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Talking to Management, Part III: The Competition

Talking to Management, Part 3: The Competition: This was originally published on RealMoney on April 17, 2007:

Talking to Management: The Competition

What are you seeing that you think most of your competitors aren’t seeing? Or: What resource is valuable to your business that you think your competitors neglect?

This question is an open invitation to a management team to reach into its “brag bag” and pull out a few of its best differential competences for display. The answer had better be an impressive one, and it had better make sense as a critical aspect of the business. Good answers can include changes in products, demand, pricing and resources; they must reflect some critical aspect of business that will make a difference in future profitability.

Consider two examples from the insurance industry, both of which are future in nature:

I posed this question to the CEOs of several Bermuda reinsurers, and the answer was: “We don’t think that the profitability of casualty business is as profitable as the reserving of some of our competitors would indicate.” That might have been a bit of trash talk; perhaps it was a word to the wise. I favor the latter interpretation.

Then there was a CEO who suggested that many specialty casualty insurers he competed against had underinvested in claims control. That’s fine in the bull phase of the cycle, but it can spell trouble in the bear phase, when cash flow might go negative and skilled claims adjusters are hard to find.

If you could switch places with any of your competitors, who would it be and why? Alternatively, if you think you are the best positioned, who is next best, in your opinion?

This question usually won’t get an answer in large forums. It’s best saved for more intimate gatherings, because to the wider investing public, most companies portray themselves as the best. Also, in diversified corporations, it’s useful to ask this question of divisional heads rather than the CEO. They have a closer feel for the competition they face on a day-to-day basis.

When answered, this query can yield new research vistas. Who knows company quality better than an industry insider? The response can bring out the unique reasons a competitor is succeeding — and, potentially, what this company’s current management team is doing to challenge the competitor.

Note: The opposite question, “Which companies are not run properly?” will not get answered, except perhaps in one-on-one meetings. Few managements will publicly trash-talk the competition. The few that will do so deserve a red flag for hubris.

As an example, I had an interesting experience while at a financial conference. I was at a breakout meeting where J. Hyatt Brown, of Brown & Brown, was taking questions. Of the insurance brokers, Brown & Brown is no doubt the best managed, and Hyatt Brown has strong opinions and is almost never at a loss for an answer. When my turn to ask a question came up, I said, “OK, you’re the best-run company in your space. Who is No. 2?”

Hyatt Brown looked reflective, paused for 20 seconds and answered that it is was tough to say, but he thought that Hub International (HBG) was No. 2. And now Hub has gone private in a much better deal than Goldman Sachs’ (GS) buy of USI Holdings (USIH), from a quality standpoint. To my chagrin, I didn’t buy Hub off of Hyatt Brown’s comments. I missed a cool 59% in 10 months, but you can’t kiss them all.

What would your competitors have to do in order to reverse-engineer your competitive position? Or, why do you suppose other companies don’t adopt your methods?

This question gets at what management views as its critical differences for business success. The answer had better be a good one; it should be something important, and hard to duplicate. As Warren Buffett might put it, we are trying to determine the size and depth of the “moat” that exists around the business franchise.

If the answer doesn’t deliver an idea that is weighty and makes sense from a competitive standpoint, you can assume that the business doesn’t have a lot of franchise value and doesn’t deserve a premium multiple.

Valero Energy (VLO) is the leading oil refiner in the U.S. It also has the leading position in refining both heavy (high-density) and sour (high-sulfur) crudes, which cost less, leading to higher profit margins. It would cost a lot of money for a competitor to create or purchase the same capacity, assuming it could get all of the regulatory permits to do so.

On a competitive basis, who has the most to lose in the present environment?

Some executives won’t name names, but they might be able to point out what characteristics the worst-positioned competitors don’t have. In commodity businesses, the executive could point at those with bad cost structures. In businesses where value comes from customization, the executive could say, “To be a real player, you can’t just sell product, you must be able to assess the needs of the client, advise him, sell the product, install it and provide continuing service, leading to ancillary product sales.”

As commodity prices move down, the recent acquirers and developers of high-cost capacity fare the worst. With life insurance today, scale is becoming more and more of an advantage. Smaller players without a clear niche focus are likely to be the losers; that’s one reason I don’t get tempted to buy most of the smaller life insurance companies that trade below book value. Given their fixed expenses and lack of profitability, they deserve to trade at a discount to book.

Full Disclosure: long VLO

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.