Update on bank investment thesis: WFC, USB, Lloyds TSB

The banking sector is undergoing a tremendous amount of stress and change, with parameters that fall beyond our earlier investment thesis for banks WFC and USB and Lloyds TSB (UK). It is necessary to reconsider the investment thesis for banks, and incorporate these latest data points.

Broadly the following macro changes have to be factored into the investment thesis:

1. The macro environment is turning out much worse than expected. This will drive losses and loan defaults are likely to increase to outlier levels unless some form of government guarantee or intervention takes place. The chart of loan resets (below) suggest that more pain is to come as the wave of Alt A and Prime loan resets hit.
   
   
2. The probability of the macro ecosystem changing is rising: regulators and/or the market may make it difficult for banks to sell their loans. If this persists, then banks will likely have lower ROAs because they will have to hold loans on the balance sheet. This could lead to a fundamental downward revaluation of bank equities.

For WFC and Lloyds TSB specifically, their investment merits need to be re-evaluated. WFC's acquisition of Wachovia and Lloyds TSB's acquisition of HBOS has created a great amount of uncertainty:

1. How much bad assets are there sitting on the acquired bank's books? WFC and Lloyds TSB have good credit underwriting and a good loan book; it can only be hoped that their acquisitions have equally good loan portfolios.
   
   
2. Both WFC and Lloyds TSB have a good business model, and are able to price their products at a premium. HBOS on the other hand, has traditionally relied on low prices to win business. Wachovia is in the middle of the road, not relying on low prices, but not able to command premium prices either. This suggests that the customer bases of acquirer and acquiree are very different, and that their business models are also very different. Whether these can be integrated is a large unknown.

Monthly Mortgage Rate Resets Chart:

Source: http://www.businessinsider.com/john-carney-chart-of-the-day-monthly-mortgage-rate-resets-2009-9

Consumer Staples Stocks - Long term outlook for the FMCG industry, and what it means for investors

FMCG businesses like P&G, Unilever, and Colgate-Palmolive are often seen as reliable long term investments, because their products are seen as daily necessities and are perceived to have strong brands with economic moats. The major FMCG companies' decades long track record of steady earnings growth reinforces this image.

However the last century's structural factors that allowed FMCG companies to evolve their economic niche are changing rapidly. Changes in technology, lifestyles, and the business landscape have brought the FMCG industry to an inflexion point in its evolution. The playbook that gave FMCG companies their past success is gradually becoming outdated. As investors, we need to critically analyze this; we cannot blithely project their future earnings by extrapolating from their past successes.

The value proposition of FMCG

The FMCG business was made possible by the technological advances of the industrial age, mass production, cheap transportation, and chemical and materials technology. FMCG companies leveraged these advances to create affordable products that improved people's lives, products which gradually came to be considered essential for daily living like shavers, toothpaste, detergents, shampoos, and so on. They created this value for consumers by:

1. Bringing new chemical and materials technologies to daily life. FMCG companies translated technological advances into new products that improved lives. Shampoos, better soaps and detergents, powders for washing machines, sanitary products, cheaper and safer food, and so on, brought technological advances to bear on improving daily living. This is similar to how Google, Amazon and eBay are today improving our lives by creating services based on advances in information technology.
   
   
2. Using mass production and cheap transportation to make their products affordable. FMCG companies applied mass manufacturing to achieve low unit production costs and make their products affordable. The dropping costs of transportation allowed centralized manufacturing to serve ever more distant markets, further increasing the economies of scale in mass production.

How the leading FMCG companies succeeded up to today

The leading FMCG companies succeeded by (1) identifying and manufacturing products that people wanted to buy, and (2) providing a compelling reason for retailers to stock those products.

1. Creating products that people want to buy. There are 2 ways for a FMCG company to have a product range that people are willing to pay for:
   
   (a) A company can manufacture products that are already in the market, at more attractive prices. This is the low cost executor strategy, to produce only goods which meet well identified needs, and use a low cost of manufacturing as a competitive weapon. For example, if it has been established that consumers are willing to buy margarine, then simply manufacture margarine on a large scale so that you can sell it to consumers cheaper than your competitors. Companies like Unilever excel at this strategy.
   
   (b) A company can innovate and develop new products (or features/solutions) that improve people's lives. This requires a large investment in market research and technical innovation, to identify hitherto unserved needs and use technology to create new products to serve those needs. P&G is an example of a company that has succeeded with this strategy. It has (a) mature market research and product testing capabilities, and (b) extensive expertise in chemical and materials technology. Such companies can typically charge a premium for their products, provided the differentiated value is communicated to, and perceived by, consumers.
   
   
2. Providing a compelling reason for retailers to stock their products. FMCG companies rely exclusively on retailers as the channel to the consumers, and getting retailers to stock their products is key to their success. There are 2 ways they can do this:
   
   (a) allowing the retailer to earn more money by selling those products than other products. This was done either by (1) providing innovative products that consumers are willing to pay more for, and/or (2) providing products that people want at a price lower than what the retailer can find elsewhere or by manufacturing it on its own. Their adoption of mass manufacturing and increasing volumes achieved the latter, as FMCG companies gradually evolved to become many times bigger than individual retailers.
   
