Since times of maximum chaos are fertile ground for opportunity, it's worthwhile to revisit the building blocks of business value creation. Let’s start at the basics.
A business creates a solution to an existing need and sells this solution in the form of a product or service. The profitability of this business depends on 1) the value it creates for its customers, and 2) a piece of the value this business can capture and keep for itself. We can measure the success of this value capture on two simple metrics: 1) Operating margin, and 2) Return on Capital. We generally assume that if the potential market size is large, the profit pool will be just as large. However, this is profoundly untrue. In no way is the size of the profit pool related to the size of value creation. Once we examine these three groups: 1) Hospitals, 2) Restaurants, and 3) Automobiles; it becomes immediately clear that despite the large benefits of health, social connection, and mobility to a very large population, businesses within these groups haven’t been able to capture the value they created for customers.
But if we take a step back and examine various groups of businesses within the entire industry, things get clearer. In aggregate, this value chain - a cumulative result of a series of activities of multiple participants - creates a certain amount of total value. And generally, a select few groups within the chain fare substantially better than the overall group. Why is this the case? Well, it has to do with competition, regulation, and capital consumption.
The most important component of investing is to understand 1) the total value created by the value chain, and 2) to identify the key cogs in this wheel. Not all participants are entitled to equal profits. Let’s look at the three groups below, who belong to the same industry as the example above:
The medical industry exists to solve the problem of a patient. While the endpoint is between a caregiver and a care receiver, the entire value chain consists of insurers, equipment companies, contract R&D companies, pharma, hospitals, physician groups, etc. If you are part of this industry or have studied it, you might already know who captures the majority of the profits here. Pharma companies and insurers have always been much better investments than hospitals or physician groups.
Similarly, the restaurant industry in the United States is a large and fragmented industry. We like to dine out frequently to whet our appetite for variety and build social connections. But the restaurant business is highly competitive with no barriers to entry, high human capital turnover, and high failure rates. Despite the competition, Franchisors are highly predictable and profitable. The Franchisor model combines the best of both worlds: the entrepreneurial spirit of the franchisee with disciplined, systematic thinking of large corporations (product development and marketing). Therefore, long term financial results of franchisors are very attractive in a poor industry.
The automotive business is no different. Despite providing a real utility to drivers and passengers - imagine a world without cars - the automotive manufacturing business is highly competitive and lacks differentiation. And over many decades, its proven to be a bad business. But within the auto value chain, auto part retailers are very profitable. Their competitive advantage is a distribution system that creates a high availability of parts for customers. And the results speak for themselves in the form of high margins and return on capital.
Next time, you think a certain product or service would make a good investment, stop and think twice. Ask yourself - What does the industry value chain look like and will this product or service despite its merits, capture part of the value for itself that it creates for customers?
This material does not constitute an offer or solicitation to purchase an interest in Latticework Partners, LP (the "Fund"). Such an offer will only be made by means of a confidential offering memorandum and only in those jurisdictions where permitted by law. An investment in the Fund is speculative and is subject to a risk of loss, including a risk of loss of principal. There is no secondary market for interests in the Fund and none is expected to develop. No assurance can be given that the Fund will achieve its objective or that an investor will receive a return of all or part of its investment.
This material contains certain forward-looking statements and projections regarding the future performance and asset allocation of the Fund. These projections are included for illustrative purposes only, are inherently speculative as they relate to future events, and may not be realized as described. These forward-looking statements will not be updated in future.
I am an investor and these are my personal thoughts on investing, behavioral finance, markets, and sports viewed through the prism of a Latticework