastful of success in the markets

·        few can see any reason for a change

·        political stability seems unending

·        empty restaurant and trains seats are rare

 

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·        sudden appearance of new cars in the neighbourhood

·        investors think they are geniuses, complete novices show interest in risky investments and their ‘success’ is highlighted in the press

·        investment conferences are packed and the circulation of publications like Investors Chronicle is at a peak

·        conspicuous consumption of luxury goods, such as fireworks, champagne and cigars at Christmas and New Year parties.

 

The indicators of a bad bear market are the reverse and are excellent buy signals.

 

2. The cycle of opportunity

‘We view our level of liquidity or gearing as probably the most fundamental decision we have to make on behalf of the shareholders of Personal Assets –much more so than which individual stocks we should buy or sell.’

Ian Rushbrook, fund manager.

 

We have now analysed the economic cycle and where we are in it. We turn our attention to how different asset classes behave in the cycle so that investors can profit by riding trends.

How asset classes behave in a typical economic cycle

Shares, property, cash and bonds are attractive during different stages of the economic cycle, in that chronological order, and provide opportunities. Let us assume that we are near the top of the cycle in year one, as outlined in the table at the start of chapter 4. The economy has boomed and inflation is on the prowl.  Interest rates increase to combat this and now is the time to be out of shares and into cash. This is because share prices drop before the real economy falters, as the stock market is a lead indicator by anticipating the future some six to nine months ahead. Cash is king, benefiting from high interest rates and ready to take advantage of juicy prices in the ensuing recession. Property still remains robust for a couple of years but then it succumbs as well, although in this current cycle it has lasted longer as it has been propped up by ultra-low interest rates.  Assuming that interest rates do rise, bonds should then be bought, locking into these high rates just as they begin to fall, which is when the recession has run half its course. Sell bonds when their prices rebound, which is approximately one year before the bottom of the recession.

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Share prices have been now falling for some years in this scenario. Buy shares six months before the bottom of the recession, as they begin to rally following the lowering of interest rates to kick-start the economy. Property should be bought as the ‘green shoots of recovery’ become apparent. Inflation has now been wrung out of the system in this painful manner. Share prices and property rise until the economy begins to overheat. Inflation is starting to increase and higher interest rates can be foreseen. Now is the time to switch out of shares and into cash since we are approaching the top of the cycle and the process can then start all over again.

The conclusion is to be in cash at the peak of the cycle and in the subsequent recession. Then invest in bonds to benefit from falling interest rates, then shares and, lastly, property, near the trough of the cycle. Note that the best time to buy the asset is at the start of their runs and then hold them until switching to another asset class that becomes more attractive. If an investor is in the wrong asset class and, in particular, if it is bought at the end of its run rather than the beginning, then it is likely to be very costly.

Investment strategies

‘If you warn 100 men of possible forthcoming bad news, eighty will dislike you right away. If you are right, the other twenty will as well.’

Anthony Gaubis, investment counsellor.

 

a. Hold cash and recession resistant shares

 

A sensible investment strategy with the economic cycle past its peak might be to hold up to, say, half a portfolio in cash with the rest in shares that will withstand a recession. Bonds and property should be sold. Shares can offer opportunities whatever the cycle, it is just that performance is much more difficult in a bear market. To be out of shares completely is another strategy. However, an investor might well then miss the re-entry point and trying to pick the bottom of markets is practically impossible. Stock markets have a nasty habit of shooting up unexpectedly. However, the shares selected must be able to withstand a recession.  It is imperative, therefore, that they have sound business models in attractive sectors, as pointed out below and in chapters 1 and 2.

 

A long-term ‘buy and hold’ strategy for shares will be unsatisfactory, as it is guaranteed to be hit by bear markets caused by recessions. Unit and investment trusts that track, or quasi-track, the index will similarly disappoint. Managers rarely want to stray too far from the performance of their peers, no matter how

 

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unsatisfactory it may be. There are some funds, such as Personal Assets and RIT Capital Partners, that actively move in and out of asset classes to ride the cycle with success but they are a rarity.

b. Hedge and other funds

‘Protection against adverse market conditions was provided by our liquidity, the diversity within the portfolio and the increased investment in asset classes which are less directly correlated to markets. Your company has been an investor in selected hedge funds in the pursuit of absolute and relatively consistent returns.’

The Lord Rothschild, chairman of RIT Capital Partners.