   (b) by making customers ask for their products by name, so that a retailer can't afford not to stock the product. FMCG companies needed to communicate with consumers to tell them why they should ask for a particular product. To do this, they developed brands, which are fundamentally a signaling mechanism to tell consumers something about their products. When managed properly, brands were very effective in the pre-information age, when information was scarcer, less accessible, and where consumers could not easily share information.

Changes in the world between the 20th century and the 21st century that affect the FMCG industry

The year 2000 roughly marks the watershed between 2 eras in the evolution of the FMCG industry. Several things have changed between the 2 eras:

1. Some retailers are now as big, or bigger than many FMCG companies, nullifying the FMCG companies' economies of scale advantage. Prior to the 1990s, retailers were much smaller than FMCG companies. This meant that FMCG companies were much larger than retailers, and hence FMCG company produced products would inevitably have a cost advantage to private label / store manufactured products. However the size and scale of retailers today allow them to commission private label manufacturing for products (whose technology is available to private label manufacturers) on a scale as large as the major FMCG manufacturers.
   
   
2. It is harder for FMCG companies to sustain a technological edge and build brand value, because chemical and materials technology have moved to the upper end of the technology innovation S-curve. The last century was a period when chemical, materials and industrial technology were starting to evolve rapidly, and new industrial technologies brought us innovations like the washing machine, rice cooker, and other home appliances. During this time, well managed brands that communicated capability were a source of competitive advantage. It was also difficult for competitors and upstarts to manufacture the products because technology know-how was not widespread. They did not have the know-how (e.g. advanced detergents, shampoos etc) or scale to manufacture effectively.
   
   However, technology progress in chemical, materials and personal/household technology is now entering the upper end of the S-curve. While technology advances continue at a rapid pace, fewer of these advances are "paradigm changing". People are no longer experiencing "shock and awe" at new products coming onto the market, and are generally able to understand new FMCG products. There are also fewer radical advances in categories; for example, in many cases, the difference between a good detergent and a cutting edge detergent is not dramatic. The result is that the value of brands deteriorates for capability driven brands, and makes it hard for consumers to differentiate one product from another. The widespread availability of manufacturing and technology know-how also makes it easier for upstart competitors to manufacture functionally near-equivalent products. The result is that many categories of FMCG goods are in danger of being commoditized.
   
   
3. The mindset and norms of people brought up in the Information Age reduces the value of brands. The generation that grew up in the information age is culturally different from the generations before. Compared to the past, when information was harder to come by, people are now used to looking for information on product attributes and sharing product reviews. Information is freely available and the new generation is mentally predisposed to looking for information. The value of brands as a signaling mechanism is reduced. For example, observe how the online jeweler Blue Nile has been able to build a large customer base relatively quickly. In the past, it would have been unthinkable for consumers to buy thousand dollar pieces of jewelery over the phone, much less over the Internet. High value purchases of such hard-to-assess products would only be done at trusted jewelry stores.
   
   It is also difficult to command a mass audience because of the decline in attention to mass media, and the change in people's attitudes to consuming information. The old formula for building brands through mass communications will no longer work.
   
   It is an open question if it is possible to build billion dollar brands in this new environment. In the annals of history, it is entirely possible that brands will be seen as an artifact of the industrial age, when information was consumed as a one-way feed through mass media.
   

Types of brands, their characteristics, and
how the changes described diminish their value

The FMCG companies used mass communications to market their brands, to induce an respondent conditioning response in consumers. So that for example, if a consumer thought of "cleaning power" he/she would automatically reach for a box of Tide. In some cases where the product delivers an assessable and keenly felt capability or experience, operant conditioning also kicks in. Fundamentally, there are several types of brands:

1. Brands that serve as a Quality / Safety signal - the quality guarantee of a product. For example, Lea and Perrins Worcestershire sauce - the distinctive icon imprinted on the label combined with a past experience of the product, serves to communicate its taste and ingredient quality. This was particularly important in the era when there were many manufacturers and the market had many products of differing base levels of quality. For example, the Heinz brand conveyed an image of safe food made with good ingredients. The value of this type of brand decreases once all products presented in a market are of comparable quality or meet certain universally demanded specifications. It also decreases when people have the ability and predilection to exchange notes about the quality of a product. For example, an Auto Company may be known for making low quality vehicles, but with Auto review sites today, it is possible for consumers to identify the occasional high-quality car model from this manufacturer. The value of building a brand like Toyota that conveys quality gradually begins to diminish.
   
   
2. Brands that serve as an Experience signal - the promise of a particular experience. For example, the Cadbury label conveys the promise that the chocolate bar insde the wrapper will have the same taste, or type of taste, that you expect from Cadbury products. The value of this type of brand erodes when people are able and have the predilection to exchange notes/reviews on a product. For example, the Hilton and other hotel brands used to serve as a signal of a certain experience. Smaller hotels who had no brands were at a disadvantage. Even if they provided better service than the big luxury chains, it was impossible for them to be well known for it. But this has changed in the new Internet age. With review sites like Trip Advisor, even small hotels without such brands can become known for their quality of service.
   
