Which industry should you pick?

 Which industry should you pick?

Last week, we introduced some basic financial ratios to help an investor evaluate an individual company's stock through its financial statements.

Today, we move on to the broader picture, one that spans the entire business world.

While an individual company can be managed well and costs are kept low, the best businesses will struggle to perform in an industry that has adverse fundamental conditions.

A well-publicised example is the airline industry. Legendary investor Warren Buffett called it a "gruesome" business.

"The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money ... Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers," he wrote in his 2007 letter to Berkshire Hathaway shareholders.

The airline industry is intensely competitive, with multiple airlines offering similar routes and low-cost carriers dramatically reducing the cost of air travel.

Profit margins have been squeezed as a result. An article in The Economist last year noted that the net profit margin of the world's airlines over the last 40 years averaged just 0.1 per cent.

Singapore's own flagship, Singapore Airlines (SIA), a blue-chip component of the benchmark Straits Times Index, has been hit by high fuel costs and competition from Middle-Eastern premium carriers and low-cost carriers.

It has a fortress balance sheet, with $4.85 billion in cash and bank balances as at end-2012, and negligible debt to boot.

But lower earnings and a doubtful industry outlook had caused its stock to plummet from a high of around $20 a share before the 2008-09 financial crisis to about $11 now.

Its low-cost carrier peer traded on the Singapore Exchange, Tiger Airways, fared much worse. Investors who bought in around its listing at end-January 2010 and held their shares until end-March this year would see the stock fall by around 45 per cent.

SIA may have an established brand, reinforced by a reputation for good service and the charm of the Singapore Girl.

It is, for the most part, a profitable business. But when compared to other companies in a sector like telecommunications, there are better deals out there for investors.

If dividends were reinvested, SIA's average annual return from end-April 2003 to end-March 2013 was 7 per cent. By contrast, SingTel has an annual return of 15 per cent in the same period.

Other telcos fared even better. M1 has a similar 10-year annual return of 17 per cent. StarHub, since its listing around October 2004 till end-March 2013, has an annual return of 28 per cent.

Could the differences be due to the fundamental nature of the businesses they are in?

Business moats

In the same shareholder report, Mr Buffett wrote: "A truly great business must have an enduring 'moat' that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business 'castle' that is earning high returns.

"Therefore, a formidable barrier such as a company's being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success," he said, referring to some of his holdings.

Investors can apply Mr Buffett's thinking to the industries that companies operate in.

Just as there are companies that maintain a competitive advantage through efficient production or a strong brand, there might be industries where companies that establish a foothold tend to perform well in.

Take the alcohol brewing industry, for example. Singapore's Tiger Beer-making Asia Pacific Breweries (APB), even before the takeover excitement last year that pushed its share price to stratospheric levels, was already generating solid returns every year.

Its average annual return with dividends reinvested from end-1999 to end-2009 - a period that saw three recessions - was 16 per cent, according to Bloomberg.

What about Heineken, the Dutch giant of a brewer that paid $5.4 billion for Fraser and Neave's stake in APB last year?

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