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Companies

  • Building Heaps & Piles at BHP

    Roger Montgomery
    April 18, 2012

    PORTFOLIO POINT: Given the outlook for Chinese growth and iron ore prices, is it time to cast a critical eye over your BHP holding?

    The 2001 merger of BHP Limited and Billiton Plc created the world’s largest diversified resource company. The company is also one of the largest in the world by market capitalisation and I would guess one of the longest-held stocks in many investors’ portfolios, as well as one of the most likely to have been inherited by superannuants from their parents.

    Operationally, the company is nothing like it once was. Seriously underperforming assets and overpriced acquisitions had to be written off in the late 1990s, and since then external candidates including Paul Anderson, Brian Gilbertson, Chip Goodyear and, most recently, Marius Kloppers have taken the top job at the Big Australian. Under their sound stewardship – and the biggest mining boom in history – BHP’s share price has risen from less than $10 when the merger was consummated to almost $50 prior to the GFC, and again a year ago. But since then, BHP’s share price has crashed 30%.

    A year ago, with the share price at its zenith, many analysts were extolling the virtues of BHP. I note one company said their positive view on BHP was due to low-cost and long-life mines, growing production and cost discipline. With demand from China strong, the common refrain of course was – and still is – that the outlook for BHP’s products was (and is) bright. Many also went on to add that copper had a strong bullish case over the next two years, and with global consumption outpacing supply and a lack of new high-grade deposits coming into production imminently, the marginal cost of copper was set to rise, which could only be positive for the price. And back in November 2010, some analysts were applying a notional price/earnings multiple of 12 to the EBIT numbers of UBS and Goldman Sachs of $US12.4 billion to $US12.8 billion, to arrive at an independent iron ore business valuation of $US144 billion – roughly the same as the market of the entire conglomerate at that time.

    So what has happened?

    Well, the copper price is indeed up 13% since March 2010, but BHP’s share price languishes. And I wonder whether the talk of new in-the-ground metrics to value iron ore assets is akin to the bubble-talk price/sales and price-per-click ratios being proffered as a new way to value internet companies back in 1999 and early 2000.

    BHP’s principle revenue drivers are the price of iron ore (for the manufacture of steel), the price of oil and base metal prices (predominantly copper). Emerging economies and their insatiable demand for construction and manufacturing materials has thus far ensured BHP grows its revenues and earnings.

    Talk to BHP employees and they’ll tell you it’s all really quite simple: ‘Dig it (iron ore) out of the ground for $33 and sell as much of it as you can (currently the price is $US140/mt)’.

    But how much of it can they sell? And at what margin?

    China’s economic data shows its economy is growing at the slowest pace in recent memory. China’s economy expanded at its weakest pace in 2.5 years in the fourth quarter of 2011. Sagging real estate (something I have warned investors here to watch) and export sectors have heralded a sharper slowdown, while triggering pro-growth responses from the government.

    Most recently, gross domestic output rose just 2% from the previous quarter, suggesting to some economists that underlying momentum is slowing more rapidly than expected.

    Interestingly, the fourth-quarter growth rate was the slowest pace since the second quarter of 2009. And this was when the global economy was emerging from a deep recession. It also marked the fourth straight quarter in which growth had slowed down.

    Importantly, recent data shows net exports and property investment subtracting from growth. This latter development is a serious concern for investors in BHP, because the property sector is worth some 13% of total economic output and steel is the primary input for building construction.

    Back in March 2010, I wrote: “The key concern for investors is to examine the valuations of companies that sell the bulk of their output to China. Any company that is trading at a substantial premium to its valuation on the hope that it will be sustained by Chinese demand, without a speed hump, may be more risk than you care for your portfolio to endure.

    “The biggest risks are any companies that are selling more than 70% of their output to China, but anything over 20% on the revenue line could have major consequences.

    “BHP generates about 20%, or $11 billion, of its $56 billion revenue from China; and Rio 24%, or $11 billion, from its $46 billion revenue. BHP’s adjusted net profit before tax was $19.8 billion last year and Rio’s was $8.7 billion.

    “…BHP’s profitability would be substantially impacted by any speed bumps that emerge from China…”

    Annual growth in China’s property investment of 12.3% as at December marked a sharp slowdown from November’s 20.2% pace. Housing investment dropped precipitously in December, while many property developers are warning 2012 looks worse.