   
3. Brands that serve as a Capability signal - a description of a new feature brought about by new technology. This is particularly useful when people are trying to adapt to something new. For example, when washing machines were first introduced, people relied on washing powder brands because they were unfamiliar with the difference between the various types of detergents. The value of this type of brand erodes once people are familiar with the technology, or are able to assess the product's capability, and have the predilection to exchange notes on the product or technology. Brand products whose capability cannot be easily assessed, such as the "beautifying power of a facial cream" or the "germ killing properties of a cleaning liquid", tend to retain their value better, since consumers cannot assess the product's capability and need to "trust" that the product is doing what its brand says it's supposed to do.
   
   
4. Brands that signal an Identity or Message - For example, some brands like Harley Davidson are designed as an identity which people can take on. As social animals most humans want to belong to a group, and need to communicate their status or position to members of their community. Brands such as Harley Davidson provide for this. Other brands such as See's candies or Godiva chocolates are partly designed to indicate a message of "I bought something exclusive and expensive for you". The value of such brands is largely determined by how well they are managed, and the relevance of the message within the context of the zeitgeist of the day.

Perhaps brands in this new age of information will only have value for products that are:

• (i) Edge of Consciousness (Mental shortcut). Low-priced and/or where it doesn't make sense to go spend so much time looking for information. In other words, products that exist at the edge of our decision-making consciousness. Brands are particularly useful in this area if the market is full of bad products/"lemons", because the value of a brand as a mental shortcut in decision making is enhanced.
  
  
• (ii) Extreme Risk Aversion (Risk-reward ratio of trying new products is not good) Where there is extreme risk aversion, for either evolved, physiological, psychological or cultural reasons. For example, any product that comes into contact with the mucosa of the human body. In this category are products for whom the impact of a bad product far outweigh the potential benefits that come from trying a "better product".
  
  
• (iii) Operant Conditioning. Where the brand is a signal of an experience which is part of a consumer operant conditioning, where the signal and the experience reinforce each other (typically where the brand is a signal of an experience which the consumer craves, and experiencing the product causes the consumer to react to future encounters with the signal).
  
  
• (iv) Quality / Capability cannot be objectively assessed. For example, in cosmetics or nutritional products such as health foods and vitamin supplements, where the quality and effectiveness of the product is largely subjective. (This is not to say that such products cannot be assessed in clinical trials; rather within the context of an individual's assessment of the product effectiveness for him/herself, the assessent is subjective)
  
  
• (v) Signal of a message or identity. For example, luxury brands which indicate exclusivity and the wealth of the owner. This taps into a primal human need to identify with a group and/or show-off. It also applies to expensive gift brands, where there is a need for a person to signal the importance with which he considers the gift receiver. This ties to a fundamental need of social animals like humans, and is unlikely to go away. These brands only need to stay in touch with the zeitgeist, to make sure that they are not "out of date".
  

Why the existing FMCG playbook won't work so well
in the next few decades

The confluence of these forces results in a world where (1) the cost advantage enjoyed by FMCG companies from economies of scale are now available to retailers too, (2) the value of brands is deteriorating as consumers are prone to searching for and sharing information, (3) the rate at which FMCG companies can introduce new product capabilities is slowing down, because chemical-materials technology has entered the upper end of the S-curve.

In this environment, it is easier for upstart competitors (local FMCG players, or retailer private labels) to surface. Just as a hypothetical example, consider yourself a next generation consumer walking into a large retailer: When you see a product on the shelf, what makes you decide to buy it /a competitive product? It's probably a combination of:

1. the product proposition, communicated by its packaging and price, and whether it meets a need you have
2. its shelf position
3. its performance / technical ability, and your past experience with it (if any)
4. what you've heard about it before

In the past, 1 and 4 would have be signaled by brands and brand marketing; and 3 would have been something that few companies could duplicate easily. Large FMCG companies had the advantage.

However, in today's world, 3 is easy for private label or upstart competitors to match. 4 is now becoming the domain of new communications technologies, and no longer communicated by brands. 1 & 2 are firmly in the retailer's court - they can confer the advantage here to house brands. In other words, retailers now have the upper hand.

Summary

The major FMCG companies won't disappear overnight because of consumer inertia. But long term investors need to reassess their long term prospects.

For investment analysis purposes, there are various wildcard scenarios that are also worth thinking about:

1. The end of cheap transportation / rising oil prices. Global supply chains may be disrupted. End of cheap transport may make it uneconomical to manufacture at central location for the world, for lower value-to-weight goods. This would remove the economies of scale of large FMCG companies, and make it economical for local competitors to pop up because they can nullify the cost advantage of the big companies.

Analyzing Retail Stocks - Economics of the business, and what it means for investors

In this post, I describe the nature of retailing and the key factors that affect a retailer's health. It broadly forms the base of the investment thought process for investments in retailers.

The nature of the retail business

and the fundamental drivers of success

The retail business is a tough one, and very few retailers succeed in building enduring businesses. The retail landscape has changed tremendously over the last few decades. Fast food restaurants have replaced Automats, and big box retailers have risen to prominence at the expense of high-street/city center retailers. Retailers have to adapt to changes in fashion, lifestyles and consumers tastes. Large established retailers that fail to adapt can fall swiftly; witness how bellwethers like Sears, K-Mart and Circuit City have gone from boom to bust in a matter of years.

