Strategy

1
Strategy Investing

• Chris Argyrople, CFA
• Concentric
• Corporate Strategy Investing

2
Competitve Strategy

• What is more important?
• Price
• Financial Performance (growth)
• Corporate Strategy
• Industry Factors
• Implementation
• Answer They are All Important
• Finance and Strategy must be analyzed together.

3
Industry Analysis (Hooke Security Analysis on
Wall Street)

• Serious research starts at industry level
• In-depth industry study is prerequisite for a
  proper security analysis
• Chosen industries dont have to be stellar
  performers, they just have to be reasonable
• Dont be afraid to have a contrary opinion. If
  you want different results than others, you must
  invest in different securities

4
Competitive Strategy The Core Concepts (Michael
Porter)

• Competition is the core to success or failure
• Two key questions
• Industry Attractiveness
• Firms Position within Industry
• Creating Competitive Advantage
• Create value for buyers that exceed the cost of
  creating it
• Either provide lower prices or more benefit _at_
  same price

5
Structural Analysis of Industries

• Industry attractiveness is the fundamental
  determinant of any firms profitability
• Goal of Strategy Change the Rules in Firms
  Favor
• Product sexiness does not drive profitability
  industry structure does
• Many high-tech industries like PC hardware are
  not profitable for all participants (Compaq,
  Packard Bell)
• Low-tech businesses can be very profitable
  Postage Meters

6
Affecting Industry Structure

• Most important for firms to alter industry
  structure in their favor
• Not all 5 forces will be equally important for
  each firm in any industry
• Each industry has unique structure
• Firms can easily destroy industry structure (as
  easy as they can improve it) by reducing entry
  barriers (through new designs), or extended price
  cutting

7
Reaction by Competition

• Whenever firms make a move, they must consider
  the competitive reactions. If competitors
  imitate your price cut, everyone could be worse
  off
• Industry destroyers are often 2nd tier firms
  stretching to overcome competitive disadvantages
• Leading firms usually dictate structure, but
  anything they do usually affects all firms

8
Value to Buyer is Source of Value

• Satisfying buyer needs is core of success in any
  business
• Happy customers are necessary but not sufficient
  for profitability
• Industry structure determines who captures the
  value
• If buyers have lots of power, they keep the value
  for themselves leaving little for the firms
  (same concept for suppliers)

9
Capturing Value

• If an industrys product creates minimal value
  small profits for industry
• If value created for buyers, structure is
  crucial
• Autos lots of value but small profits
• Medical Services value and higher profits

10
Porter 5 Forces Model
11
Competition

• Industry Group of firms that produce products
  which are close substitutes
• Industry factors are often more important than
  firm specific issues
• Example Highly Less
• Profitable Profitable
• Pharmaceuticals Grocers
• Software Retailing

12
6 Major Entry Barriers

• SCALE ECONOMIES
• Can be present everywhere Manufacturing, Design,
  Purchasing, Sales, Service, etc.
• PRODUCT Differentation / Technology
• CAPITAL
• SWITCHING COSTS
• Capital PLUS Training
• DISTRIBUTION CHANNELS
• GOVT. POLICY / REGULATION

13
Advantages Independent of Scale

• PROPRIETARY TECHNOLOGY
• FAVORABLE RAW MATERIAL ACCESS
• GOOD LOCATIONS
• GOVT. SUBSIDIES, LICENSES, PATENTS
• LEARNING CURVE
• FIRST MOVER ADVANTAGE

14
Warning Signs

• RIVALRY
• Price competition usually hurts everyone (unless
  it successfully drives out competition). Beware
  of price competition. It is usually very bad
  news for a stock.
• EXIT BARRIERS - perpetuate Overcapacity
• Types Labor, no buyers for assets, govt.
  restrictions, emotional exit barriers.

15
Buyer Power

• Number of Customers.
• An industry is powerful when there are many small
  customers. No customer has significant impact.
• Uniqueness of Product.
• If no substitute readily exists, then an industry
  has power over customers.
• Brand Preferences.
• Buyers who prefer a certain brand (cigarettes,
  for example) have lower power.

16
Buyer Power

• Size of Purchase.
• If cash outlay is low, customers do not have
  power. For large purchases like automobiles,
  buyers can exert power because their demand is
  very price elastic.
• Switching Costs.
• High switching costs give the industry strength.
• Significance of Product Quality.
• If industrys quality is not important (to the
  quality of the buyers product), the customer
  will minimize the product search.

17
Buyer Power

• Threat of Vertical Integration.
• If a buyer has a credible threat of vertical
  integration, he exerts more power.
• Information Available to Buyers.
• Lack of information about capacity, markups, etc.
  put buyers at a disadvantage.
• Low Profits

18
Supplier Power

• Product Substitutes.
• Industry has power over vendors if substitutes to
  the suppliers product exist.
• Number of Suppliers.
• A large number of suppliers cant exert
  influence.
• Entry Barriers in the Suppliers business.
• If the entry barriers are low, companies can
  squeeze out suppliers through vertical
  integration.
• Ability to Delay Purchase of Vendors Product.