    The booming housing market helped drive China’s parabolic growth, but the government’s attempts to engineer a ‘deflation’ of the property bubble appear to have had a sharper effect.

    This compounds the adverse impacts on the country’s manufacturers and exporters from weakening European export markets, rising labour costs and inflation, as well as the widely reported leadership handover.

    If you inherited BHP Billiton (BHP) and/or own it in your superannuation fund, you have to do more than simply keep a close eye on China. If indeed the writing is already on the wall, you need to decide whether you are going to respond.

    Skaffold’s valuation for BHP has, as I previously predicted, been falling. The 2012 valuation of $36.85 has indeed been leading the share price lower, as Ben Graham might have suggested it would when he explained that in the long run the market is a weighing machine. (BHP is currently trading at about $34.51) For those who are interested, my Rio valuation is $70.62 (Rio is currently trading at about $66.12).

    However, my BHP valuation currently rises to $44 for 2014, but I say “currently” because I suspect by 2014 an iron ore supply response will have forced the iron ore price lower, and triggered a raft of earnings revisions that will reduce BHP’s valuation.

    China may continue to drive GDP with capital and fixed investment spending on fast trains, highways, cities and airports, but irrespective of whether the GDP is 9% or 6%, the proportion of fixed-asset investment cannot be sustained at 60% of GDP. More importantly, the iron ore China does require may be purchased at much lower prices and like the declining margins Apple faces on its new generation iPads, and Gerry Harvey endures on sales of widescreen TVs, BHP may also have to endure lower margins on iron ore while also selling less.

    Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 18 April 2012.

    by Roger Montgomery Posted in Companies, Energy / Resources.

  • MEDIA

    How can you beat the market?

    Roger Montgomery
    April 14, 2012

    For many, beating the market indices is the hold grail of share market investing.  In this Australian article published 14 April 2012 Roger Montgomery discusses how you too can beat the market using his Value.able investing strategy.  Read here.

    by Roger Montgomery Posted in Companies, In the Press, Investing Education, Value.able.

  • MEDIA

    What are Roger Montgomery’s Value.able insights into Mining Services?

    Roger Montgomery
    April 14, 2012

    Do New Hope Corporation (NHC), Northern Star Resources (NST), Mt Gibson Iron (MGX), Navarre Minerals (NMC), Allmine Group (AZG), Credit Corp Group (CCP), Matrix composites (MCE), Coffey International (COF), Data #3 (DTL), Breville Group (BRG), UGL (UGL), QR National (QRN) and Seymour Whyte (SWL) make Roger’s coveted A1 grade?  Watch this edition of  Sky Business’ Your Money Your Call broadcast 14 April 2012 to find out, and also learn Roger’s current insights into the Mining Services sector. Watch here.

    by Roger Montgomery Posted in Companies, Energy / Resources, Intrinsic Value, Investing Education, TV Appearances, Value.able.

  • MEDIA

    In April 2012 where does Russell Muldoon see good Value.able investments? (Part 2)

    Roger Montgomery
    April 10, 2012

    Do Lonrho Mining (LOM), Integrated Research (IRI), Hawkley Oil and Gas (HOG), Boart Longyear (BLY), Forge (FGE) and Environmental CleanTechnologies (ESI) achieve Roger and coveted A1 grade? Watch Part 2 of Sky Business’ Your Money Your Call 10 April 2012 program now to find out. Watch here.

    by Roger Montgomery Posted in Companies, Investing Education, TV Appearances, Value.able.

  • MEDIA

    In April 2012 where does Russell Muldoon see good Value.able investments? (Part 1)

    Roger Montgomery
    April 10, 2012

    Do Thorn Group (TGA), Maverick Drilling (MAD), Campbell Brothers (CPB) and Galaxy Resources (GXY) achieve Roger’s coveted A1 grade? Watch Part 1 of Sky Business’ Your Money Your Call 10 April 2012 program now to find.  Watch here.

    by Roger Montgomery Posted in Companies, Investing Education, TV Appearances.

  • WHITEPAPER

    INTEREST RATES, THE BEST IT GETS. IT’S TIME TO DEPLOY CASH

    Curious about the investment landscape in 2024? It appears that the current market offers a plethora of enticing opportunities for investors, a rarity not experienced since pre-pandemic times. This unique scenario stems from a confluence of factors, including elevated yields and comparatively rational equity valuations.