Retailers are fundamentally in the business of distribution. They create value by getting products to consumers, in a manner accessible to them when they need it. For a retailer to be successful, it needs to:

1. Stock products that customers intrinsically want. Retailers are rarely able to generate intrinsic demand for a product. The intrinsic demand for a product is determined by a combination of product marketing, consumer lifestyles and the prevailing zeitgeist. What retailers do is to meet that demand by making the products available to consumers. Retailer merchandising and presentation play an important role in stimulating the desire to purchase a product, but they only work if the customer has a fundamental need/demand for the product. For example, it's unlikely a retailer will succeed in selling chicken feed in New York city, no matter how creatively the product is merchandised.

Retailers can either create their own items to stock (such as retailers like the Body Shop, or the general provisioners of the early 1900s who sold brand-less commodity items), or stock items made by other companies, as long the products are what people desire and fit into the position and mind share occupied by the retailer. FMCG companies add value for the retailer by supplying them with products that their customers want, at a lower cost and with less hassle than having to develop the products themselves. This symbiotry between FMCG companies and retailers has evolved over the years, since it started in the late 1800s when P&G, Colgate and other FMCG companies were founded.

Retailers need to adjust their merchandise mix over time as tastes and needs change over time. Products that are considered necessities today may become irrelevant in a decade, and products that people aspire to change over time. Many retailers fail because they do not keep up with lifestyle and zeitgeist changes.

2. Make it convenient for consumers to buy. Because people generally do not derive value from the buying process; they see it as something they have to go through to get to the value that products deliver (e.g. refreshment from a drink, the cleaning power of a soap, etc.). People tend to buy from the store that is the most convenient to buy from.

What about people who enjoy shopping? While it's true that they derive value from the shopping activity, the actual purchasing process is not something they would place much value on. Their shopping expeditions will generally be to places which are convenient, being both accessible and a one-stop destination for the merchandise being sought. So making it convenient for consumers to buy is key to successful retailing. To do this, retailers must:

• (a) be accessible in the context of its customers' lifestyles. People will only visit stores that are conveniently accessible to them. The only exception is when a store sells something that a person has become addicted to or induces a strong physiological response, such as pornography and addictive items.
  
  For example, malls and big box stores fit the car-centric lifestyle of suburban shoppers in the U.S. Big box grocers find it harder to succeed in Japan because many people there do not drive, and also have small fridges which cannot store a week's worth of shopping. Instead, convenience stores scattered amidst the urban alleys are more suited to the Japanese lifestyle, because most Japanese consumers walk to subway stations on their way to and from work.
  
  The way people shop changes with changes in their lifestyle, which is typically driven by technological advances and changes in the zeitgeist. For example mail order used to be a convenient way to buy things, but is today rarely used as (1) people are more mobile and able to travel to stores easily, (2) modern logistics networks bring all kinds of goods to local stores, obviating the need to buy from a faraway mail-order retailer, and (3) the prevalence of Internet shopping, which has made mail order less relevant (though not extinct - for example, NBrown in the UK still runs a large home shopping operation)
  
  
• (b) be a one-stop shop for the position that it has carved out in people's minds. Each retailer has a position in the customer's mind (for example, a store to buy "natural remedies" or "imported groceries" or "stuff at bargain prices"), and the merchandise mix in the store must support that position. When a customer walks into a store, he/she should be able to find all the items that he/she is looking for. A successful shopping trip reinforces the retailer's position in the customer's mind, while a wasted shopping trip makes it more likely that he will choose another store in future. No amount of positioning marketing will help if the store doesn't have the range of goods a customer looks for.
  

The economics of the retail business
and sources of competitive advantage

The economics of the retail business are similar to that of the distribution business. Both are a combination of a logistics network and a trading business (inventory management). Like distributors, retailers are price-takers when there are multiple competitors serving the same target customers. On the other extreme, a dominant retailer in a town enjoys a natural moat that gives it pricing power. This does not mean that a retailer's pricing power grows with size, rather there is a tipping point between the two extremes.

• A retailer generally has no price-setting power when there is a competitor serving the same group of customers. (i.e. targeting the same customer profile, and present the same assortment of goods at the same locations/customer touch points). The economics of the distribution business are such that a customer faced with the choice of buying from 2 or more distributors will not be willing to pay much more for one distributor's services as opposed to another. Certainly some people may be willing to pay more to visit a cleaner/less crowded store, but the premium they are willing to pay is minimal. The players are price-takers, and the only sustainable competitive advantage is to be the lowest cost operator within its market. Having the lowest cost of operations and procurement allows the retailer to match all competitor price actions while remaining profitable.
  
  
• However a retailer has price-setting power if no other retailer is serving the same group of customers. For example, if a grocery store is the only one that is accessible to the residents of a town, then the retailer can generally set the prices for its services. Likewise, the only store to sell specialty cheeses in a city can set the price for its services.

Size is a source of competitive advantage. All things being equal, the economics of retail are such that the value that a retailer brings to customers increases naturally in proportion to the size of its operations. The largest retailer will almost by definition (a) be the most accessible to customers with the best network of sites by virtue of the in-place nature of the business, and (b) have the widest range of goods. The economies of scale that exist in distribution means that the largest distributor is also likely to have the lowest unit costs, and thus able to offer the lowest prices in order to fend off competitors who try to compete on price.

