Podcast Summary
Understanding Market Share Dynamics and Its Impact on Returns: Companies with larger market shares tend to have higher returns on capital and lower risk. Maintaining and expanding market share through innovation and competitive advantages is crucial for both businesses and investors.
Michael Mauboussin, the head of Consilient Research at Counterpoint Global, recently conducted an extensive research on market share and its impact on returns. He was motivated by the increasing scrutiny on market share, returns on capital, and capital allocation. The research delves into the importance of market share dynamics, the relationship between market share and returns, and the role of markups in generating profits. The findings suggest that companies with larger market shares tend to have higher returns on capital and lower risk. Additionally, the research emphasizes the significance of maintaining market share and expanding it through innovation and competitive advantages. Overall, understanding the dynamics of market share is crucial for both business leaders and investors to make informed decisions and allocate resources effectively.
Market share dynamics and industry concentration: Historically regulated markets are evolving towards winner-takes-most or winner-takes-all markets due to technological advancements. Market shares are not static and can change dramatically over time. Understanding market share dynamics and factors contributing to concentration is crucial for investors and businesses.
Market share dynamics have evolved significantly over time, with an increasing trend towards winner-takes-most or winner-takes-all markets. Historically, these markets were often regulated, but with technological advancements, we are seeing more concentration in various industries. However, market shares are not static and can change dramatically over time, as seen in the examples of Google's dominance in search and Microsoft's in word processing. The report highlights that market share stability can be quite unpredictable, and even industries that appear to be monopolies, such as Google and Microsoft, were not always guaranteed to maintain their dominant positions. The automobile industry is an interesting case where concentration levels have decreased substantially over the last 50 or 60 years. These market dynamics are crucial for investors and businesses alike, as they can impact profitability and long-term success. The report also raises the question of whether regulation will play a role in shaping these markets in the future. Overall, the report sheds light on the importance of understanding market share dynamics and the factors that contribute to concentration in various industries.
Assess industry dynamics with market share analysis: Investors can evaluate industry stability, competition, and potential growth by examining market share trends, entry and exit data, and market size.
Market share analysis is a valuable tool for investors. By examining market share stability and entry and exit data, investors can assess industry dynamics and potential competition. Market share stability refers to the degree of change in market shares over time, with low change indicating a more stable industry. Entry and exit data reveal industry maturity and competition levels. Additionally, understanding minimum efficient scale and total addressable market can help determine an industry's capacity to accommodate multiple competitors. These tools provide valuable insights for investors to make informed decisions.
Identifying low concentration industries and tracking companies breaking out: Focusing on industries with low concentration and companies creating value beyond market share can lead to successful investing, but it's challenging to implement in real-time and market concentration doesn't always equate to profitability. The 'value stick' concept can help illustrate this idea by focusing on creating value for customers.
Identifying industries with low concentration and tracking companies breaking out of that can be a successful investing strategy. However, it's important to note that this strategy can be difficult to implement in real-time and may be easier to identify in hindsight. Additionally, market concentration does not necessarily equate to profitability, and profitability tends to align more closely with market share. The concept of the "value stick" can help illustrate this idea. The value stick represents a vertical line with willingness to pay at the top, price in the middle, and cost and willingness to sell at the bottom. Willingness to pay represents the highest value a customer is willing to pay for a product or service. Understanding the value stick can help investors focus on creating value rather than just achieving market share or low costs. This strategy was first introduced in the mid-1990s by Brandon Berger and Stewart, and a more recent book, "Better, Simpler Strategy" by Felix Oberholzer-Gee, provides a clear and detailed explanation of the concept.
Focus on increasing consumer's willingness to pay: By focusing on increasing consumer's willingness to pay, companies can create more value and satisfaction, leading to a successful business model. Examples include network effects in platform businesses and complementary goods.