 

One route to consider is hedge funds, which have grown enormously in popularity and now number 6,000 worldwide with assets of $9 trillion. They have a variety of strategies to protect against bear markets. Their tools include shorting (selling shares they do not own), derivatives, futures, options and leverage. Many aim to be market neutral by being equally long and short and to make money from stock picking. They are predominantly based offshore and target high net worth individuals. FTSE 100 company Man Group is one of the leading providers with $40 billion under management. George Soros’ hedge fund is Quantum and Warren Buffett ran one in his early years and said there was nothing mystical about it. Another offshore fund is Green Cay Asset Management run by Dr. Jane Siebels and is majority-backed by billionaire Sir John Templeton, the legendary global investor.

One solution for a private shareholder may be to buy an investment trust, like RIT Capital Partners, that invests in hedge funds as part of its wider remit to manage a portfolio of shares and securities. Alternatively, a private shareholder may try hedging himself by going long and short or, instead, just going short in anticipation of a bear market but this strategy is for professionals only.

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CHAPTER 4

Which sectors to buy and sell during the economic cycle

 

‘Draw a circle around those businesses you understand and then eliminate those that fail to qualify on the basis of value, good management and limited exposure to hard times’.

Warren Buffett

 

We now examine the competitive advantage of individual sectors, like beverages, rather than business models, such as moats and recurring revenue, that cut across numerous sectors, as discussed in chapter 2. We then discover which individual sectors to buy and sell during a typical economic cycle. The starting point is to consider UK and international competitive advantage.

UK competitive advantage

The UK initially secured international competitive advantage with the advent of its industrial revolution in the nineteenth century. This gave it first mover advantage but this waned when the rest of the world industrialised and began to catch up on the UK’s first mover advantage. Other factors which strengthened its competitive advantage included language, geographical position, natural temperament of the population, reputation, history and perceptions of value.  Today, the UK’s international competitive advantage is in various sectors that tend to dominate the top of the FTSE 100. They score highly in the table that follows and are beverages, pharmaceuticals and health, tobacco, food and drug retailing, oil and gas, and banks. These are followed by food producers, utilities, aerospace and defence, and life insurance. This does not mean that these sectors are attractive at all times, or that each company therein is attractive. Gems can be discovered in unattractive sectors. However, it is a useful reminder of where the competitive advantage lies and which have long-term potential. Those sectors that lack power have a low score in the table below and, unsurprisingly, include chemicals, electronics, electrical and engineering.

International competitive advantage and ‘Wal-Martisation’

‘While you’re negotiating for a 35 hour week, remember that they have only just got 66 hours in Taiwan and you’re competing with Taiwan.’

Victor Kiam, of ‘I liked the shaver so much I bought the company’ fame.

 

Asia is fast becoming the powerhouse of the world. This megatrend can be expected to last for decades and will probably intensify. From an economic point of view, the West and Asia will benefit if each specialises in those activities

 

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where it has competitive advantage and trades goods and services with other countries where it does not. China and its billion people on low wages have a powerful competitive advantage in manufacturing, not only in low cost but, increasingly, in quality too. Southern China has reached the stage of development where costs have risen and production is shifting to the north, where they are still low. Japan has competitive advantage in high-quality goods, such as consumer electronics and cars, although its manufacturing heart is being hollowed out as production shifts to low-cost countries.

Companies that can transfer production to low-cost countries have little choice but to do so or they will be beaten by the competition. If the value created can be captured by the sector, then profits will benefit accordingly. If however, they are frittered away in ruthless competition then the consumer will benefit but this may, nevertheless, increase overall demand and perhaps provide critical mass.  Some sectors are unable to benefit from this megatrend and they include general retailers, transport and oil.

Intense international competition has meant that the fat in businesses is not just being cut out but is being fried out in a pan. This reflects the megatrend towards the ‘Wal-Martisation’ of the world. Price is increasingly the main, if not the only, matter that counts in selling goods. Wal-Mart piles them high and sells them cheap, as evidenced by sales that have reached $1 billion in a single day.  Increasingly, if the correct price point is hit then customers ring the phone off the hook. Miss that price point by just a shade and the phone is silent. The internet has aided and abetted this extreme price consciousness. 