The largest enjoys a positive feedback loop where its increasing size improves its competitive position, which in turn increases it size, and so on. Once a dominant position is achieved, the economics of distribution gives the retailer a structural competitive advantage and makes it very difficult for smaller competitors in the same category to compete.

This doesn't mean that no other retailer competitor will survive, because consumers don't just base their buying decisions on these factors; there will be people who prefer the competitor's store because of its color scheme, etc. (This applies less to distributors who sell to businesses, because business buyers tend to make economical decisions. Take for example, the different buying behavior between consumers and fleet-buyers when they buy cars. The former will be influenced by styling, while the latter will be driven by fuel efficiency and maintenance costs.)

Building an enduring long-term retail business
with a sustainable competitive advantage

The economics of the business means an enduring retail business is one that is able deliver value to its customer and achieve and retain dominance. This means that an enduring retailer is on that is able to:

(1) Constantly adjust its inventory to continuing stocking products that its customers want, and adjusting its mindshare position in its customers' minds accordingly. (or it could try selling products that are relatively insulated from fashion trends and quick changes in demand)

(2) Constantly adjust it store accessibility, to be accessible even when its customer's lifestyles change. (or it could be serving a consumer group whose lifestyle that isn't expected to change much)

(3) Achieve the lowest cost of operations. In the retail business, this means:

• (a) Maximizing inventory turns. Moving inventory as quickly and efficiently as possible. Fast moving inventory also allows the retailer to reduce the capital intensity of the business, and increases the flexibility to quickly change stock when customer needs change. Conversely, slow moving inventory means that capital is tied up (and financing costs incurred), and also prevents the retailer from purchasing new stock to cater to seasonal or changing customer demands.
  
  
• (b) Maximizing sales per square foot. A higher sales intensity increases capital efficiency and productivity. Per unit operating costs are also reduced through the efficiencies gained from selling more in a single location.
  
  
• (c) Maximizing economies of scale. This is a business where there are economies of scale. A retailer that has higher purchasing volume will be able to extract more price concessions from its suppliers. Likewise, higher merchandise volume means that the retailers logistics and distribution infrastructure will be better utilized. For example, trucks will travel with full loads, and the fixed costs like warehouse management systems will be amortized a larger volume of merchandise.
  

Openings that an upstart competitor can exploit
to displace a dominant retailer

The competitive landscape of retail is like an open savannah, where the playing field is flat with few natural defensive positions. The factors of production, technology and merchandise used in retail are available to all competitors. Likewise consumers can switch retailers easily, and lifestyle and fashion changes affect all retailers. A competitive retail landscape is like a highly evolved Savannah ecosystem, where individual players have carved out their own survival space (value to customer, delivery model etc), and their incumbency is evidence of their competitive strength within a niche. In other words, they will likely have found the best way of utilizing existing factors production for a particular customer niche. The more competition the incumbents have defeated, the less likely it is that there are unexploited factors that the incumbent has overlooked.

In this landscape, competitors can establish a survival space only if one of the following openings exist:

(a) They ride a changing consumer wave or change in zeitgeist. In other words, exploit a changing customer profile which the incumbent isn't attuned to. For example, Sears used to be the dominant retailer in the United States, but the rise of suburbia, the auto-culture and changes in tastes allowed big-box stores and category killers to muscle in on Sears' dominance.

(b) They find some technology or operating technique which the incumbents have overlooked. This is difficult, but not impossible. Walmart did just that to K-mart, by exploiting the logistics efficiencies of building store in geographically contiguous fashion. It built out its network of stores in small towns by going into towns next to each other. This logistics efficiency allowed it to achieve lower costs that the incumbent discounter K-Mart, which had store that were situated in big cities hundreds of miles apart.

(c) The incumbent messes up. The dominant retailer may also mess up, for example, by allowing its store to be infested by rats. Dominant retailers can also the mistake of muddying its position and deviating from the formula that made it successful. For example, a retailer with the position of lowest-cost discounter may try to become an aspirational retailer that sells higher-end goods. Because of the Savannah like competitive landscape, deviating from a survival space means that a retailer is exposing itself to open competition from other players who have already found the competitive advantage in their survival space. The dominance in one survival space often does not translate to another survival space, and the retailer will be starting from zero in its competitor's stronghold. This doesn't mean that a grocery discounter will be unsuccessful selling discount electronics, because the competitive dynamics of both areas are similar. But a discount grocer trying to sell fashionable clothes is going to find it tough going, because the survival dynamics in each space are vastly different.

What this means for Investors
who invest in retail companies

Investing in retailers involves a quantitative assessment of the retailer's cost position and dominance, and a qualitative assessment of whether its position, customer base, and accessibility to its customers are likely to continue relative to zeitgeist and technological changes. It basically means:

1. identifying retailers that have established strong survival spaces, and
   
   
2. constantly monitoring the landscape for evidence of competitive openings that may have been created, and
   
   
3. constantly monitoring the changes in consumers' lifestyles and evidence that the retailer is keeping up with these changes
   

It is more than a simple spreadsheet exercise, unless we are planning to liquidate the retailer for its assets.

