Thursday, January 2, 2014

The myth of industry size and growth in strategy/capital allocation

One of the most pressing questions that I come across is the importance of industry size and growth in making a capital allocation decision.

For eg., would you invest into a company that is making healthcare IT in the US (in the light of the healthcare reforms) or  into an ebay challenger in an emerging market like India ?

In each of these cases, the novice investor in me would gravitate towards how big the industry was, how competitive the field was and how fast it was growing etc. That was, until I saw the TED lecture by Daniel Kahneman and understood the power of patient, deliberate, second degree thinking.

I realized that looking at the market size and growth, while being important, is akin to an aspiring sportsperson looking the size and the spoils of the established athletes in the sport before plunging into it full time. So, would you choose cricket in India, because it is a much bigger sport than kabaddi ? By the same logic, Tendulkar should'nt have chosen cricket. After all, did'nt he take up tennis watching John McEnroe win Wimbledon in the early 1980's.

Myth : The larger a market, the more shareholder value it creates

What matters a lot, lot more is your own skill sets, capabilities and passion for the sport. Some of the greatest businesses happened from "inside out" entrepreneurs - Bill Gates of Microsoft wrote something that gave him joy, Warren Buffet tap dances to work because he loves investing and Google was created because Larry Page/Sergey Brin felt they could organize information in a way hitherto never done.

What matters a lot more is how " consolidated"' the market is - viz., how differentiable the various competitors are within that segment.

This reminds of the famous quote by Warren Buffet, at the peak of the 1999 dot com bubble, ostensibly justifying his decision not to invest into unprofitable, dot com stocks:

"The physical growth prospects of an industry do not necessarily have any correlation to shareholder returns. If that was the case, the US automotive industry would have generated more than the ZERO return it generated over the last century as it grew a million-fold. "

This is especially true of industries which exhibit one or many of the following characteristics :

- Low switching costs (eg., small box retail)
- Commoditized production (unbranded textiles, non-rare commodities)
- Low degree of differentiation ( eg., e-commerce retailers)

What, it seems, then matters is skill sets and competence, MORE than the market and the size and the growth of it.

This was, more than ever, the case with several buy-outs/acquisitions - a fact I was quite late to recognize. As this excellent article, points out, this is a fact that can be overlooked by even the best minds - including the world's greatest management consultants and thinkers.

So, there it is, the moat around the castle is far, far more important than the size of the castle itself - a lesson that will stick with me always.

No comments:

Post a Comment