19
Supplier Power

• Existence of Unions.
• A unionized industry may discourage new entrants,
  thus giving existing suppliers power.
• Industry Capacity Relative to Demand.
• Excess capacity in a suppliers product line
  diminishes vendor strength
• Product Differentiation or Brand Loyalty.
• Undifferentiated products with low brand
  allegiance cant exert power.

20
Supplier Power

• Importance of Suppliers Product to Industrys
  Product.
• If the suppliers product is unimportant to
  industry quality, then suppliers have less power.
• Industry small of Suppliers Sales
• Sometimes a product is too small to waste time on
• Suppliers Ability to Forward Integrate into
  Industrys Business
• Switching Costs

21
Product Substitutes

• Existence of Substitutes.
• How close are substitutes to your companys
  products?
• Price / Quality advantage of Substitutes.
• Advent of New Technologies.
• Usually the biggest risk often can blindside a
  slow-moving, large beauracracy.
• Switching Costs.
• Often a product is designed as a system input.
  Switching requires product redesign and
  Re-training
• Importance Subst. often over/under estimated

22
Industry Rivalry

• Industry Growth Rate is the fundamental
  determinant of an industrys competitiveness.
• Growth firms expand without price competition.
• Industry Cost Structure.
• High fixed costs provide incentives to fill
  incremental excess capacity at below market
  prices. This is bad.
• Scale Economies.
• Capacity Utilization.

23
Industry Rivalry

• Exit Barriers. (can increase competitiveness)
  Examples
• Government restrictions
• Emotional attachment (management, entrepreneur)
• Unique Assets. Difficult to sell.
• Costs to close plant layoff employees.
• Brand Loyalty and Product Differentiation.
• Switching Costs.
• Number of Competitors.

24
Industry Rivalry

• AMOUNT OF PRICE COMPETITION.
• BEWARE OF PRICE COMPETITION.
• Strategic Importance. If the business is of
  strategic importance to competitors, then rivalry
  will be strong. Conversely, if some competitors
  have vertically integrated into the business,
  they will not be as fierce.

25
Types of Generic Strategies

• 1) COST LEADERSHIP
• 2) DIFFERENTIATION
• 3) FOCUS (Niche)
• Cost or Differentiation Focus
• Stuck in the Middle
• Guaranteed Low Profitability
• Firms that Switch Strategies too Often

26
Generic Strategies Low Cost, Differentiation,
Focus
27
Cost Leadership

• There can only be one dont want to be one of
  several firms vying for the spot.
• Must convince others to abandon this strategy,
  depends on preemption
• Low cost producer guaranteed a good position at
  equivalent prices, the low cost producer has
  higher margins
• Sources of advantage scale economies, low-cost
  designs, proprietary technology, better access to
  raw materials etc.

28
Differentiation

• Be unique on some dimension that is valued by
  buyers
• Get Premium Pricing for differentiation
• Differentiation can be based on product, delivery
  system, marketing approach etc.
• Price Premium must exceed added cost of
  differentiation to add value

29
Focus Cost Differentiation Focus

• Focuser selects a target segment (or niche) and
  tries to get competitive advantage in the segment
  (even though no overall advantage)
• Exploit cost advantage in certain segments
• Differentiation focus exploit buyers special
  needs in those segments
• Narrow focus is not sufficient for good
  performance

30
Example of Focus

• Craft beer like Sam Adams differentiation focus
• Low cost Royal Crown cola

31
Stuck in the Middle

• Stuck in the Middle try to be everything to
  everybody
• Firms often try to get competitive advantage
  through all strategies and achieves none
• Firm stuck in the middle can still be profitable
  if other competitors are stuck or if the industry
  itself is highly profitable

32
3 Conditions for being both Cost Leader
Differentiation

• Can simultaneously achieve both cost leadership
  differentiation if
• Competitors are stuck in the middle
• Cost is affected by share or interrelationships
• Firm pioneers a major innovation

33
Risks of Cost Leadership

• Competitors Imitate
• Technology Changes
• Other bases for cost leadership erode
• Cost focusers achieve even lower costs in target
  segments
• Proximity in differentiation is lost

34
Risks of Differentiation

• Competitors Imitate
• Bases for differentiation become less important
  to buyers
• Differentiation focusers achieve greater
  differentiation in target segments
• Cost proximity is lost

35
Risks of Focus

• Target Segment becomes structurally unattractive
• Structure Erodes
• Demand Decreases
• Segments differences narrow ( thus broad
  competitors enter space)
• Advantages of a broad line increase
• New Focusers in sub-segment industry

36
Other Points

• Build / Hold / Harvest this is not strategy,
  these are results of strategy
• Acquisitions are not strategy they are a means
  of achieving a strategy
• Market share does not describe competitive
  position. Share is not a cause of competitive
  advantage but a result of it.

