Key insights
- An industry's competitive landscape and a company's position within it have been closely linked to changes in profitability and, ultimately, a stock's return potential.
- As assumptions about the future swiftly change to adapt to the COVID-era reality, assessing competitive strength is perhaps more important than it has ever been.
- In this note, we discuss Causeway's proprietary competitive strength framework that we believe addresses some of these important issues and aids in stock selection.
One of the most critical responsibilities of the active value investor is determining why a stock is trading at a low multiple of near-term earnings relative to the market or peers. There are many acceptable reasons β including short-term cyclical, restructuring, and operational challenges β and then there is one answer that is typically not acceptable β intractable structural problems. Stocks of companies and industries facing significant structural pressures or structural declines are unlikely to rerate upward since the market will ascribe a negligible terminal value to the business. Multiples of these stocks are low and will remain low, and they may even face existential threats in extreme circumstances.
Weeding out stocks with structural problems ties in very closely with the theoretical underpinnings of the value premium itself. The typical risk-based explanation for the value premium goes something like this: Value companies are risky because they face uncertain futures, and thus value investors should be rewarded with higher-than-market returns for assuming this risk. Though these prescribed higher returns have remained stubbornly elusive in recent years, value's risk-based explanation seems as valid as ever, especially during the COVID-related market volatility. 2020 has been a year of extreme changes in assumptions and paradigms as analysts abruptly shift their views of the post-COVID world. Separating the long-term winners from the long-term losers in this new world is essential.
Examining the competitive structure of industries is one way to do this. More than four decades ago, Harvard Business School Professor Michael Porter first identified "five forces" that shape industrial competition: the threat of new entrants, the bargaining power of buyers, the bargaining power of suppliers, the threat of substitute products or services, and the rivalry among existing competitors.[1] He argued that a thorough analysis of how these forces impact competition would provide insight into an industry's profit potential. However, competition is never static, so in addition to these point-in-time characteristics, we should also be aware of structural changes underway β perhaps as a result of technological change or disruption β that might impact the future prospects of an industry.
Relative industry returns in recent years make it clear why competitive dynamics matter so much. The Global Industry Classification Standard (GICS) sorts all public companies into 69 industries based on their principal line of business. In Exhibit 1, we evaluate the relative return and volatility statistics for the top and bottom five industries sorted by Sharpe Ratio over the last 10 years. The industries on this list probably will not surprise most market participants. Those at the bottom of the list include energy, airlines, and metals & mining, all industries characterized by lack of product differentiation, very little (if any) pricing power, significant competition, and fairly low barriers to entry. Those at the top of the list (software, IT services, health care) have more substantial competitive "moats" in the form of intellectual property, network effects, and switching costs. Industry structure and dynamics have inevitably played a prominent role in stock price performance.
Recent industry returns appear to be highly related to industry structure.
Exhibit 1. MSCI ACWI Index Top/Bottom 5 Industries Sorted by Sharpe Ratio (Last 10 Years)
Note: All 69 GICS industries in the MSCI ACWI Index are sorted based on realized Sharpe Ratio from October 31, 2010 to October 31, 2020 using gross, unhedged index returns. The table above includes the industries with the highest five and lowest five Sharpe Ratios. Sharpe Ratio is a measure of risk-adjusted performance that divides the average return minus the risk-free return by the standard deviation of those excess returns (returns above the risk-free return). Sharpe Ratio calculation assumes monthly implied 10-Year U.S. Treasury yields as the risk-free return. Source: FactSet, MSCI, Causeway Analytics
Initially inspired by Porter's Five Forces, Causeway sought to build a framework to quantify competitive strength. While staying true to our value philosophy, we recognized that stocks in especially strong and sustainable competitive positions may deserve to trade at a valuation premium to the market. In our development process, we also aimed to expand on Porter's initial framework along two dimensions. First, rather than accept a static snapshot of industry structure, we wanted to capture changes over time to measure how well (or not) an industry is embracing technological change. And second, we wanted to consider an individual company's position in the broader framework. As stock pickers, we need to understand if a company's figurative "star" is rising or falling within an industry to seek to gauge its profitability and return potential.
We ultimately developed a model that examines current levels and expected trends in a broad range of metrics relevant to competitive strength: margins, returns, competition, industry structure, market share, and balance sheet strength. We include some top-down, industry-wide assessments regarding competitive intensity, however most of the metrics are company-specific. Nevertheless, we can easily aggregate company scores to the industry level on a float-weighted basis to gauge the relative strength of each industry. In Exhibit 2, we observed those industry-level scores as of October 31, 2010 and compared it to that industry's Sharpe Ratio over the subsequent 10 years. The two variables share a 0.58 correlation, indicating that those industries with the most robust competitive dynamics went on to deliver the strongest risk-adjusted returns (and vice versa).
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