Another megatrend is the dumbing down of jobs that take out the skill with easy to learn and powerful personal computers. There is great demand for cheap and cheerful bodies but much less demand for expensive middle and senior managers.  This has thinned the ranks of the prosperous middle classes that spent freely and those that catered for them have seen business suffer, for instance expensive, four-star hotels in Austrian ski resorts. The cheap and cheerful chalets down the road that manage to produce a Wal-Mart type product that hits the price point remain packed. Therefore, it is increasingly important to differentiate products that add real value to the customer in order to achieve premium pricing. The alternative is to be in the Wal-Mart business with an ultra-low cost base and a very keen sense of capturing market share on a continuing basis that keeps the competition at bay. This is a difficult job to do indefinitely without hiccups. There is, however, little middle ground.

There will be a place for niche producers in the West for the likes of up-market

 

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car manufacturers, such as BMW, that have immense image and prestige.  However, the long-term outlook for manufacturing is bleak. It has been shrinking faster in the UK than Germany, France and the US since 1997. It has fallen from 21% of GDP to 17%. Services, for example leisure, are difficult to import and are largely immune from overseas competition. In some sectors, like telecommunications, banking, software and engineering consultancy, the back office and call centres can be transferred to low-cost countries.

Which sectors to buy and sell during the economic cycle

The economic cycle of opportunity table, which follows, starts with the asset class to hold over the cycle, namely cash, bonds, shares and property, and this was discussed in chapter 3. Each sector is scored for its recession resistance and competitive advantage. The annual profit growth over the last five years and the profit margin is also specified.

There is a time to buy and sell various sectors, as illustrated in the table. Non cyclical sectors are: beverages; food producers and processors; pharmaceuticals; health and personal care; tobacco; food and drug retailers; telecommunications; and utilities. They should ideally be bought in the third year of the cycle when share prices are depressed but demand for these goods is robust, as they are needed in good and bad times. Consequently, they tend to have strong recession resistance. They can then be held until near the end of the cycle and sold around year nine. Alternatively, they are candidates for holding if an investor decides to have an exposure to shares regardless of the cycle, as explained in chapter 3. 

Cyclical sectors are resources, basic industries, general industrials, cyclical consumer goods, cyclical services, information technology and financials, which includes real estate. They should be bought later than non cyclicals in year five when their prices are rock bottom. Share prices then begin to increase, as the market will anticipate the end of the recession by approximately nine months.  Demand will recover and will boost profits enormously. These sectors are sold earlier than non cyclical sectors, in around year eight. An investor will then be partly or fully out of the market before it begins to discount the top of the cycle when it will de-rate these recession-prone sectors harshly.

Note that the sector headings and order correspond to the FTSE Actuaries Share Indices classification for ease of reference, as this details performance, dividend yield and cover, PER and total return in summary form. This classification is also used to group all of the individual shares into sectors. Both are listed daily in the

Financial Times. Thus, an investor can track sectors that are of interest and then

 

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drill down to see individual shares in that sector from a quick perusal of the paper.

There are likely to be shares that will do well in any sector and a stock picker will focus on these, rather than be swayed by sector moves. However, the job is made harder without a reasonable sector tailwind. Note that this chapter analyses each individual sector and thus complements chapter 2, as that examination of competitive advantage cuts across numerous sectors. For example, sector consolidation discussed in chapter 2 applies to banks, pharmaceuticals and oil.  Each of these sectors is assessed below individually to see what competitive advantage they possess.

The economic cycle of opportunity table, overleaf, scores the recession resistance and competitive advantage of each sector over a typical ten-year economic cycle.  Although these scores are subjective, they should provide a reasonable guide.  The competitive advantage points are awarded in the same manner as for sector business models in chapter 2, namely the power of the sector to achieve low cost and/or differentiate itself so that it adds value. Above all, it is crucial to be able to control revenues streams.

The economic cycle

The Economic Cycle of Opportunity can be viewed on the following link on 144:

http://www.harriman-house.com/businessmodels/extracts/Chapter_4.pdf

 

We now look at each of the sectors in detail. The score for recession resistance and competitive advantage is 1 for highest and 5 for lowest, with an average of 3. Note that this does not score them as attractive sectors on valuation or technical analysis grounds since these change daily. The sector’s capitalisation as a percentage of the UK stock market at the end of 2004 is also shown. This is also the date used for the profit and growth margins in the table.

4a. Non cyclical consumer goods
Beverages: recession resistance 2, competitive advantage 1. Percentage of stock market capitalisation 3%.

‘Diageo. Based on the Latin word for day and the Greek word for world.  Diageo captures what this business is all about – bringing pleasure to consumers every day around the world.’

The logic behind the new name for the merged Guinness and Grand Metropolitan.

