Peter Lynch, the legendary investor, once quipped that it’s best to invest in businesses that any idiot could run, because sooner or later one will. This begs the question of what drives the economic returns of businesses: is it the competitive forces of that industry or the skill of management? It’s likely a combination of both.
The following graph looks at the distribution of value creation for a range of industries. The blue bars are measuring the spread between the cash flow return on investment (CFROI) and the cost of capital for 68 global industries as defined by MSCI’s GICS system. The data was taken from a sample of 5,500 public companies. The smaller graphs focus on the value creation (or value destruction) for companies within a specific industry.
Source: Credit Suisse HOLT
What we can observe is that on average some industries create business value, and others destroy business value. However, we can see that within any given industry there are firms creating value, and others destroying value. What this means is that even the industries that on average create the most business value contains firms that actually destroy value.
In a paper discussing “business moats” and what drives the returns and value generation of businesses, Michael Mauboussin hones in on the airline industry. Below is an industry map that details the various participants in the airline industry.
Source: Credit Suisse
Mauboussin uses the concept of a “profit pool” to essentially quantify where in the airline value chain the economics accrue, looking specifically at how the value creation within an industry is distributed. In other words, which participants are reaping the benefits of the secular tailwinds experienced by the airline industry such as 4-5% annual global air traffic passenger demand growth? What is clear is that the benefits of strong passenger demand growth are not being spread equally across participants in the airline value chain; in fact, it’s quite the opposite.
The following profit pool chart for the airline industry maps economic profitability on the y-axis (i.e., CFROI less the discount rate), and x-axis is the share of industry gross investment for each industry sub-group. The size of the rectangles for each group represents the product of invested capital and economic return, or the total value added for the sector. While sectors such as CRS, travel agents and freight forwarders generated healthy positive economic value, they invested a relatively small amount of capital, and this positive value creation was insufficient to offset the significant value destruction caused by airlines and airports. The International Air Transport Association estimated that over the 2002-09 business cycle, the airline industry destroyed an average of $19 billion of shareholder capital per annum.
Source: Based on International Air Transport Association, “Vision 2050”, February 12, 2011; via Credit Suisse
N.B.: Returns data is from 2002-2009, and investment data is as of 2009; CRS = computer reservations systems; ANSP = air navigation service provider.
There are certain industries, and the airline industry fits squarely in this category, where the economics are so challenging that there is little a good management team can do to generate positive economic value. To quote Warren Buffett: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact”. At Montaka we seek to find businesses that are both cheap, and able to reap an outsized share of the industry economics. It is these investments that we believe are likely to have a greater likelihood of performing well for our investors over time.