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?

Its 20-year return from end-1989 to end-2009 was 13 per cent a year. British firm Diageo, which produces Guinness stout, Johnnie Walker scotch whisky and Smirnoff vodka, had an average annual return from end-April 2003 to end-March 2013 of 16 per cent.

These companies all have several things in common. They have established brand names in an industry dominated by just a few big players. Many readers would remember Guinness, Tiger or Heineken advertisements.

People drink in good times and bad, and they are willing to spend. Brewers do not undercut each other in price wars, but compete through offering products that taste different.

In contrast, for airlines, people or companies cut down on expensive holidays or trips during bad times. In the mass market, the lower the price, the better.

Competitive pressures keep prices low and hence make it difficult for profit to be made in the long run. Many airlines have gone bankrupt or merged.

Five forces

This is not to say that all airline stocks are unprofitable. But it becomes much more difficult to pick the right stock if business conditions make it tough to make money.

There is a classic methodology used to analyse industries. Harvard Business School professor Michael Porter developed a framework known as the "five forces".

He argued there were five things that determined the level of competition within an industry, and hence how attractive it was to invest in them.

In economic theory, a perfectly competitive industry is one where no participants have the power to set prices for products, which tend to be commodity-like and undifferentiated.

In such an industry, no profit can be made in the long run, meaning firms can only make enough to cover their costs. These industries are considered unattractive to invest in.

In contrast, significant profits can be made in industries where companies can charge a high price for their goods and services without worrying about competition.

Prof Porter's five forces that determine competitiveness are:

the threat of new entrants to the industry; the intensity of rivalry between established players in the industry; the threat of substitute products; the bargaining power of customers; and the bargaining power of suppliers.

Investors might want to use this framework to think about the fundamentals of the industry that their chosen company operates in.

For example, on the threat of new entrants, one might want to consider the barriers to entry that would-be competitors face.

The restaurants industry has low barriers to entry.

Opening a restaurant, or at the very least a food stand or hawker stall, requires relatively low start-up capital. The cooking skills involved to sell edible and hygienic food are not too difficult to acquire. As a result, there are thousands of restaurants to choose from and the industry is a fragmented one.

On the other hand, one needs to spend a lot of cash to set up a telecommunications network. It is also not easy to get regulatory approval. Thus there are only three telcos in Singapore, each having a substantial customer base.

Both industries supply products that are considered necessities, or near necessities. Substitute products are easily available. Hawker centres in Singapore provide a cheap alternative to restaurant meals.

For telcos, customers who do not like SingTel, for example, can always turn to M1 or StarHub to get a similar phone or Internet plan.

But the difference with telcos is this: they use two-year contracts and subsidised smartphones to tie customers down. If you do not like your telco's standard of service, you might be deterred by high cancellation fees when thinking of signing up for another. In the meantime, you will be paying monthly charges.

As for food, once you do not like the meal at a restaurant, you do not go back again.

Life cycles

One can also think about the industry in terms of which stage of "life" it is in. Is it a sunset industry, such as textile manufacturing in the US while entrepreneurs were setting up lower-cost factories in India, China and Vietnam?

Is the industry in its infancy, like the mobile phone industry was in the 1980s or the smartphone industry in the late 1990s?

Identifying potential high-growth areas and narrowing one's search to the most promising companies there could reap the investor rewards if the industry takes off.

One can also think about the broader trends shaping the world, and which industries will benefit as a result.

The industrial revolution in the 18th and 19th centuries dramatically altered incomes and economic growth. Demand in metal parts, used to make machinery in factories, soared.

In the 21st century, the populations of developed countries will age significantly, Singapore included. China will also age as a result of the effects of its one-child policy.

What will older people spend on? Healthcare stocks have been outperforming in the past year as the investment community bets on rising demand for drugs and health insurance.

Investors can use financial statements to gauge the value of a company. But they also need to understand the opportunities and threats present in the industry that the company is in.

The ultimate goal and challenge of investing is not just to find companies that are profitable now or next year, but those that remain so for decades to come.

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