Companies should focus on increasing willingness to pay from consumers rather than just raising prices. This approach results in increased consumer surplus and customer satisfaction. A powerful example of this concept is the capture of network effects in platform businesses, where the value of the good or service increases as more people use it, leading to higher willingness to pay without a corresponding price increase. Another example is the presence of complementary goods, where having a cheap or free complement can make the primary good or service more valuable. By focusing on increasing willingness to pay, companies can create more value for consumers and themselves, leading to a more successful business model. Conversely, companies that solely focus on raising prices without considering willingness to pay or willingness to sell may face challenges and decreased consumer and supplier satisfaction.
Price, production cost, and market dynamics: Understanding the relationship between price, production cost, and market dynamics is crucial. Companies can benefit from complementary goods, sharing customer data, and creating a great work culture to influence prices and optimize strategies.
The relationship between the price of a good or service and its production cost, or marginal cost, is crucial in understanding market dynamics. The discussion highlights two aspects: willingness to pay and willingness to sell. On the willingness to pay side, complementary goods and services illustrate the chicken-and-egg problem. For instance, electric vehicles and charging stations. The value of one increases when the other becomes more accessible, creating a cycle of mutual benefit. Regarding willingness to sell, companies gathering and sharing customer data can lead to increased efficiency and lower costs, allowing for lower prices while maintaining good returns. The famous Walmart and Procter & Gamble case study is an example of this. Lastly, creating a great work culture can lead to employees being willing to work for less, resulting in an "employee surplus" that benefits both the employer and the employees. Market power, the ability to influence prices in a market, was also discussed. The paper explores how understanding markups, the difference between price and marginal cost, can help businesses identify their market power and optimize their strategies.
Markups and Market Power: Markups, the difference between price and marginal cost, have increased significantly since 1980, indicating greater market power for some companies. This trend can be attributed to the rise of 'superstar firms' and intangible investments.
When a company prices its good or service above the marginal cost, it indicates market power and results in a decrease in consumer surplus but an increase in economic profit. This concept is often measured using markups, which represent the difference between marginal cost and price. Historically, markups were relatively low and stable from 1955 to 1980, but since then, they have significantly increased, indicating greater market power for some companies. This trend can be attributed to the emergence of "superstar firms" within industries, which pull away from the competition and drive up markups. To calculate markups, one can use a production function that involves dividing sales by the cost of goods sold and multiplying the result by an output elasticity function. However, some academics argue that intangible investments should also be considered as input, and these investments have seen significant growth since 1980.
Underestimated Intangible Investments in Financial Statements: Intangible investments, often overlooked, impact a company's performance. Focus on understanding net operating profit after taxes (NOPAT) and considering intangibles' impact on ROIC for a clearer evaluation of a company's returns on investments.
Intangible investments, which have become more prominent in businesses, have been underestimated in financial statements due to their classification under sales, general, and administrative costs. Academics suggest adding a component for intangible investments to the cost of goods sold, leading to a change in the markup picture and a gentle rise in the slope, but no alarming results. This adjustment eliminates within industry effects and reveals that high-performing firms, or "superstar firms," are the ones investing the most in intangibles. However, measuring intangibles is challenging, and the debate continues on how to accurately quantify and categorize these investments. Return on Invested Capital (ROIC) is a widely used metric to evaluate a company's earnings on its investments, but the presence of intangibles complicates the picture. Recent research on ROIC with and without intangibles can help investors gain a clearer understanding of a company's returns on investments. To cut through the noise, investors should focus on understanding net operating profit after taxes (NOPAT) as the foundation for calculating free cash flow and evaluating returns on investments. Additionally, considering intangibles' impact on ROIC and using multiple metrics to assess a company's performance can provide a more accurate and comprehensive understanding of its value creation.
Understanding Return on Invested Capital (ROIC): ROIC measures a company's earnings relative to its invested capital and helps determine if it creates value by exceeding the cost of capital. Be cautious with free cash flow as a performance measure and make adjustments for overlooked factors.