Analyzing oil companies - The economics of the energy, commodity and materials business, and valuation traps

One school of thought is that investing in commodity-processing/resource-owning companies, such as oil majors like XOM, RDS, BP and CVX, and pulp and paper companies like Votorantim Celulose e Papel (NYSE ADR: VCP), is a good way to preserve wealth during periods of elevated inflation. The underlying hypothesis is that the price of commodities will rise in line with the general price level, allowing them to grow their profits in line with inflation.

However as with all investments, it is crucial not to overpay for a stream of earnings or you will end up with negative real returns. We'll look at one way of analyzing and valuing a commodity-processor/resource-owning company's earnings quality. We'll also see why in some cases we are better off buying commodities directly.

The economics of Commodity producing businesses

- they are price takers

Because their products are seen as commodities, customers have no particular reason to pay significantly more for a product from one company over another. In many cases, it is also relatively easy for customers to switch suppliers. This means that commodity sellers are price takers who cannot sell their product for more than the market-clearing price. The implication is that:

1. The strongest company is the one with the lowest cost of production and cash reserves. One of the worst things that can happen to a commodity company is if the market price for the commodity drops below its cost of production, making it lose money every day it stays in business. (While hedging can ameliorate this, it is only a short term solution) So well-funded companies with the lowest cost of production will have the most sustainable competitive position; if prices drop, the lowest cost company will be able to run with the lowest losses until all other competitors go broke and withdraw capacity from the market, allowing prices to rise to a profitable level.
   
   
2. They are vulnerable to price-irrational competitors. A competitor that decides to sell product below cost could drive the company out of business. This is a particular risk in "essential commodity industries, as governments may run loss-making state-owned competitors for political reasons. This is also a risk if the industry requires large amounts of fixed capital to operate, because ailing competitors may resort to flooding the market with product just to cover some part of their fixed costs (ie. manufacture as much as possible, as long as variable production costs are covered).

Durability of competitive position

- Factors affecting Earnings stream quality

Because they are price takers with an undifferentiated product, they have a durable earnings stream only when (a) the environment minimizes chances of prices falling below their operating costs, and (b) in the event that occurs, they are the best positioned to weather the down period until prices recover.

Industry reports and published financial statements can give you an indication of which companies are the most competitive, and have low production costs. The leading companies typically achieve their competitive position by (1) having economies of scale, (2) acquiring commodity reserves with lowest costs of production, and (3) applying operational efficiency and technology to minimize production and overhead costs. Unless there are disruptive events, it is likely that the leading companies will retain their competitive positions over the short term. However, the long-term durability of their earnings stream depends on 2 principal factors:

(1) The probability of price-irrational competitors emerging (such as government funded competitors). This depends on:

1. the geo-political environment: For commodities that are considered strategic assets, there is always the possibility that interventionist governments may setup state-funded not-for-profit competitiors. States with resource reserves are especially good candidates for this. The probability of this happening is balanced by the existance of trade barriers and trade agreements which can prevent dumping of commodities into foreign markets.
   
   
2. the cost structure of existing competitors. Competitors that are heavily in-debt and/or have high overheads may flood the market with product, just to cover some part of their fixed overhead costs/debt servicing. They can price product below true (fixed+variable) costs over the short run, just to meet cash flow needs.

(2) the probability that an upstart competitor can achieve lower costs of production. This depends on:

1. The components of the cost of production. For example, the bulk of the cost of steel production lies in the cost of energy needed to run furnaces. So a competitor could achieve lower costs of production if it managed to find a cheaper source of power, for example by erecting a new dam for cheap hydroelectric power. You would need to analyze the probability of this happening to estimate the earnings quality of a commodity company. Likewise a pulp and paper company's costs could predominatly be in forestry costs, so a competitor who could open up cheap forestry landbanks (because of climate change or changes in government rules) could gain a competitive edge.
   
   
2. Commodity re-cyclablity. Recyclable commodities like gold present the possiblity of a recycler finding a way (through technology, or finding an untapped source or cheap recycled gold) to produce re-cycled commodity at a lower price than extracting it out of the ground. For example in the gold market, it is conceivable that gold prices can fall below the cost of production of even the lowest cost miner, because there is a huge supply of gold which is already in the hands of consumers. Because gold is indestructible, there is always the possiblity that existing consumers may flood the market with their gold, and depress the market price of gold below it cost of extraction from the ground.
   
   
3. Probability of changes in the company's competitive sphere. The "competitive sphere" is the range of competitors who can serve the customers that the company is serving, and it varies according to the nature of the commodity. For example, a perishable commodity like fresh milk has a local competitive sphere (as long as customers aren't open to ESL milk or UHT milk which can be supplied from thousands of miles away e.g. by Fonterra in New Zealand). Competitive spheres can change with technology. For example, natural gas used to be a local product which could only be transported along a pipeline to nearby consumers. However, with technology advances and the build up of LNG processing facilities worldwide, natural gas can now be converted into LNG and shipped anywhere across the world, making its competitive sphere a global one. The lowest cost producer in a particular region might find itself displaced from the lowest cost position when compared with producers across the globe.
   
