Sunday, November 20, 2011

Barriers to Entry and Fixed Costs - Part I

Much has been written about barriers to entry in assessing industry dynamics.  My favorite author on the subject is Bruce Greenwald - especially because he is both an economist and a value investor.  His book Competition Demystified offers insights to barriers to entry that can relatively easily be added to an investor's toolkit.  He discusses similar thoughts in other books, such as Curse of the Mogul.  All are informative and interesting.

I'd like to begin by address the term "barriers to entry."  When I first became interested in learning about competitive forces and competitive advantages, I took the phrase "barriers to entry" quite literally.  I thought the term meant that when barriers to entry existed, new firms were prevented from entering the market.  Sometimes this is true, such as in the case of when government licenses and patents prevent others from copying the incumbent's business model.  In other instances, the "barrier" in "barriers to entry" simply refers to the rational behavior from potential entrants.  By this, I mean that despite profits earned by industry incumbent(s), potential entrants realize there is no opportunity for abnormal profits on the margin.  With this in mind, the potential entrants rationally choose not to enter.  The assumption that firms will act rationally serves as the barrier to entry in this circumstance.

How can it be true that a firm in the industry can earn above average profits, but potential entrants all believe that they will be unable to do the same? From what I've learned, it largely occurs when fixed costs are present. Fixed costs are costs incurred that do not vary with the number of units produced or sold.  Fixed costs relevant to the evaluation of barriers to entry exist at the company, its suppliers, and its customers.   Here, I'd like to focus on evaluating barriers to entry resulting from analysis of the company's customers.

Multiple customer-related rational barriers to entry exist.  Commonly cited examples include search costs, switching costs, and network externalities.  A brief description of each of these follows below:

Search costs:  Costs involved in looking for a new supplier or service provider.  It can include monetary costs of the search, or time spent and the inconvenience of conducting the search.  For example, if one wanted to change financial advisors, the selection of a new advisor would likely involve an in person discussion of philosophies, investment objectives, and investment capabilities.  After undergoing these discussions, there is no guarantee one would find an investment advisor better than the one used previously.

Switching costs:  Costs involved in using a new product.  A common example includes time and effort learning how to successfully use the product.  I remember when I was an adolescent I stuck with Nintendo video game system when the Sega Genesis became available, because I had become used to the Nintendo game controller and did not want to learn to use the Genesis controller.

Network externalities:  An externality is a cost or benefit not born by those involved in a transaction. In some markets, the product or service becomes more valuable as the customer base grows.  Microsoft Office became more valuable as more individuals and companies utilized the software - sharing electronic files in a compatible format is often quite valuable.

The one common theme between each of these customer-related barriers to entry is that fixed costs incurred by the customer are involved.  Search costs are fixed costs, provided the customer finds the product or service purchased acceptable for repeat purchase. If the customer is willing to choose the same supplier or service provider for the next purchase, no search costs are necessary.  Likewise, the very name "switching costs" identifies that it will not be incurred if the customer chooses to stay with existing suppliers/service providers.

Network externalities are slightly more complicated.  In many instances, the benefit derived from the increasing customer base is that sharing becomes easier or more beneficial.  Sharing can occur between customers (e.g. Microsoft Office, EBay) or indirectly by providing feedback information through the supplier (e.g. Google, Netflix).  To share information effectively, users generally must become sufficiently familiar with the product or service.  The time invested in gaining familiarity is a fixed cost.  Although the cost of gaining familiarity with a competing product or service may be small, habits are hard to break.  I have not considered trying Bing to perform internet searches because I am in the habit of using Google, although I imagine it wouldn't require a significant investment of time and effort to become fairly proficient in using Bing.

When looking at barriers to entry from a customer-related sources, the label of the source as search costs, switching cost, or network externality is generally more important in evaluating the strength of the barrier than in identifying barriers that exist.*  In fact, I believe these labels may obfuscate important observations if they don't fit neatly into a discrete category. For example, switching costs can also serve as network externalities, as in the case of Microsoft Office.  What is important, however, is the identification of customer related fixed-costs already incurred.  Whether monetary or temporal, the presence of customer fixed costs provides a hurdle for any potential entrant's efforts to acquire customers.  The larger the fixed cost relative to the price of the product or service, the larger  the hurdle becomes and the more durable the company's advantage may be.

* I do note that the presence of search costs and switching costs likely serve to defend a company's existing market share,  while the presence of network externalities may suggest growth of market share may persist.