Return on Invested Capital (ROIC) is a crucial metric for evaluating a business's financial performance. It represents the earnings generated by a company for each dollar of invested capital. To calculate ROIC, subtract capital charges from net operating profit after tax (NOPAT), and divide the result by invested capital. The left side of the balance sheet represents the "stuff" or assets, while the right side signifies the financing of those assets. ROIC helps determine if a company creates value by exceeding the cost of capital. However, be cautious when using free cash flow as a measure of performance, as it can be misleading. Traditional definitions of free cash flow, such as cash flow from operations minus capital expenditures (CapEx), often overlook crucial factors like stock-based compensation and leases. Therefore, it's essential to make adjustments for these items to gain a clear understanding of a company's financial situation. Empirically, the distribution of returns on capital shows that while medians remain relatively stable, there are significant differences between low and high return on capital businesses. This underscores the importance of understanding a company's strategy, such as cost leadership or differentiation, in relation to its ROIC. By breaking down ROIC into no PAT margin and capital velocity, we can plot companies on a 2x2 matrix for a more comprehensive analysis.
Positioning a company in the matrix of high/low margin and high/low capital velocity: Analyzing a company's margin and capital velocity helps categorize it as a cost leader or a differentiator. Intangible assets and SG&A costs can impact ROIC calculations, requiring careful consideration and industry-specific guidelines.
Understanding a company's position in the matrix of high/low margin and high/low capital velocity can help categorize it as a cost leader or a differentiator. Additionally, adjusting ROIC calculations by including or excluding goodwill and intangible assets can significantly impact the results. Companies are increasingly investing in intangible assets, and determining the appropriate percentage of SG&A costs to be considered intangible investments and assigning asset life to these investments are challenges in making accurate calculations. Recent research provides industry-specific guidelines for these calculations. The empirical findings reveal that the tails of the distribution, representing high-margin, low-capital velocity companies, have the highest ROIC.
Understanding ROIC with Intangible Investments: ROIC calculation with intangible investments accounted for can reveal accurate financial performance and higher returns for young, intangible-heavy companies.
The Return on Invested Capital (ROIC) calculation can provide a more accurate view of a company's financial performance when intangible investments are properly accounted for. The traditional distribution of ROIC can be skewed when looking at young, intangible-heavy companies, which often have negative ROIC due to large investments in research and development or marketing. By capitalizing these expenses as investments, the ROIC calculation can shift these investments from the upper left corner of the strategy matrix to the bottom right, revealing higher margins and lower invested capital velocity. This method sheds new light on the underlying economics of businesses and can be particularly beneficial for investors seeking to identify companies with high returns on capital. However, it's important to note that accurately quantifying intangible investments is an ongoing effort in the finance, strategy, and accounting communities.
Companies with high returns on capital have higher price to book ratios: Identifying businesses with sustainable competitive advantages that maintain high returns on capital is crucial for investors. Capital allocation practices and trends can significantly impact shareholder returns.
Higher return on capital businesses tend to have higher price to book ratios, reflecting the market's recognition of their superior economic profits. However, the relationship is not perfect due to the lack of consideration of growth in the calculation. Furthermore, companies' positions in the return on capital rankings can change over time, with significant implications for stock price performance. Companies that move from high to low returns on capital see their stock prices get crushed, while those that move from low to high returns see their stock prices do extremely well. Therefore, identifying companies with sustainable competitive advantages that can maintain high returns on capital is crucial for investors. Companies' capital allocation practices and trends have also evolved over time, with increasing importance placed on effective capital allocation as companies mature and generate cash. Capital allocation can significantly impact shareholder returns, and both good and bad capital allocation practices can be objectively identified.
Capital Allocation: The Key to Long-Term Value Creation: Effective capital allocation from internally generated cash, debt, and equity impacts long-term value per share. Mergers and acquisitions and intangible investments like R&D are significant sources. Dividends and buybacks are perceived differently by CEOs and CFOs.
Effective capital allocation is crucial for building long-term value per share in companies. The majority of capital comes from internally generated cash, but companies can also obtain cash through debt issuance and equity issuance. While the reduction of equity issuance is generally a good sign, it also means shareholders have limited oversight over how companies use their capital. Good or bad, capital allocation depends on the relationship between price and value, and historically, mergers and acquisitions have been the largest source of capital allocation. However, intangible investment, such as R&D, is becoming increasingly significant. It's essential to understand that capital allocation decisions, including buybacks and dividends, are perceived differently by CEOs and CFOs, with dividends being considered more sacred and buybacks seen as a residual concept. The research conducted by academia, particularly in the area of intangible investment, is a burgeoning field and will continue to be an area of interest for the quantitative community.
