May the force be wth you - Part 2 ( Industry Strikes Back)

I have at numerous instances in life encounter people who argue with me that education is not a necessary condition for success. The classic example that they quote is of Dirubhai Ambani. Look at what he achieved as a school dropout. Didn’t Bill Gates also drop out of college to start Microsoft in a garage?

It is important to understand what a outlier event is or survivor bias is. I think it is critical for every individual to understand some basic statistics. The principle of normal distribution and basic probability.

To believe that Dirubhai Ambani who is essentially a outlier event beyond the six sigma levels reflects the mean is a folly. The average graduate would do better than a average under-graduate and taking it forward a average post grad would do better than an average graduate.

So what does this have to do with investing and my previous post on Porter’s model for industry analysis.

It for me answers why it is important to understand a industry structure.

There are industries where the dice is loaded against the participants in the industry. Ex Airlines where it is rare to find profitable companies. There are industries like commodity companies which follow cycles and it is difficult for a individual company to break out of cycle.

Does this mean that all participants in these industries are doomed? The answer is no. However the dice is loaded against the company. There could be a great airlines company which could be extremely profitable but would essentially reflect the outlier and not the mean of the industry.

So while analysing a company it is important to understand the industry structure under which operates so as to get a fair picture of what are the forces acting against or for the company.

As Buffett says “"When a manager for a reputation for brilliance tackles a business with a reputation for poor fundamental economics, then its the reputation of the business that remains unchanged”.

May the force be with you

I remember Obi Wan Kenobi telling Luke Skywalker in Star Wars “ May the force be with you” and “ Use the Force Luke”.

It brings back memories of a era gone by and reminds me also of something that I read a long time back Michael Porters “ 5 Forces Model”. To be honest there is a certain amount of cynicism that one displays during one’s MBA days for stuff that one would call “ management gyan”.

But like the way I appreciate Asterix comics or Calvin & Hobbes differently from the way I enjoyed them maybe 10 years back, Porter’s 5 forces model provides a nice framework to analyse a industry.

Buffett talks about the moat principle where the business should have adequate competitive advantage. I believe Porters “5 Forces Model” meshes in nicely with what Buffet said and provides a starting framework for evaluating a company.

The Five Forces
The threat of substitute products
The existence of close substitute reduces the leverage that a company has to raise prices as it lead to customers switching to substitutes. Also there could be substitutes which could make the current product irrelevant. Technology products are a classic example of this.

The threat of the entry of new competition
Low entry barriers into a business will ensure that the arbitrage of supernormal profits will get wiped out as more and more competition enters the business.

The intensity of competitive rivalry
Higher competitive rivalry could lead to the race to the bottom in terms of pricing and profitability. Airlines industries is a classic example.

The bargaining power of customers
Classic example would be concentrated set of buyers. Or the risk of buyers backward integrating or switching to substitute products.

The bargaining power of suppliers
Again concentrated set of suppliers could easily squeeze margins and ensure that the business cannot earn supernormal profits.

Porters 5 Forces model is a good starting off point in evaluating the moat around the company. Of course there are other variables that can be added to the process.

Which brings us to the question “ Why do we need to evaluate a industry structure in analysing a company”? That is for the next post.

Till then “ May Porters 5 Forces be with you”.

Addition to the Blog

I have added a new series of links in the blog which covers links to blogs / websites of professors / academicians.

My areas of interests is in the domain of economics, capital markets and behavioural finance. I would be most happy if readers of the blog have suggestions in terms of academicians in these domains, links to whom I could add to the blog .

Piramal Life Sciences or Slot machines

I was reading the balance sheet of Piramal Life Sciences that a friend of mine handed over for me to evaluate.

Piramal Life sciences is the demerged arm of Piramal healthcare which is a research driven drug discovery company. It was formally the R&D unit at Nicholas Piramal. It focussed on four therapeutic areas cancer, diabetes, inflammation and infectious disease.

The balance sheet was a interesting read. The company has zero or negligible sales and is burning cash/ posting net loss of about Rs 25 crores a quarter. It posted a net loss of Rs 110 cores for FY 09 and has accumulated losses of about Rs 202 crores.

This is against a equity and reserve base of about Rs 183.6 cores effectively wiping out the balance sheet. Most of their molecules are still in Stage 1 and 2 of clinical trials.

They have been funding themselves thru short term ICD loans from the parent company and the auditor has even made a remark about using short term funding for long term asset.

Drug Discovery - Risky business
Drug discovery is a risky business with very high upfront capital commitment and low success rate. The payoff’s could be extremely high for a blockbuster molecule but it is tough to assign probabilities. The demerger model is essentially to derisk the parent company from vagaries of drug discovery.

Which brings us to the reason for this post …..

How does a retail investor believe that he can understand the risk return payoff of the drug discovery business when the parent pharma company itself is not sure on this?

I can understand venture funds investing in a business like this bcos that’s there capability set but a retail investor getting into a stock like this is beyond me.

I would rather go with a slot machine even though I know the odds are against me but atleast I understand the odds. The stock incidentally is quoting at Rs 55 giving it a market cap of about 125 crores.

Nilekani farewell at Infosys

I was reading about the news article covering Nandan Nilekani's farewell at Infosys after 28 years as he moves into the government.

Came across CEO Kris Gopalakrishnan's quote which I liked and sharing it
" I have known u for longer than I have not known you". :-)

Dr Reddys Laboratries

When I was enroute to office today I started reading Dr Reddys balance sheet in the car. It had a interesting piece of data that I thought of sharing.

Dr Anji Reddy the chairman writes and I quote

“ If any shareholder had purchased 100 shares during your company’s IPO in Aug 1986, plus the 60% rights issue in Aug 1989, and held on these till date, the person would be owning a total of 5760 shares at a face value of Rs 5 per share. Against a outlay of Rs 2500 ( Rs 1000 in the IPO and Rs 1500 to purchase 60 shares of the rights issue at Rs 25 per share), that investor would have earned a total of Rs 1.95 lacs of divided, including current years proposed dividend.

On 31st March your company’s share on BSE was being quoted at Rs 488.65. Thus, the value of the investors portfolio would have been Rs 28.15 lakhs”.

Now that’s a 1000 bagger in 23 years. A fixed income instrument assuming doubling every 6 years would have been grown 16 times in that period.

If only I had spent less time and money chasing girls in my teens :-). Now I know where Warren Buffett got it right by starting early.

Disclaimer: I am not recommending the Dr Reddy’s stock and I own all of 10 shares, kept just to get the balance sheet :-).