37
Product Life Cycle
38
Changes in Growth

• DEMOGRAPHICS
• TRENDS (Social)
• CHANGES IN SUBSTITUTES (Cost Qual)
• CHANGES IN COMPLEMENTS
• PENETRATION
• TECHNOLOGY / PRODUCT CHANGE

39
Model Industry Analysis

• Industry Classification
• Life Cycle Position, Business Cycle
• External Factors
• Technology, Govt., Social, Demographic, Foreign
• Demand Analysis
• End Users, Growth, Trends Cyclicality around
  trends
• Supply Analysis
• Concentration, Ease of Entry, Industry Capacity
• Profitability
• Supply/Demand Analysis, Cost Factors, Pricing
• International Competition Markets

40
Business Cycle

• Three Types of Industries
• GROWTH, DEFENSIVE, CYCLICAL
• Growth Industry above average growth independent
  of the business cycle
• Defensive Industry Stable (mostly upward slight
  dip in downturns) performance throughout business
  cycle (food, utilities etc.)
• Cyclical Industry Earnings track the business
  cycle

41
Issues in Industry Classification

• Self-deception is a key problem once an industry
  is classified as a growth industry, analysts
  often miss its move out of the category
• Dont paint all industry participants with the
  same brush not all firms in mature industry are
  mature

42
External Factors

• Technology What is obsolescence risk?
• Government Policy can create industries (i.e.
  auto airbags)
• Social Changes Lifestyle can affect industries
  (trend toward fast food etc.)
• Demographics Greying of America (healthcare,
  golf industry)
• Foreign Influences Foreign steel auto are good
  examples

43
Demand Analysis

• Top-Down Analysis Look for correlation between
  economy sales (example cement industry
  correlated to GNP )
• Industry Life Cycle Where is the industry within
  its life cycle?
• External Factors Qualitative Analysis
• Establish a sales forecast, often by
  extrapolating trends (look for turning points)

44
Other Issues Demand Analysis

• Customer study is key study buying habits
• Geographical differences
• Growth Industries measure penetration
• Untested Industries does product fill a need?

45
Supply Analysis

• Supply is a function of excess capacity
• Add up capacity of all firms
• Pricing is linked to capacity overcapacity
  indicates lower prices

46
Industry Pricing

• Factors Influencing Pricing
• Product Segmentation
• Industry Concentration
• Ease of Entry
• Price changes of Supply Inputs

47
Strategy Investing

• Long Term Perspective
• Augments The Numbers
• Analyze
• INDUSTRY
• FIRMS COMPETITIVE ADVANTAGE
• Pay Attention to
• Cash Flow, Cyclicality
• Growth Rate Changes in Growth Rates
• Capacity / Substitutes / Change in Comp. Position

48
Strategy Investing

• Great Long Term Investments have Sustainable
  Competitive Advantage
• Like to Pay a Reasonable Price for firms with a
  Moat around them
• Growth at a Reasonable Price GARP
• Pay attention to Industry as much as firm
• Who has the best strategy today?
• Microsoft? - GE? - Gillette? - Thoughts ???

49
Determining Sustainability of Competitive
Advantage

• DC Mueller, in Profits in the Long Run, found
  that there is incomplete regression to the mean.
  Why?

50
Why Might Excess Profits Persist?

• Maybe the high-profit groups are riskier (thus
  the markets require higher returns)
• Some advantages are subtle to detect, especially
  in a world where the same resources are available
  to all firms.
• Why might resources be immobile?
• Culture, Brand Image, Location, Relationships,
  Patents, Scale Economies, Customer Access, etc.

51
Example of Sustainability QWERTY Keyboard

• Sometimes the answer is VERY SIMPLE
• QWERTY is a sub-optimal keyboard configuration
  invented in 1873
• QWERTY invented to minimize typebar clashes (we
  dont have typebars anymore)
• All world records for typing have been set on the
  Dvorak keyboard, invented in 1932
• Apple IIC computers came with a keyboard that
  switched between QWERTY Dvorak
• TOUGH TO GET PEOPLE TO CHANGE !!!

52
Reputation Buyer Uncertainty

• People generally go back to the same place to buy
  their gasoline etc.
• Habits are tough to break
• Once you are satisfied with a product, it is
  difficult to get people to switch !!
• Why do people still buy Intel processors when AMD
  might be faster cheaper?

53
Why Early Movers Fail

• Royal Crown invented diet cola
• Lotus 123, D-Base all lost 90 share
• These firms may not have the Complimentary Assets
  necessary for product leadership
• Early movers often fail to innovate next
  generation products are superior

54
Management is the Key Variable

• Good Companies are run by Good Management Teams
• Goodwill can be destroyed. This means that, Long
  Term, people are a companys main assets.
  Example
• 1960s, General Motors, PanAm, IBM, ATT were like
  Microsoft, Gillette, Coke, and GE today.
• Lousy Management ruined GM, it could ruin Coke
  too!

55
Evaluating Management

• Characteristics of Good Management
• Ownership interests aligned with shareholders
  (i.e. they own lots of shares)
• No empire building. Acts in best interests of
  stockholders. Examples
• Increased Dividends, Stock Buybacks etc.
• Good information systems
• People Focus
• TRACK RECORD

56
Checklist for Management Evaluation

• How have they done in the past?
• Are they buying or selling shares?
• Have you listened to the conference call?
• Is Mgt. more or less cautious vs. normal?
• Do their actions support shareholder value or
  empire building?
• Too many options grants to themselves?
• Any recent Changes to the Mgt. Team?