Wednesday, November 16, 2011

My take on a Keynesian view

Daniel Kuehn writes an interesting piece here, which includes the following (brief) description of his Keynesian views of the business cycle:

What makes me a Keynesian is that I actually think one of the major problems we're facing is that the act of saving and the act of investing are done by separate people, and that while people may want to provide a lot of loanable funds right now, investors don't have work to be done that earns a worthwhile rate of return. To a large extent, this is a vicious cycle. There's nothing to invest in because demand is weak. But demand is weak because there is not enough to invest in. Even if this equilibrates - even if income gets ground down through the paradox of thrift to the point that the loanable funds market clears, there's still no reason to expect that it will clear at a full employment level.

I don't consider myself of a Keynesian mindset and am increasingly drawn to ideas from the Austrian school. One aspect of Mr. Kuehn's statement above I think warrants alternative consideration. If I could edit his first sentence, I would offer additional details that may alter the ultimate conclusions:

...while people may want to provide a lot of loanable funds right now, investors don't have work to be done that earns a worthwhile rate of return relative to its risk, given the existing and expected dynamics of the economy.

With these additional factors included, demand is not the only consideration that can address a downturn. Other factors include:

a) a reduction of the uncertainty on the rate of return on investiment. This factor could include regulatory, health care cost, tax, or other considerations entrepreneurs and firm owners face. Uncertainty about the demand for goods is one of the factors here as well.

b) an increased outlook for the rate of return on investment, exclusive of demand effects. As economic activity shifts between industries and sectors during a transition period, the dynamics of the economy change and new opportunities are presented. I believe Austrian economists have described the continual structuring/restructuring of an economy as "roundaboutness."

Demand definitely has a role to play in a the functioning of a monetary society. The demand for goods, at the very least, provides the signals with which market participants then use to determine profitable opportunities for capital and intermediate goods. As more capital is deployed and specialization occurs, costs will fall and production should expand. I think its important to note that demand is only one variable in the equation of returning the economy to full employment. Additionally, it is not necessarily the default variable to remedy during downturns.

Monday, November 14, 2011

Revisiting Growth and Value Styles

The investing community has generally considered two investing "styles" of equity investments - growth and value.  These two styles purport to represent the types of stocks certain investors seek for their portfolios.  Value investors have been characterized as seeking low P/E, low M/B, and high dividend paying stocks. Growth investors, in contrast, are thought to target high P/E, high M/B, and low or no dividends.  A third style, "growth at a reasonable price," is also cited as an investment philosophy – one pursuing growth stocks but only at an appropriate price.  (This characterization implies that general growth investors care nothing about the price paid for their investments, something very peculiar indeed.)

The style labels of value and growth have troubled me.  I considered the terms growth stock and growth investor to be uninformative.  This is because, I thought, all rational investors are looking for one thing: a stock whose price is below its intrinsic value.  Notice  the word "value" contained within my preceding description, while the word "growth" is missing.  This simple thought led me to conclude that all successful investors were really value investors, some of which may mistakenly refer to their approach as a growth style.  Prominent investors (Warren Buffett comes to mind) have made eloquent observations suggesting growth is simply a component to the basic investment analysis process.  I agreed with this type of assessment.

Fairly recently I have become quite interested in the Austrian school of economics.  One basic tenet of the Austrian school is that the trends and results of complex systems such as our economy "emerge" and are not part of a linear process of cause and effect that can be easily be identified or forecasted in advance.  This belief in "emergence" is largely an accepted principle of complex adaptive systems, a term that describes our economy, among other things. Other complex adaptive systems include the stock market and natural ecosystems.  Complex adaptive systems form when an participants in an environment exhibit interdependencies, i.e. when each individual’s actions depend on the actions of others.  Often times, emerging results in complex adaptive systems can be observed in the form of power laws. A famous power law is the "80/20" principle, where 20% of the units can explain 80% of an effect.  More on power laws can be found here.

How do the idea of emergence and complex adaptive systems relate to my thoughts on growth investing?  Based on what I’ve learned from complexity, I’m more and more convinced that growth investors must analyze the likely emergent results produced by the system, as opposed targeting individual company for analysis.  Said differently, a growth investor must analyze the relevant ecosystem first to identify an emerging winner, whereas a value investor can select individual companies to evaluate. One could label this as a simple top down vs. bottom up difference, but I would disagree.  In the growth style, the analysis is done only at the top, or system level.  There is no “down” necessary for a “top down” analysis.

Importantly, the tools used for analysis are likely different between growth and value investors.  As mentioned above, complex systems often do not exhibit linearity.  There is no clear cause and effect when the environment becomes nonlinear.  These systems do demonstrate predictable patterns, however, such as power law distributions.  Successful growth investing may depend less on fundamental analysis behind a convincing investment thesis than timely recognition of an emergence pattern.  Value investors, on the other hand, stay more in a linear environment.  Microeconomic principles can be applied when cause and effect is clear.  Fundamental analysis and industry dynamics are easier to apply in this environment.  A rigorous investment thesis is more likely to succeed for value investors.