Checklist series, Part 3: Industry analysis
"When a manager with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."
Warren Buffett
This item shows up near the top of the checklist because it can be an early disqualifier for a potential investment.
Some industries just suck, and depending on the investment manager’s comfort with uncertainty, they can choose to bypass companies in the wrong industry regardless of a company’s prior track record. Warren Buffett famously didn’t buy technology stocks for a very long time (his investment in Apple notwithstanding, but I would argue that’s was a consumer staple by the time he invested). Terry Smith won’t buy banks or energy producers. Seth Klarman has written that he avoids “over-leveraged, capital intensive debtors” like airlines and utilities. Even if we don’t explicitly avoid them, every money manager has those industries that just give them “the ick.”
I definitely have preferences but try to avoid hard and fast rules. Being much younger than Buffett, I don’t have a fear of technology; in fact, some of my biggest winners have been tech companies. I had historically avoided commodity producers, but that changed eventually.
So I’m willing to adapt and pivot. I can look past the “price taker” risk if a company is a low-cost producer with a strong balance sheet. I hate the impact that high capital intensity has on free cash flow, but I can overlook that where the current capital investment promises a high ROI.
Look for tailwinds.
The industry a company operates in can create tailwinds or headwinds. Is demand growing or shrinking? What is the competitive environment? Will technology help reduce costs, or does it threaten end markets? At the most basic level, we ask ourselves whether it’s a good business to be in.
Counterintuitively, an industry facing headwinds might produce some great investments, because the lack of new entrants allows the incumbents to focus on returning cash flow to shareholders.
Tobacco stocks are a stellar example of this. Has any other industry faced the political and social pressure than cigarette makers? But as the number of smokers has dwindled, the shares of these companies have been among the world’s best investments - partially because they don’t have to worry about the threat of new entrants poaching their customer base.
Oil stocks might fall into this bucket right now - since everyone knows we are undergoing a transition to green energy, investment in exploration has declined, even as demand may prove more resilient than expected.
But some industries are just toast and require management to reimagine their businesses. Blockbuster Video, anyone? Distinguishing between an industry headwind and an uninvestable business can be tricky, and management quality is a big factor.
Where does the business fit?
Last week, I wrote about what Karl Marx taught me about investing. As I wrote: industries consolidate around the most dominant, well-managed companies.
And so I’m looking first for the industry players with key advantages. If I’m looking at a company that isn’t the most dominant, well-managed in an industry, I want to have a very clear thesis as to why the tide will turn in their favour in the future, and key performance indicators to gauge progress towards this end. In my experience, it usually isn’t worth risking the investment in second or third-tier players.
What is the competitive environment?
It goes beyond unit economics of a particular business. When I talk about analyzing an industry, I’m also trying to understand the competitive environment that the company exists in. Are there many players, or few? Who are the suppliers? Who are the customers? How sticky are customer relationships? How much leverage do suppliers have? How many substitutes are there for the company’s actual product or service?
It can get tricky. It’s easy for me to evaluate Apple’s competitive position, because I’m a user of their technology. But enterprise software? Niche industrials? I have to rely on third party research or anecdotes, and so will have less confidence in my understanding of industry dynamics.
This is fine - none of this precludes an investment in a company. But you’ve got to be aware of your blind spots, and add the risk to your discount rate appropriately.
Like anything else, there’s an art to this, and it’s driven by intuition and experience more than it is by collecting data and following the latest news.