Beverages is an attractive sector as it offers defensive growth. It is essentially a tried and tested, simple business, although changing tastes and fashion are important factors. There has been consolidation amongst the players, as economies of scale are significant so that products achieve critical mass, for example, in distribution networks.

Its resistance to recession is above average because beverages are low-ticket items and there is high compulsion to consume. People are reluctant to give up their tipple when they need cheering up in hard times. However, there will be some fall-off in demand and trading down to cheaper brands when consumers are forced to tighten their belts.

The sector has high international competitive advantage, driven by the power of leading brands, heavy advertising and global reach. This enables its claim on disposable income to remain steadfast. However, it is not all plain sailing as the market is mature and there is tough competition from overseas brands, as well as from supermarkets’ own label drinks. Although the sector does supply own label, the margins tend to be lower. Other downsides include heavy ‘sin’ taxes and a trend towards a healthy lifestyle. Overseas developing markets are attractive as incomes rise and consumers can start to afford such high status products. Please also see leisure and hotels below.

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The profit growth of the sector over the last five years was 6% per annum, compared to 9% for the stock market as a whole, and the 19% profit margin is above the stock market’s 15%. The dominant player is the peculiarly named Diageo, with Allied Domecq a long way behind. Diageo is a gorilla and the world’s number one seller of spirits with long-proven brands like Johnnie Walker, Smirnoff and Guinness. Market segments have been established with new products like alcopops. This has driven growth, although demand can be fickle and some new launches have failed. Both Diageo and Allied Domecq are exposed to US dollar weakness. The temptation for the gorillas has been to diversify to boost profit. This has resulted in mountainous goodwill and expensive failures, such as Diageo with Burger King and Scottish & Newcastle with Center Parc.  The key, then, is to buy when the sector is cheap, as the share price will more likely be driven by a re-rating rather than profit growth. The niche players lack powerful brands and have less competitive advantage than the gorillas.

Food producers and processors: recession resistance 1, competitive advantage 2. Percentage of stock market capitalisation 2%.

Like beverages, food producers and processors is an attractive, defensive sector.  It is a stable but mature market, with sales stimulated by flair and new product launches.

Demand is robust in a recession because the products are staples of life and are low-ticket items. Brands are important to achieve premium pricing and strong product differentiation, established over many years through reputation, value for money and advertising. Supermarkets’ own brands are a threat and supplying this market has to be at keen prices and top quality. This is a tough space to occupy, as Northern Foods has found.

It has above average competitive advantage overall and is dominated by gorillas like Unilever and Cadbury Schweppes, which have significant economies of scale after extensive takeover activity but has resulted in high levels of goodwill.  Nevertheless, there is strong competition from overseas giants like Nestlé, which also has been acquisitive. Generally, the space to occupy is selling the brand to the consumer and capturing that value, like Cadbury Schweppes, rather than being squeezed into producing commodity products like sandwiches and milk for supermarkets, like Geest and Dairy Crest. Such minor players struggle to pass on higher input costs to powerful supermarkets and have to resort to cost cutting.

Nevertheless, gorillas can struggle in this regard too and Unilever has embarked

 

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on an expensive, five-year restructuring programme to reduce the ‘noise’ of having too many brands and to focus on the most promising 400. Likewise, Cadbury Schweppes has announced a somewhat similar restructuring programme. In such cases, share performance can be at the mercy of meeting restructuring targets.

The profit growth over the last five years was 10% per annum and the margin is 13%, which are both similar to the stock market as a whole. Niche players like Richmond Foods and Inter Link Foods have sound business models, in spite of supplying to powerful supermarkets, are growing fast and are more attractive than the gorillas. They both have low costs and differentiated products, with Richmond’s Nestlé brands and Inter Link’s customer relationships and new lines.  Both have avoided the trap of being overly reliant on too few customers.

Pharmaceuticals, health, personal care: recession resistance 1, competitive advantage 1. Percentage of stock market capitalisation 9%.

‘What good is health? You can’t buy money with it.’

Charlie Munger, Vice President of Berkshire Hathaway.

 

Pharmaceuticals, health and personal care is the first of only three sectors to earn the maximum score for recession resistance and competitive advantage. The sector was riding high in the mid-1990s to the end of the decade, as the market was growing, new blockbuster drugs were launched, prices were increasing and regulatory approval times were falling. This lead to overvaluations based on the lure of defensive growth. This optimism then hit the realism of a high cost base, few new drugs and a weak pipeline, strong generic competition as important drugs came off patent, longer regulatory approval times, worsening economic conditions and opposition to prices from government and healthcare bodies.  Visibility of earnings dropped sharply and emphasised the high operating risk.  The next few years offer little respite from these problems so an investor should be wary in spite of the strong recession resistance and competitive advantage. 