    READ HERE

  • MEDIA

    How can the Biggest not be the Best?

    Roger Montgomery
    March 31, 2012

    Roger Montgomery expounds upon his Value.able investing approach to illustrate how Big does not mean Best when choosing companies in this Australian article published on 31 March 2012. Read here.

    by Roger Montgomery Posted in Airlines, Companies, In the Press, Investing Education.

  • Another Aussie Investing Classic.

    Roger Montgomery
    March 30, 2012

    I enjoyed the process of writing Value.able immensely and its best seller status suggests there’s a growing band of individuals in Australia who’d like to be successful value investors.  If you want to become a successful investor or simply invest successfully, I believe it’s best to learn from those that have a demonstrated track record. As Buffett once observed, “Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway.” One bloke who I count as a mate, a successful investor and who doesn’t need to take the subway, has written a book on investing that I think will prove to be a classic. Matthew Kidman and I were on CNBC together recently and knowing we were going to be on air together we happened to bring in our respective books, which of course we swapped. I have finished reading Matthew’s Bulls Bears & a Croupier, enjoyed it immensley and I commend it to you. If you were wondering what you were going to read over Easter, well now you have a very profitable suggestion.  I am sure Matthew would love to hear what you think so be sure to return here and post your thoughts and questions.

    Before I go, here’s an extract from Bulls Bears & a Croupier (pp173-176). It’s one of the many real life stories in the book and this one ties in nicely with our value investing and ROE methodology…

    “ABC Learning Centres

    I first met Eddy Groves in 2001. I was sitting at an outdoor cafe with Geoff Wilson when he came strolling down Macquarie Street with a stockbroker, planning to pitch the float of his childcare company, ABC Learning Centres. If memory serves me correctly, he was wearing a light grey suit with an open neck shirt. He didn’t quite fit the textbook profile of a CEO, with his shoulder-length blond hair and Cuban-heeled boots. When I said to Geoff, ‘Here they come’, he leaned over and said, ‘How are we going to invest with this guy? He looks like Johnny Farnham’.

    Over the next hour Eddy, still only in his thirties, was subjected to a range of tough questions, but to his credit, he wowed us with his knowledge of the childcare business. At that stage the company only had 31 centres in its portfolio but Eddy knew every employee in every centre, every rental charge per square metre, the occupancy level of each centre, the waiting lists and so on. He was also disarmingly honest, telling Geoff and me straight up,‘The key to our business for the shareholders is the occupancy levels at our centres. If occupancy is above 90 per cent then we start to make a lot of money.’ He repeated that comment several times during that session and in many subsequent meetings. I have not met a CEO before or since that day who demystified a business so rapidly for incoming investors.

    At first we weren’t convinced. Still sceptical of this young Queenslander, and never having come across a childcare operator that relied heavily on government spending, we decided to give the float a miss. Before the company listed on the sharemarket a couple of months later, I met Eddy at least twice more and said to Geoff that we needed to look at this company more carefully, because this guy really knew his stuff. Not many people were prepared to look at the company because it was so small, but I thought it fitted into our sweet spot — undiscovered and fast growing.

    The stock listed and Eddy got busy buying more centres and spreading the gospel of his company to investors. He had enough energy to run a power station. It wasn’t long before the broader market discovered the company and its colourful chief executive. In those early days he worked exceedingly hard with only a handful of stockbrokers hovering around sniffing for fees as the company needed to raise capital to fund its endless list of childcare centre acquisitions.

    Whatever Eddy Groves was doing, it was working, and the share price increased threefold in a short space of time. It was only then that we wilted and decided to help buy a parcel of shares in ABC held by Hunter Hall, who had profited nicely. Luckily for us, though, Eddy was only just getting started. His empire around Australia was expanding exponentially and over the course of the next year or so we watched our investment triple before our eyes. Things got so hot and steamy the company thought it necessary to split its stock to create more liquidity and give the impression it was not so expensive. The pièce de résistance was the merger with Australia’s other largest childcare centre manager — Peppercorn.

    The brokers were now lining up to support the company, which was like a fee-generating machine on the back of so many capital raisings and mergers. ABC now stood at the top of the mountain.

