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In this first post for The Discovery Series, I will explain the methodology used to discover companies with competitive advantages throughout the whole series.
The purpose is not only to discover these businesses within the new or evolving industries but also provide you with the competitive analysis framework to use yourself.
We start at the industry level and then break down all different segments within that industry. For instance, the smartphone industry has the following main segments;
- Microchips (Intel, Qualcomm)
- Software Operating systems (Android & iOS)
- Hardware (Samsung, Apple, Google, Sony…)
Then as we compare at the individual companies within the segment, we also gain an understanding of the structure of the segment. For Instance, steel producers require raw materials such as iron ore to produce basic steel beams, so one segment in the steel industry is the miners of iron ore.
The majority of Mining businesses cannot set its own price for the raw material dug out of the ground, it is beholden to the prices set by the World market of all raw materials, and businesses like these are referred to as price takers. The price per tonne is determined to a large degree by supply and demand for iron ore across the world.
As history has shown, mining companies, in general, are not the best candidates for exhibiting the type of competitive advantages that will compound earning over a 10 year period at a high rate of return. The structure of the mining segment is categorised as a level playing field, where new entrants can come and go as they please, without a large company(s) preventing their entry.
Once we identify within the segment the one or two companies operating with competitive advantages, we then create a thesis for the company.
A thesis is simply a statement or theory that is put forward as a premise (a premise is a previous statement or proposition from which another is inferred or follows as a conclusion), to be maintained or proved.
Our statement is: We believe this company exhibits competitive advantages, at this point in time, for the following reasons.
It is important not to enter any type of forward looking premises in our reasoning, because some of the industries we will be exploring are in a growth stage, and a growing market always makes room for new entrants. Plus, as you will read further, adding forward looking assumptions will not help
The other reason not to implement any forward projections is most important. Because we are adopting Bayes Theorem into our process.
For instance, once we have completed our thesis on a particular company, that will become our initial belief of how the company fits within the industry (referred to as prior), and as new information (facts) emerge (referred to as likelihood), we will update our thesis with the new information thus creating a new and improved thesis (referred to as posterior), and the process repeats itself.
We as investors need to be applying this process to all stocks we own. For instance, creating a thesis as to why stock XYZ is a buy now, and then not updating our thesis with new information that contradicts our initial (thesis) belief, will significantly increase the odds of losing our initial investment.
But if we accept new information regardless if it supports or contradicts our initial (thesis) belief, we will not only avoid losing money, but increase our chances of making 10X our money, which is the whole point of investing in the first place, to make money, and equally important is to also preserve our money.
So once accepting new information as it comes to light remember; if the new thesis concludes that you sell, then sell. If it concludes holding, then hold, or if it concludes buying more, then buy. This is the proper function of the saying ‘buy and hold’. Often confused with the misnomer ‘set and forget’.
It is important to apply a Stoic mindset to the thesis, as it can be emotionally painful to read new information that contradicts our initial thesis of a stock we own, especially if the initial thesis is riddled with cognitive errors. I believe this why Warren Buffett recommends not falling in love with stocks you own. Charlie Munger has given speeches on the topic of human misjudgement, you watch an abridged and animated version of one speech here.
The Lubrizol Corporation is a great example of the type of business we want to identify.
Lubrizol is the supplier of speciality chemicals for the transportation, industrial and consumer markets. Lubrizol was purchased by Berkshire Hathaway’s CEO Warren Buffett in 2011.
A wise investor, I admire, explained to me the brilliance of Warren Buffett’s purchase of Lubrizol. One of Lubrizol’s business segments is called Lubrizol Additives (LA). LA supplies additives for transportation, including additives for lubricating engine oils, fuels and other chemicals, and industrial lubricants.
Lubricant additives, according to Lubrizol’s 2011 annual report, produced 72 percent of Lubrizol’s revenue and was the market leader. Their industrial lubricants present a demand advantage for Lubrizol.
‘Lubrizol offers a line of multi-functional turbine oil additive packages that provide long life to turbine equipment and systems. These products provide excellent demulsibility and superior foam and rust protection. In addition, Lubrizol oil additive packages offer extreme pressure protection and anti-wear properties to extend turbine life.’ Lubrizol 2011 Annual Report
The Industrial Lubricant Additives is used by original equipment manufacturers (OEMs), like General Electric, for use in their heavy duty gas turbines. Heavy duty gas turbine produces energy for the electricity grid and for other industrial energy requirements, according to GE, this pictured gas turbine can provide up to 544 MW.
Figure 2. GE Heavy Duty Gas Turbine
The cost to build a heavy duty gas turbine is approximately US$500 million (source). The engineer responsible for operating and maintenance is going to choose carefully which lubricant is used, as the lubricant, I believe to my knowledge, helps not only maintain smooth operation of moving parts but also the temperature. These gas turbines are sensitive to temperature changes, the right lubricant is essential, this creates demand advantages for Lubrizol in the form of high switching costs and search costs. No engineer wants to inform his boss that he changed lubricants, to save a few dollars, but unfortunately, the lubricant was the wrong grade, resulting in the $500 million dollar gas turbine seizing up, and now will cost millions of dollars to restore it back to working order. Inertia is a strong force working in Lubrizol’s favour.
Take into consideration that if this employee left to work in a similar position in another firm that he most likely will opt for Lubrizol lubricants to service the gas turbines or other similar equipment, further reinforcing the Lubrizol’s advantage (search costs).
We see these demand competitive advantages appear in the financial statements, with return on equity, in 2010, returning 15 percent, producing free cash flow of $513m and capital expenditures spent on plant, property and equipment to support revenues were only $175m and were paid out of operating cash flow. Where demand advantages exist, a company like Lubrizol can increase prices and customers are unlikely to flinch.
Surprising opportunities exist for the investor willing to follow their curiosity and investigate the intricacies of the whole process involved in bringing a product to market, or, just as Lubrizol’s industrial lubricant shows, investigating those companies supporting the operations of other companies.
The next post will be available 10th of August, currently in Samoa visiting my partners family, but, once I’m back home the Discovery Series will be released more frequently. Thank you for your patience.
Is there an industry or company you would recommend we cover? Please leave your suggestion in the comments below.
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Article by Adam C. Parris, Searching For Value