   
4. The Company's ability to keep acquiring lowest cost reserves. Resource owning companies constantly need to find new resource reserves to replenish reserves depleted by production. Otherwise the company will be operating in run-off mode, and will cease operations once its existing resource reserves are depleted. If the company is unable to find reserves with low extraction costs, or a competitor finds a motherlode of easy to extract reserves, then its future competitive position and earnings quality will deteriorate.
   

Valuing commodity/resource companies

- buying commodities, instead of resource companies, may be a lower risk way for investors to preserve wealth

To a long term owner looking at a company as an income producing asset, the valuation of any company is based on the present value of the expected stream of earnings which the owners can take out of the company. (We exclude earnings which need to be retained in the company, since they are needed to keep the goose alive to continue laying its golden eggs)

To arrive at a risk-weighted estimate for the future earnings stream, we need to combine all of the following:

1. the earnings that will flow from its current commodity reserves
   
   
2. the risks to those earnings, arising from changes to its competitive position (costs relative to its competitors) and the likelihood of non-economic competitors
   
   
3. the ability of the company to continue adding to its resource reserves without changing its costs of production relative to its competitors

In the short run the company's earnings will likely grow in line with inflation (assuming it also drives commodity price rises), because the company's costs of production (reserve extraction costs and reserve acquisition costs) are based on yesterday's prices while revenue is based on today's inflated commodity prices.

However over the long run, the ability of resource companies to grow earnings in line with inflation is not a sure thing. In fact, their earnings behavior over the long term is likely to be no different from the average of a basket of companies across industries. Why? Because (a) as inflation sets in, their cost of acquiring reserves and the costs of extraction will also likely go up, and (b) like all companies, they face competitive risks to their earnings. And as we have seen, as commodity producers they can face more earnings risks than non-commodity producers.

So if you are looking to preserve the value of your wealth during inflationary periods, you may be better off investing directly in commodities, if you hold the view that commodity prices will rise in line with inflation. (which is the same premise in the "invest in resource companies" hypothesis)

Valuation traps and mistakes

- particular to commodity/resource companies

One mistake is to value a company by extrapolating its future earning stream from its recent earnings history. Commodity prices tend to be cyclical in nature, because of the oscillating boom-bust feedback loop that develops; increasing production causes prices to drop, which causes production capacity to be withdrawn, which causes prices to go up, and so on. These cycles can span many years, so you need to look at the 10-year earnings history (or longer) to get a feel for the company's earning power.

For resource-owning companies, this approach also ignores the fact that the company's reserves are not infinite and will run out at some point. Management will continue acquiring new resource reserves to keep the company viable as a going concern, and the new reserves' cost of production will determine the company's earnings quality down the road. For example, an oil company with low-cost reserves may have a high quality earnings stream today. But if it cannot replenish its reserves with equally low cost resources, it will gradually slip into a weaker competitive position and become more vulnerable to losses in future. This should reduce the valuation placed on the company.

Another valuation mistake is to take the enterprise value of a commodity company as = the amount of commodity reserves they have, multipled by the prevailing commodity price. (i.e. valuing the company in run-off mode, where the company will cease operations once its existing reserves are depleted). The problem with this approach is that it assumes that it is possible to extract and sell the entire reserves all at once. In practice annual production capacity is limited, so if you want to value the company as a run-off company, you need to base your value calculation on the NPV of each year's production, until all reserves are depleted. (It is not uncommon for resource companies to have only 10-20 years of resource reserves if production rates are maintained.) You may be surprised that the NPV value expressed as a PE ratio can be in the low single digits.

The mechanics of buying stocks

Most of us receive regular statements from our stockbrokers telling us what stocks we own. But what happens if your broker goes bankrupt; will you lose all your shares? For legal and practical reasons, few people have physical stock certificates today. So how do you prove that you own your stocks if your broker goes bust, or makes a mistake?

Here's what actually happens when a stock trades, and how you can protect yourself from losing your stocks:

How the ownership of a stock changes during a trade

When you buy stocks, you're actually triggering off a long chain of activity in the financial system. But your broker is probably the only party that you deal with. Here's what happens:

(click on the image to expand it)

1. When you instruct your broker to buy a stock, your broker will go out to look for people who are willing the sell the stock you want. This could be someone else who has told the broker that he wants to sell that stock; in which case the broker would simply "transfer" the stock to you at the agreed price. More likely, the broker would have to get in touch with other brokers to find the stocks you want. This can be through a stock exchange such as the NYSE, where all trades and their clearing prices are made known to the public. Or, it could be through a network of brokers who have come together to trade. Such networks are known as Alternative Trading Systems. In general, the SEC regulates where public listed stocks may be traded, with the objective of minimizing fraud and creating a fair market for all parties. Once a willing buyer and seller are found, they are matched and the trade takes place. So far, the actual stocks haven't been transferred to you yet. Rather, you just have a confirmation that the buy trade was carried out.