    Then the 20 per cent plus growth that investors had become accustomed to started to become harder to achieve. Eddy turned his attention offshore and before you knew it he had bought businesses in the United States, followed by operations in the United Kingdom. Following a series of capital raisings, the market capitalisation of the company had soared into the billions, while the PE kept travelling north to well above 20 times forecast earnings as investor interest started to emerge from all over the globe.

    There had been some public detractors of the stock, including well-known analyst, market commentator and fund manager Roger Montgomery, who made the prescient observation that returns in the business had gradually declined over time as more and more acquisitions were made. He was, like Winston Churchill, a voice in the wilderness, with the share price rising each day as investors, including me, ignoring the financial fundamentals.

    In 2006 I went to a presentation by ABC at a big brokerage firm where there was standing room only. I was lucky to grab a seat near the door but due to the size of the crowd I couldn’t see Eddy — but I could hear him. I had decided to come along just to get an update on the latest acquisition and find out how the business was travelling. There were a lot of new investors in the room asking questions that long-term investors had asked many times before, so I was guilty of not concentrating and reading something else. And then one person piped up and asked the question: ‘What are the occupancy levels of the centres in the US?’ Eddy replied that it wasn’t important to concentrate on occupancy levels. I nearly fell off my chair. Another person asked why that was the case and Eddie launched into a long-winded answer that didn’t really make much sense.

    I didn’t stick around to hear the rest of the presentation, sneaking out the door that I was sitting near. I raced back to the office and as I walked in I said to Geoff,‘ We need to seriously think about selling our ABC Learning shares’. He said, ‘It’s fine with me’. We spent the next few days re-examining the accounts and we had a lot of questions, including what had happened to $400 million of cash that had seemingly disappeared. Fortunately for us the stock was still trading in tremendous volumes and we were able to sell our shareholding at slightly more than $7 a share.

    As is well documented, ABC Learning hit the wall in 2008 when the GFC hit. The company, which had enjoyed investor support to the tune of more than $1 billion through a series of equity raisings, had somehow found a way to fall prey to a multi-billion dollar debt burden.

    There were many lessons to learn from the ABC Learning experience, but the point here is that stocks can be in the limelight for days, months or even years, only to become a disastrous investment down the track. Invariably as a story spreads across the market and more and more people get interested, more exotic reasons are created to buy the stock. Stockbrokers will place price targets for the stock near the current share price level, and when the PE ratio goes from say 10 to a head spinning 20, the analysts will generally follow with their valuations of the business. Things like sagging returns and higher debt levels are conveniently pushed to the side by investors and brokers as they all get sucked into the vortex of a rising stock price. At some unknown time in the future the share price will reflect the financial fundamentals and start to fall. For the investor the hardest aspect is timing when this will happen rather than if it will happen.

    Our croupier Peter Proksa learned this the hard way. In his bid to avoid paying too much for a stock he has limited his investments to shares or options that trade at 1 cent of less. This method also removes the possibility of his becoming enchanted by the story rather than concentrating on the facts presented in the accounts.

    The reality was, however, that if you were onto the ABC Learning story early, like the Hunter Hall investment team, then you could have made many times your money. The key was seeing that things were changing and working out when to sell. Roger Montgomery picked it and was happy to tell the rest of the market, which should have listened more carefully. Things had changed at ABC Learning over the years and Eddy admitted it in that meeting, but most people holding the stock just weren’t listening to the message he gave everyone.

    There are snakes and ladders everywhere

    Many people will argue these two examples do not apply to the big end of town, where a special breed of stocks called blue chip resides. And there is a grain of truth in this. There is very little chance of a big company going broke in Australia due to an unwritten contract between investors and company management who know they are too big to fail. That does not make them immune from being shocking investments.”

    With Permission.

    Extracted From Bulls Bears & a croupier, John Wiley & Sons, 2012

    by Roger Montgomery Posted in Companies.

  • Guest Post: What’s the real BHP share price?

    Roger Montgomery
    March 29, 2012

    Portfolio Point: BHP Billiton is well known to every Australian investor, but what you may not be aware of is the unique opportunity the corporate structure offers the trader and investor.

    BHP Billiton was formed when BHP and Billiton merged in June 2001; following the merger the companies maintained their separate stock exchange listings. Australian investor know BHP Billiton Limited (ASX:BHP) traded on the Australian Stock Exchange, the other major listing is on the London Stock Exchange (LSE:BLT) BHP Billiton Plc. A share bought on either exchange has equal economic and voting rights, meaning you receive the same dividend payment and have equal claim to the company’s assets.