 

The strong recession resistance reflects the fact that drugs are ‘must-have’ products, are low-ticket items and typically free or subsidised for the end user. Therefore, demand and growth are never ending. Demographics favour the business, as the population is ageing, and drugs are much cheaper than hospital stays. It rides the tailwind of governments spending more on health and this is a Chapter 4 – Which sectors to buy and sell during the economic cycle

 

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main objective in some cases, such as in the UK. However, various health reforms over the years have played their part in holding down the cost of drugs.  Personal care includes household products and the gorilla Reckitt Benckiser dominates this sub sector. It has an impressive list of brands, like Dettol, that helped to increase margins in this very defensive play. Warren Buffett likes this sort of company because it has a strong consumer franchise and is similar in this regard to Gillette, in which he has a large holding.

International competitive advantage is very good and the gorillas are GlaxoSmithKline, the fourth biggest UK company, and AstraZeneca. There has been significant consolidation to cut costs, an example being the £5 billion Amersham takeover, and the amount of goodwill on the balance sheets is significant. There are very high barriers to entry due to the massive economies of scale that are needed to fund the enormous research and development expenditure, trials and the long time it takes to bring a blockbuster to market.  However, once this has been achieved, the company can enjoy that most wonderful of competitive advantages, a monopoly, for years and the super profits roll in. Eventually, the drug comes off patent, which lasts up to 20 years, and generic competition leads to price-cutting. It is a race, therefore, to bring out new products from a long pipeline more quickly than old ones lose patent protection and such a race has similarities to the oil sector. It is preferable to concentrate on a few blockbusters rather than be an average competitor in many products, as the development costs for each are comparable.

The profit growth over the last five years was 10% per annum, just above the market’s 9%. The margin is an impressive 20%, five points above the overall stock market. Niche operators are more attractive than the gorillas, examples being Celsis, which provides contamination testing and Synergy Healthcare that offers sterilisation services.

Tobacco: recession resistance 1, competitive advantage 1. Percentage of stock market capitalisation 2%.

‘We’ll all be jockeying for position in Playboy and Penthouse.’

RJ Reynolds, on new tobacco advertising bans.

 

Tobacco is the second sector to score maximum points on the recession resistance and competitive advantage yardsticks. It is a unique product as it is highly addictive and is the only legal product sold that can be lethal if used in the

 

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manner intended. Advertising bans and smoking restrictions become ever tighter and tobacco is on the black list of ethical investors. The market is stable and there is no product obsolescence.

It is difficult to imagine a product that has a stronger resistance to recession. The addiction means that customers are hooked, so demand is extremely robust and insensitive to the high price charged. Although the developed world is a mature market, there is growth in the developing world, which feeds off rising living standards that increasingly enable such products to be bought. Young populations and per capita incomes are the most significant growth drivers. 

It has very high international competitive advantage. This is a remarkable testament considering it is achieved by a commodity product where little value is added in production. It is strongly cash generative, creates value for shareholders and the cost of production is very low compared to the high selling price, which is mostly comprised of punitive taxation. There is an old saying: what other products are like tobacco that cost a penny to make and sell for a dollar? The high price encourages consumption by both legal and smuggled importing from low tax countries. Brands are important as consumers respond to status and health messages. The profitability of the sector has been undermined in the US due to price-cutting by generic brands. The PER is usually low and the yield generous, reflecting the dullish growth. The latter has been boosted by numerous takeovers and goodwill is material.

The profit growth over the last five years was 11% per annum, slightly above that of the market, but the profit margin is the highest at 28%. The strong cash flow encourages high, tax-efficient gearing. The risk of litigation is high and awards in the US are astronomical, from both the civil courts and the government, which aims to extract $280 billion in a settlement with tobacco companies. Litigation news has a major bearing on sector share prices and can provide buying opportunities. Therefore, it is important to avoid British American Tobacco, as it has US exposure, whereas Gallaher and Imperial Tobacco do not. The latter two are smaller players and takeover potential is good. This is a very popular sector in a bear market but is ignored in a raging bull market, when high growth is the mantra, so sell in the former and buy in the latter. Profit warnings are rare, which is a major advantage.

 

End of extract from Chapter 4.

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