During his recent interview with Tobias, Stephen Clapham, author of The Smart Money Method, discussed Evaluating The Company’s Industry, Capacity & Demand. Here’s an excerpt from the interview:
Tobias: You’ve done your preliminary research, and you’re satisfied that this is something you want to go forward with, what’s the next stage in the process?
Stephen: Well, the next stage, I mean, what I do, so I very often come to a situation where it’s in unfamiliar territory. So, it’s an industry that I haven’t looked at, or a geography that I haven’t looked at before. So, what I’d like to do first is to understand the industry. And it saves you quite a lot of time because you’re also one to understand the company, but understanding the company in the context of the industry, I think, is extremely important. One of the things I’m particularly pay attention to is the relationship of capacity to demand. Now, you’ll be very familiar with this, I’m sure because there’s the group here, Marathon Asset Management, not the US Marathon, but the London firm.
They’ve written a couple of books, Capital Returns is the one that’s in print now. This was a philosophy that they’ve espoused for many years. But it’s something that because of my background, one of the industries that I was worked with on the South Side was the transport sector. In the transport sector, if you’re looking at airlines or shipping, there’s actually quite a lot of data around and what capacity is doing.
The thing I find quite funny is that everybody gets obsessed about demand, so everybody’s obsessed with total addressable market and what demand growth is going to be? Well, demand growth is quite difficult to forecast, and you have quite a large range of error. Capacity growth is usually very easy to forecast because there’s all sorts of data, there’s all sorts of lead time operate in many, many industries. So, I spend quite a long time starting off looking at new situation. Looking at, “Well, what’s capacity doing? What’s it been doing? And what’s it going to do?” And if you find a situation in which capacity growth has stopped, and you’re fairly confident demand growth is going to continue, that is usually a very attractive situation. I mean, often the best situations are ones where people have started to close capacity. So, you’ve got an industry in which demand profile looks terrible, everybody hates it, and management are starting to get the message and they’re starting to close down production. Those situations can be very, very powerful.
Tobias: You find that particularly in transport. You know the sort of ships that are coming online, you know how many planes are going to be in the air, and so you can forecast roughly what that’s going to look like, and so that’s how you sort of lay in your bed.
Stephen: Yeah. When I used to do the airlines, I mean, many times made very, very good returns. I mean, it just short-term, three to six months start type of trades but looking at the amount of capacity in the market, when there’s too much capacity coming on, then the price collapses. It doesn’t take a huge amount of change in the price of the seat to make a massive dent in the airline profitability. When companies miss earnings, there is no prisoners taken, they then go down. We made lots of money on the airlines just doing that. It’s not complicated. I mean, people are more sophisticated now looking at that, but you can apply it to lots and lots of industries.
One of the industries that I used to use this for was cement. It takes quite a long time to build a cement plant. In order to build one, you’ve got to have various planning and there’s all sorts of lead time and there’s all sorts of evidence that you’re building one, so you can see what’s going to happen. One of those classic industries is very expensive to transport. So, you get areas like Florida, where there’s imported cement as competition, but for many areas inland, how much capacity there is. You can see if the new plants being built, and if there isn’t, you can feel much more confident about the demand, looking about the pricing outlook.
Tobias: It’s very interesting. So, you get comfortable with the capacity in the industry and then what’s the next stage after that?
Stephen: I just try and build a picture of the industry. I try and build a picture. I start with capacity. Of course, I look at demand, and then what’s the past demand growth? What demand drivers? Is that are those drivers weakening or strengthening? And then I look at the industry structure. Where is this company? Where is it in the industry? Who are its competitors? What I like to do is I say, “Okay, so who are the winners in this industry? And why have they been winners?” When I get on to looking at the company itself, I start to drill down and say, “Okay, so this company has been a winner in this industry. Why is that? Is it geography?” Looking at history is incredibly helpful, incredibly informative, because where you’ve come from and forms where you’re going. I like to look at that.
The other thing I like to look at, is I like to just try and understand the quality of the business. I prefer to invest in quality situations. Unfortunately, when you’re a special-situations investor, where you’ve got a very high return threshold that you need to exceed, you usually end up buying low-quality situations, you buy rubbish, because it’s cheap, and you have a reason for thinking that’s a catalyst that it’s going to stop being cheap. But understanding the quality is absolutely essential if you’re a private investor, because you don’t want to own low-quality companies because low-quality companies require a much greater attention and focus. So, you’re much better off owning higher-quality companies.
There’s a whole chapter in the book about how do you assess the quality of a business, and then I go on to talk about how to assess management and how do you think about that. One of the key things I talked about is looking at the management incentives. Are there incentivized on earnings per share, or are they incentivized on ROIC?
Companies that are incentivized on return on capital, tend to perform a lot better than companies or not. I mean, there’s all sorts of academic evidence of this. I go into some of the other things like, if you’re looking at a mining company, is the CEO, is he incentivized on the number of accidents, on the number of deaths? And if they aren’t, you’ve got to ask yourself, “Well, why not?” This whole issue of– I mean, I call that sustainability, because that’s to me is, if you’re not looking after your employees, it’s not sustainable business. If you’re in a high-risk industry, you’ve got to pay very close attention to safety because that at the end of the day means, the company that is a safe company, is a company that will persevere.
BP is a classic example of a company which got safety wrong, and paid a huge $65 billion price for it. I think it’s important to pay attention to those sorts of things. And then, once I’ve done all that, I then go in the book, I go through, how’d you look at the accounts[?]?
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