    A logical person would assume that adjusted for the exchange rate a share of BHP Billiton Limited would trade very closely to BHP Billiton Plc, surprisingly this assumption is not correct. BHP Billiton Plc has traded at a discount every day for the last five years compared to the Australian listed BHP. If the shares were interchangeable between the exchanges the law of one price would remove the price difference, but in this case it is not possible to transfer a London listed BHP share to the Australian Stock Exchange, so there is not an arbitrage trade opportunity.

    On the other hand, as the discount does not remain constant under all market conditions there is an opportunity to profit in the movement of the spread. To trade the spread a person buys one BHP and sells the other listed BHP, the trader is in a hedged position and is not concerned by the price movement of BHP they are just concerned by the movement of the discount/premium between the two shares.

    As the shares are traded on different stock exchanges in different currencies, the exchange rate and the movement of the exchange rate needs to be considered if a trader is going to take a spread position. Fortunately in this case both are also traded on the New York Stock Exchange (NYSE) in US dollars through the use of American Deposit Receipts (ADR) an ADR traded on the NYSE represents shares in a foreign company. The ADR shares are interchangeable with the company it represents, so the law of one price keeps the price of the ADR adjusted for the exchange rate in line with the share it represents.
    During the last five years the London listed BHP ADR (NYSE:BBL) has traded between 78% and 96% of the price of an Australian listed BHP ADR (NYSE:BHP), with an average of 86%.

    An excellent risk/return ratio is obtained if the trader can buy the spread near it historic low and sell when the spread moves up to its average and the timing to perform this trade is when the price of BHP is collapsing. In November 2008 when ASX:BHP hit the low of $20.10 the above spread moved 8% in 9 days, 8% might not sound like a great return but as the trade is a hedged position leverage is safely utilised to increase the return on invested capital.

    On the other hand, if you are an Australian value investor who wants to buy BHP shares at a discount to their intrinsic value there is a greater margin of safety in buying the London listed BHP for a 15% discount compared to buying the Australian listed BHP. If you follow Roger’s advice and only invest in the highly rated companies on Skaffold then BHP is not going to be a buy for you today at any price, but as the financial situation of every company is constantly changing one day in the future BHP may be rated A1 on Skaffold and at that time it might be worth you considering the London listed BHP.

    Author: David Smith 13 March 2012

    by Roger Montgomery Posted in Companies, Energy / Resources, Insightful Insights.

  • Are the pizzas better at Dominos?

    Roger Montgomery
    March 27, 2012

    PORTFOLIO POINT: Despite the headwinds facing retailers in Australia, Domino’s Pizza is growing and expanding its margins. But is that growth already be priced in?

    Retailers in Australia are facing a perfect storm of weak consumer spending, online competition and a rising Australian dollar. But despite these headwinds, there’s one company that is not only expanding its physical footprint, but is becoming a serious force online. It’s also notching up double-digit growth in Europe, in spite of the economic climate, and breaking records to boot. You may be surprised to learn that this success story is in fact Domino’s Pizza Enterprises (ASX: DMP).

    Domino’s Pizza listed on the Australian stock exchange in May 2005, and opened its 400th store in the same year. The company is the largest pizza chain in Australia and enjoys a growing presence in France – a country that, with the exception of the United States, consumes more pizza per head than anywhere else in the world – Belgium and the Netherlands, having bought existing operations in those countries in 2006 and becoming the largest Domino’s franchisee in the world. Domino’s Pizza now operates more than 889 stores, employs more than 16,500 people and, according to one report, makes more than 60 million pizzas per year. And all of this is run by a Lamborghini-driving CEO, who is as obsessed about Domino’s today as he was when he merged his 17-store franchise company into what is now Domino’s Pizza Enterprises.

    The company’s online strategy has been a raging success, not only for pizza ordering but also for recruitment. When the company launched its iPhone App in 2009, it became the number one free app on the iTunes site within five days. Today, 40% of orders are made online and the company expects this to be 50% in the next six months, with a third of these orders to come from mobile devices.

