The business

The economics of the business is one of three key evaluations that an investor has to make. Of the three key evaluations, this is easier (though still very difficult) than the other two key evaluations of management and valuation.

Michael Porter’s book “Competitive Strategy” describes five forces that determine industry profitability. This provides a useful framework to evaluate the business.

1 Ease with which new entrants can compete: The higher the entry barriers, the better. Entry barriers include large capital costs to set up, brand loyalty for existing businesses, difficulty of setting up new distribution networks coupled with difficulty of accessing existing distribution networks, high learning curve for new products, difficulty of obtaining inputs, threat of retaliation by strong existing businesses.

2 Bargaining power of suppliers: The best case is where the business can choose to buy its materials and services from a large number of suppliers who are competing strongly among themselves.

3 Availability of substitutes: The customers should preferably not have substitutes to choose from. If substitutes are available, then the questions to be addressed are the relative price of the substitutes and the ease with which the customer can switch to using substitutes. Concorde was the most technologically superior passenger plane of its time. But competion from technologically inferior planes, which passengers preferred for their lower price, made Concorde commercially unviable.

4 Bargaining power of buyers: Obviously, the lower the bargaining power of the buyers, the better. The worst case is where the business is dependent on a single buyer as was the case with the British suppliers to Marks and Spencer when M&S abandoned its policy of buying British to seeking suppliers offering the best deal, wherever they may be.

5 Rivalry amongst existing businesses: Some businesses have such intense rivalry that, while this is great for the customers, none of the businesses make satisfactory profits. This commonly happens in commodity type businesses where the customer does not care who the supplier is as all the offerings satisfy his needs.

It is also very important to identify and evaluate the risks inherent in the business as your capacity for and attitude to risk may be incompatible with the inherent risks of some businesses. Some examples:

1 Technology businesses are vulnerable to their products being made obsolete by new technologies and then the sale of the erstwhile best selling, but now obsolete, products drop off sharply. This is specially risky for one product companies rather than those that hold a portfolio of different products. Once great photography companies like Kodak and Polaroid lost their advantage when digital cameras made their products obsolete.

2 Cyclical business like shipping, construction and property which have years of good profits followed by years of losses. At the end of each cycle is there value creation or destruction?

3 Businesses prone to disasters that can wipe out many years of profits, e.g. banks, pharmaceuticals, etc. Warren Buffett: The banking business is no favorite of ours. When assets are twenty times equity ... mistakes that involve only a small portion of assets can destroy a major portion of equity.

Below I give quotes from some of the most successful investors regarding selection of businesses suitable for consideration.

Warren Buffet
1 It will rarely, if ever, pay you to buy a bad business at any price.
2 Good jockeys will do well on good horses, but not on broken down nags. When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.
3 We favour businesses and industries unlikely to experience major change. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek. As investors, our reaction to a fermenting industry is much like our attitude towards space exploration: We applaud the endeavor but prefer to skip the ride.
4 A horse that can count to ten is a remarkable horse – not a remarkable mathematician. Likewise a textile company that allocates capital brilliantly within its industry is a remarkable textile company – but not a remarkable business.
6 It is no sin to miss a great opportunity outside one’s area of competence.
7 Time is the friend of the wonderful business, the enemy of the mediocre. It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
8 In a difficult business, no sooner is one problem solved than another surfaces.
9 I have not learned how to solve difficult business problems. What we have learned is to avoid them. In both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult. We’ve done better by avoiding dragons than by slaying them.
10 A business that must deal with fast-moving technology is not going to lend itself to reliable evaluation of its long term economics.
11 Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms... But I would rather be certain of a good result than hopeful of a great one.
12 Your goal as an investor should simply be to purchase, at a rational price, a part investment in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.
13 ... a great investment opportunity occurs when a marvellous business encounters a one-time huge, but solvable, problem as was the case many years back at both American Express and GEICO. Overall, however, we've done better by avoiding dragons than by slaying them.

John Ballen
1 There are some very capital-intensive industries where it is very difficult to have sustainable returns over the longer term.

John Neff
1 I advised fund directors to restrain stock selections in the industrial products segment to predictable companies in predictable industry climates.

Van Schrieber
1 Find the best industry, the one which is in the forefront of innovation; then find the best participants in that industry and buy those stocks.

Scott Johnston
1 You want to focus on the strongest industry sectors and the strongest stocks, because the better, stronger companies should decline less in a bear market and come out of the starting blocks faster during the rebound in a bull market.
2 I want companies in industries that are doing well in the market pricewise. It is it's awfully difficult for any company to be doing well in an industry that is doing poorly. If you have a sector that's flat on its back, it might be the greatest company with the greatest story ever, but when the institutional salesmen are out there calling around trying to get your interest, the answer is likely to be, hey, forget it. I don't want to own semiconductors; it's a dead group

Laura Sloate
1 We don’t invest in technology stocks. The creators of technology have their own network and you really have to understand it.

Burton Malkiel
1 Investments in transforming technologies have often proved unrewarding for investors. In the 1850s, the railroad was widely expected to greatly increase the efficiency of communications and commerce. It certainly did so, but it did not justify the prices of railroad stocks, which increased to enormous speculative heights before collapsing in August 1857. Electricity in the early twentieth century had profound effects on the layout and design of factories and led to a large increase in the productive efficiency of the economy. But throughout the first two decades of the century, electric utilities were poor investments. Similiarly, airlines and television manufacturers transformed our country, but most of the early investors lost their shirts. The key to investing is not how much industry will affect society or even how much it will grow, but rather its ability to make and sustain profits.

Peter Lynch
1 When somebody says “Any idiot could run this joint”, that’s a plus as far as I’m concerned, because sooner or later any idiot is probably going to be running it.”

Benjamin Graham
1 Obvious prospects for physical growth in a business do not translate into obvious profits for investors.
2 The experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries.