I am, by no means, an expert. But one of the most defining pieces of financial literature I’ve ever read is Michael Mauboussin’s “Measuring the Moat”. Clearly, this goes with ‘Sustainability’ part of the framework.
I am simply going to summarize the fairly long paper here, in the hopes that we can determine if at least a majority of the “measuring” can be done for the Indian market. In addition to this, I am going to add my own addendum to the paper in a very few places. So if you see something amiss compared to the original work, it’s just me trying to improvise.
Here’s the short legend for what I’m going to write below: Wherever you see a word bolded, it’s a concept / cog of the model. Wherever you find an bolded and italicized phrase below, it is a data point that we should attempt to get for companies in India (In the paper, Mauboussin has used data from U.S. companies).
Competitive Life Cycle: Firms go through 4 distinct cycles and where they are usually determines what they do: (1) High innovation; (2) Fading returns; (3) Mature; and (4) Need restructuring. The idea is that a firm’s Return on Capital (RoE / RoCE / CFROI) converges towards the firm’s Cost of Capital over time. As long as the Returns are above the Cost, firms create Value (Called “Economic Value Added”).
| Industry Analysis |
Industry Analysis is split into 3 parts: (1) Get the lay of the land; (2) Assess industry attractiveness through an analysis of the ‘five forces’; and (3) Consider the likelihood of being disrupted.
Get the lay of the land
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Construct an Industry Map, covering all parts of the value chain and to assess the size of the industry. Create a Profit Pool (Operating Profit / Net Profit) to assess which parts of the chain are the most and least profitable.
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Measure Industry Stability by laying out Market Share changes over a long period. Lesser the change in market share, the better. Use Pricing Stability (Operating Margins) to determine pricing power (Correlation to Raw Material prices over time is optional). More stable, less correlated Margins are better.
Industry Attractiveness
Determine Industry Structure using the Porter’s Five Forces model. Porter recommends using industry analysis to understand “the underpinnings of competition and the root causes of profitability.”
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Supplier Power: What kind of leverage does your supplier have over you? Check Payable Days with regards to the Industry Average Payable Days.
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Buyer Power: What kind of leverage does your customer have over you? Check Inventory Days and Receivable Days with regards to the Industry Average Inventory Days and Receivable Days.
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Threat of Substitutes: How likely is it for your customer to switch to a substitute product? Difficult to measure, IMO. Perhaps check Market Share of a company’s individual products Vs the substitutes (No issues for single product companies).
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Threat of New Entrants (Barriers to Entry): How easily can a new entrant gain market share? Check the Rate of Entry and Exit (No. of firms entering and exiting the industry) for the industry in question over a long period (Something like what @dd1474 did for figuring out the Survival/Mortality Rates?) . For an even deeper analysis of Barriers to Entry, study: (1) Asset Specificity; (2) Scale of Production (Existing Fixed Assets compared to country average); (3) Capacity Utilization; (4) Reputation; (5) Contracts, licenses, patents (Countable, comparable with industry average - perhaps order by difficult to get) (6) Learning curve benefits; (7) Network Effects; and (8) Exit costs (Losses in the last few years of firm that exited the industry).
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Competitive Rivalry: User the Herfindahl-Hirschman Index (HHI Index) (Need Market Share details for at least 75-90% of the industry) to determine industry concentration. Typically, industries with a HHI Index score > 1800 are said to be less concentrated. Concentrated industries are more profitable than crowded industries.
Disruption and Disintegration
Christensen’s “Disruptive Innovation” Model. Too subjective to summarize here. Here’s the original paper. The basic idea is that there are three types of disruptions: (1) Sustained Innovation (Small players continuously innovating new processes/products); (2) Low-end Disruption (Predatory Pricing); and (3) New-market disruption (Creating a completely new, non-existent market, but offering to the same customers)
| Company Analysis |
Company Analysis to be added later.
Meanwhile, here’s a nice checklist from the paper for the whole shebang: Value Creation Checklist.pdf (167.9 KB) (Pages 56 and 57 in the original document)