    Domino’s recently reported its half-year results and saw an improvement on almost every KPI. Same-store sales growth was strong, exceeding expectations in both Australia and Europe; margins improved and stall rollouts continued; the balance sheet strengthened, as did free cash flow; and, despite even lower debt, returns on equity increased. Domino’s concluded by upgrading its full-year 2012 guidance.

    My friends at American Express should be able to confirm that while fashion retailing is one of the hardest gigs to be in, restaurants and cafes are one of the best. This is something Domino’s Pizza CEO Don Meij would know only too well. Despite challenging economic conditions, particularly in Victoria and New South Wales, same-store sales grew by almost 9% and total sales were up 11.2%. In Europe, where conditions are arguably much worse and youth unemployment is in the high double-digits, Domino’s recorded 12.6% total sales growth and 7.5% same-store sales growth. By the end of financial year 2012, another 60 to 70 stores will have been opened, net profit is expected to grow by 20% (despite adverse currency movements), and same-store sales growth is expected to be in the order of 5 to 7%.

    In the last three years, earnings per share have doubled (no doubt the company has also taken market share from its peers, such as KFC) and despite a substantial decline in borrowings, return on equity has increased from 17% to 23% (see Skaffold.com screenshot below)Rising returns on equity, with little or no debt, is an indication of powerful business economics. Generally, as a company gets larger, its returns on equity stabilise or decline. Domino’s, however, enjoys an ability to raise prices and, some say, reduce pizza sizes without a detrimental impact on volume sales. This is, in my estimation, the most valuable competitive advantage it has. Granted, it’s a surprising conclusion to put forward for a franchisee (for a look at how things can go wrong for a franchisee company, look no further than Collins Foods).

    Dominos displays declining debt (red columns), rising equity (grey columns), rising return on equity (blue line) and rising profits (green line).  Source:  Skaffold.com

    Since 2004, Domino’s profits have increased 40.11% p.a. from $1.954 million to $20.7 million.  To generate this $18.759m increase in profit, shareholders have tipped in an additional $64.37 million of equity and left in earnings of $34.82 million.  In other words every additional dollar contributed and retained has returned around 19%.  During the period under review the company has also reduced its borrowings by $9.11 million from $24.65 million it held in 2004 to $15.54 million at the end of FY2011.

    Analysts worry about the risks associated with growing a business in Europe in the present climate. Rising commodity input prices, including oil for delivery vehicles and wheat for flour, and the stronger Australian dollar are also points of concern. In the face of these perceived challenges, the company continues to grow and expand its margins. It also expects greater than 25% profit growth from Australia within three years. Clearly, Domino’s competitive advantages are proving those analysts who said Australia was ‘ex-growth’ wrong. And the company is also moving to electric delivery scooters to hedge against higher fuel prices.

    Domino is a high quality business – Source: Skaffold.com

    I have not been able to buy Domino’s shares – as much as I would like to – because they have not been cheap enough for me. My valuation is based on the idea that I want to reduce my risks as much as possible by ensuring I obtain a bargain. DMP has simply never traded at a bargain price. But with a price close to $9.00 today, you could (admittedly with the benefit of hindsight) put forward the argument that the $2.65 the shares traded at in 2009 was every bit a bargain. The issue is simply the discount rate that I am willing to use to arrive at my valuation. If I use 8% to 9%, my valuation approximates the lower historical prices. But is 8-9% enough? I think not.

    What would you pay for a business earning $25 million this year and $29 million next year, perhaps $35 million the year after that? If you said $300 million or $350 million, I’d label you a value investor, but today the market capitalisation is more than half a billion dollars. At that kind of multiple, I would guess the growth has been ‘priced in’. I would rather be certain of a modest return than hopeful of a great one, and at current prices – despite the obvious track record of the company and the very great skill of its management – I think buyers are being hopeful. Unless, of course, they know a takeover is imminent.

    Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 27 March 2012.

    by Roger Montgomery Posted in Companies, Consumer discretionary, Investing Education, Value.able.

  • Guest Post: Forcing Bright Prospects

    Roger Montgomery
    March 23, 2012

    Created by Harvard Business School professor Michael Porter to analyze the attractiveness and likelihood of profitability of an industry, Porter’s Five Forces are a simple but powerful tool for understanding where power lies in any business situation. Using this tool, you can gain insight into the competitive strength of an investee candidate.

    While these Five Forces are typically used by companies to determine whether new products, services or businesses may be profitable, investor’s can use them to analyze the competitive position of any industry member.