Optimal capital allocation requires strategic thinking and flexibility: Successful capital allocators adapt to changing circumstances and consider the specific needs of each business unit, evaluating strategies rather than just individual projects, and allocating resources beyond just capital.
Effective capital allocation is a dynamic process that requires flexibility and strategic thinking. Companies often exhibit conservatism in their spending, with little movement in capital allocation from year to year. However, optimal capital allocation requires a fresh perspective each year, considering the specific needs of each business unit. Additionally, it's crucial to evaluate strategies rather than just individual projects, as a seemingly beneficial project may not align with the overall strategy. The findings also highlight the importance of resource allocation beyond just capital, emphasizing the need for companies to consider human resources and other intangible assets. Ultimately, the most successful capital allocators adapt to changing circumstances and make informed decisions based on the best available information.
Capital Allocation: Strategic Thinking, Flexibility, and Timing: Effective capital allocation requires a strategic mindset, flexibility to adapt, and the ability to make timely decisions. Human relationships and forward-thinking perspectives can also influence success.
Successful capital allocation involves a combination of strategic thinking, flexibility, and a willingness to act. The discussion highlighted the example of Bill Stewart at Boston Purina, who demonstrated the importance of constantly assessing the value of assets and making timely decisions. Human elements, such as personal relationships, can also influence business decisions, as seen in the anecdote about a CEO and his neighbor. Additionally, CFOs tend to be conservative in their decision-making, and companies can improve by being more forward-thinking and understanding the future. The last few years have seen significant market changes, including a shift from negative to positive real interest rates, which has impacted various asset classes. However, the fundamental principles of capital allocation, such as strategic thinking and flexibility, remain essential.
Navigating Capital Allocation and Disruptive Innovation in Today's Economy: Companies face opportunities to adjust capital allocation strategies amid increased returns for various asset classes and disruptive innovation, particularly in AI and healthcare.
The current economic landscape presents both challenges and opportunities for companies, particularly in the areas of capital allocation and disruptive innovation. The expected returns for various asset classes have significantly increased in the past year, driven by higher inflation and interest rates. This trend has created dislocations and potential opportunities for companies to adjust their capital allocation strategies, whether through mergers and acquisitions, share buybacks, or other means. Additionally, disruptive innovation continues to shape the business landscape, with artificial intelligence (AI) being a particularly noteworthy area of focus. The rapid advancements in AI have the potential to disrupt industries and labor markets, but the ultimate impact on jobs and value creation remains uncertain. As always, it's important for companies to stay informed and adaptable in the face of these changing dynamics. Some other exciting areas of innovation include healthcare, where remarkable developments continue to emerge. Overall, it's an intriguing time to be observing and participating in the business world, as new technologies and trends continue to reshape industries and create opportunities for growth. To gain a deeper understanding of these themes, I would encourage everyone to read the recent reports on return on capital, capital allocation, and market share.
Focusing on business fundamentals for excess returns: Michael Lebowitz emphasizes the importance of understanding businesses and their earning potential through focusing on fundamentals for excess returns. Check out Colossus.com for resources and sign up for Colossus Weekly for key ideas from each episode.
The importance of focusing on the fundamentals of businesses and their ability to generate excess returns. Michael Lebowitz, a renowned financial analyst and researcher, has been emphasizing this theme in his recent research. He encourages listeners to delve deeper into his reports, which offer valuable insights into understanding businesses and their earning potential. The speakers expressed their gratitude for Michael's time and knowledge, and encouraged everyone to continue learning about these concepts. If you're interested in exploring more, check out Colossus.com for access to all podcast episodes, transcripts, and resources. Additionally, sign up for Colossus Weekly, a newsletter that distills the key ideas from each episode and shares other valuable content.