2. The next thing that happens is the settlement process. This is where the stocks you bought actually get "delivered" to you. In the past, all stocks were held in certificate form. If you owned 100 shares of Company X, you would have a stock certificate which said just that. This was an extremely important piece of paper, because it was like cash in the sense that if you lost it, you lost your stocks. The stock broker would literally get the stock certificate from the seller (or the seller's broker) and hand the certificates to you in exchange for a cash payment. Some people would keep their stock certificates in a bank vault, others would keep them with a custodian in a custodial account, and yet others would leave them with the broker so that they could be easily sold later on.

The paperless settlment process today
- Stocks are often held in the broker's accounts

However today, most countries operate a paperless stocks system, in which no paper certificates are transferred between sellers and buyers. Instead, ownership of a stock is recorded in the books of various parties in the financial system. When you buy a stock, there is no paper certificate that gets transferred to you. Rather, a book entry (or many book entries) is made to say that the stocks have been transferred from the seller's account to yours.

At the heart of the system is a depository institution (for example, the Depository Trust and Clearing Corporation (DTCC) in the United States, or the CDP in Singapore). All brokers open an account with the depository institution and "deposit their stocks" there. After a trade, the buying and selling brokers will notify the depository that the ownership of the stock that was traded should be changed. The depository institution will then updates its books to move the ownership of the stocks have from the selling broker to the buying broker. It also manages the transfer of payments between brokers, and minimizes counterparty risk through various guarantees and insurance schemes.

The depository institution may notify the company (whose stock was traded) about the change in ownership of stock. All listed companies keep track of their stock holders in a "register of stockholders". It lists all the people who own the company's stock, and allows the company to know who to send dividends to, and who to notify in the event there are corporate actions which require a shareholder vote. In many cases, the company will outsource the work of maintaining the shareholder register to a stock transfer agent, such as Computerserve. (The transfer agent can do other things too, like manage dividend distributions, issue share certificates, and more. Stock transfer agents are also known as share registrars in some countries)

In practice, depository institutions and the settlement system is different from country to country. For example, the DTCC can also act as a custodian. Likewise, many brokers also offer custodial services, especially for foreign shares which you purchase through them. They may in turn, use other custodians (through sub-custodial accounts) and brokers in other countries to carry out your foreign trades. The way the DTC in the United States works is described here:http://www.dtcc.com/downloads/about/Following%20a%20Trade.pdf)

You'll notice that so far, the stocks aren't registered in the name of the person buying the stock. Instead, the stocks are usually held in the name of the broker. This is known as holding your stocks "in street name", because for all appearances to the rest of the world, it is your broker who owns the stocks. It is only in your broker's books that an entry is made to say that the stocks belong to you, to make you the "beneficial owner". Many people do this, because it makes it easier to get the broker to sell the stock later on.

So do you legally own the shares?
- No, but the law does offer some protection against broker misbehavior

Strictly speaking, you are the legal owner in the eyes of the company (that you invested in) only if you have registered your stock with a company's stock transfer agent and appear on the company's shareholder register. Otherwise, the securities technically belong to the brokerage firm or the custodian bank. So in general, it is important to use reputable and financially sound brokerage firms and custodians. Simply going for the cheapest broker isn't necessarily the wisest course of action.

Nonetheless, the Securities Investor Protection Act of 1970 does offer some protection to investors in the United States. It empowers the Securities Investor Protection Corporation to offer compensation to investors in the event a brokerage company fails. However, it is not a general insurance fund like what the FDIC does for savings accounts. Notably, it does not compensate investors if there is investment fraud or if your broker simply makes a mistake in executing your trade.

How to get yourself registered as the legal owner
- and protect yourself from broker failure

However, you can always ask for the stocks to be registered in your name in the company's register of stockholders. If you ask, most publically listed companies will explain to you how you can contact their stock transfer agent and get your stocks transferred from your broker's name to your name. The benefit of this is that you won't have to worry that you'll lose your stocks if your broker goes bust, or if some massive fraud is taking place at your broker's office. The downside is that it becomes much harder to sell your stock. To sell your stock, you'll need to tell the stock transfer agent to transfer ownership of the stock to your broker, then ask your broker to sell the stocks for you. Brokers often charge extra for this service, because of the hassle of deregistering them from your name on the stockholder register.

Some buyers, especially large institutional player like mutual fund managers, will ask their brokers to transfer ownership of the stocks to custodian banks, like State Street, instead of registering the stocks directly in their name with the stock transfer agent. They do this to use the services which the custodian banks provide, such as portfolio management and reporting. The separation of duties between trading (the broker) and holding inventory (the custodian bank) also reduces the chances of fraudulent activity. For example, with this separation of duties, it would be difficult for a broker to take money from the buyer without actually buying the securities it was supposed to buy.

Bottom Line: How to protect your right of ownership

The bottom line is, if you are investing a significant sum of money, go with an established and reputable brokerage. That way the probability of the broker failing to make good on its mistakes (or the possibility of fraud) should be lower.

If you intend to hold your stock for a long time, then consider having it registered with the company's stock transfer agent. That way, you will be officially recognized as being an owner of the company. 

[ You might wonder how depository institutions, custodians, and brokers identify the thousands of stocks that are traded. Wouldn't there be confusion especially since many companies trade on different exchanges? Fortunately, the industry has standardized on the use of a unique CUSIP/ISIN number for each security. This makes it possible to clearly identify a particular security.]