    The importance of ROE and buying companies with bright prospects is sacrosanct here at the Insights Blog but why? Return on equity is an important explanatory variable for superior share price performance and so we want businesses that can sustain high rates of return. When I talk about bright prospects it is the sustainability of these high rates of return that I am referring to. Whether the bright prospects relate to a rising tide of customers, the ability to pass on rising costs, the ability to be the low cost provider or the changing competitive landscape, how these factors serve to produce a high rate of return on equity is what we care about.

    Numerous economic studies have shown that different industries can sustain different levels of profitability. This can be attributed to differences in industry structures. Within those industries however there is a pecking order of companies and Kathy’s column on Porter’s five forces reinforces the need to understand where your investee candidate sits and whether that high ROE being produced today can be sustained.

    Porter’s Five Forces model is made up by identification of 5 fundamental competitive forces:

    Barriers to entry
    Barriers to entry measure how easy or difficult it is for new entrants to enter into the industry.

    Threat of substitutes
    Every top decision makes has to ask: How easy can our product or service be substituted?

    Bargaining power of buyers
    the question is how strong the position of buyers is. For example, can your customers work together to order large volumes to squeeze your profit margins?

    Bargaining power of suppliers
    This relates to what your suppliers can do in relationship with you.

    Rivalry among the existing players
    Finally, we analyze the level of competition between existing players in the industry.

    Kathy writes…

    Calculating the ROE or debt levels of a company is the easy part. But how does one determine if a company has bright prospects? The Porter’s Five Forces model is a tool that I have found to be helpful when picking companies in which to invest. I came across this model while I was studying an Information Systems subject at University.

    The Porter’s Five Forces model was developed by Michael Porter to help understand a company’s competitive advantage. The five “forces” that are identified by Porter are:

    1) Threat of new entrants

    New entrants can increase market competition between companies. In the absence of a dominant player, this can lead to erosion of profit margins.

    The threat of new entrants is highly dependent on the barriers to entry. For example, it is relatively easy to start a small pizza business, but it would be difficult to compete with or replicate Cochlear’s business due to the massive R&D costs and intellectual property that is hard to obtain.

    2) Power of suppliers

    Suppliers can place pressure on margins if they are dominant players in the market. This can be observed in the computer chip manufacturing space where Intel and AMD are the dominant manufacturers. These two companies arguably control the technology that is available to consumers because the manufacturers of computers must build them to accommodate AMD and Intel’s CPUs.

    The power of suppliers can also be witnessed in the building industry where suppliers increase their prices as a result of rising commodity costs. These price increases are difficult for builders to pass on in the current subdued climate as consumers are already stretched with high housing costs.

    3) Power of customers

    A profitable company depends on attracting and retaining customers. However, customers hold the power when they can easily switch to a competitor’s product or service.

    In a competitive market where there is little product differentiation, particularly in industries where products have become commoditised, customers have the power to force businesses to compete on price. This is evident with online book stores, where consumers have the ability to search for and compare the cheapest prices across online retailers such as Amazon, eBay, Book Depository and Booktopia, forcing traditional bricks and mortar book stores to compete.

    4) Availability of substitutes

    In the majority of industries there are substitutes that a customer might use if prices become prohibitively high. Substitutes can be seen in the energy sectors, for example, petrol is increasingly being substituted with ethanol in cars.

    New technologies also create substitutes. The introduction of electronic downloadable music has been very popular with consumers who wish to purchase and download music at their convenience. CD sales have dwindled much to the dismay of record labels. Companies need to be agile and adapt to new trends. Kodak is a classic example of a company that did not move with the times.

    5) Existing competitors

    Competitors all fight for market share by developing their brands and by attempting to attract customers. Increased competition can lead to the erosion of profit margins. Innovation can help, however this is difficult for businesses that operate in a commodity-type business. Retailers (e.g. Coles, Woolworths, Myer) typically sell the same products as their competitors, and perhaps their private label products are a means for them to differentiate themselves from their competitors.

    I hope this has given everyone some food for thought. These are the things
    I try to think about before I invest my hard earned money.

    Thanks Kathy for your post.  If you would like to list a couple of companies that you believe dominate their industry and will sustain high rates of return on equity, simply click on the Leave A Comment link below.

    by Roger Montgomery Posted in Companies, Insightful Insights, Value.able.