Investment Analysis
In industries without structural competitive advantage, the lack of barriers of entry will entice new entrants to compete until returns are reduced to the cost of capital. In such competitive industries, strategy is moot: only efficient operations matter in attempting to earn the cost of capital.
In industries with structural competitive advantage, the evidence demonstrating the presence of barriers of entry is:
- stable market share controlled by a few dominant players; with
- stable lucrative relative margins and returns on invested capital well above their cost of capital.
The sources of competitive advantage are local by definition:
- scale: fixed cost and network effects;
- demand-side customer captivity: habit and search and switching complexity;
- supply-side cost: technology and learning for a proprietary and improving product; and
- regulation: raising fixed costs as barriers of entry.
Investment valuation can be grounded in the analysis of sustainable competitive advantage:
- asset value: the lowest reproduction cost of resources employed;
- earning power value: the value of current earnings extended forever; and
- growth value: the value of current earnings growing with industry expansion.
The asset value can be estimated from the firm's working capital, fixed assets and product development costs. The current earning power of a firm can be broken down into the expected return of the asset value at the cost of capital augmented by franchise earnings derived from structural competitive advantage. The sustainability of franchise earnings can be assessed by the strength of the competitive advantage. For industries without competitive advantage, growth would not create value since sustainable returns above the cost of capital cannot be achieved. For industries with competitive advantage, the presence of barriers of entry and the prisoners dilemma among the dominant players implies stable market share which cannot be profitably disturbed. In either case, the only sustainable growth should be assumed to be the expansion of the entire industry.
The Canadian Real Estate Industry
A typical Vancouver development project's value chain looks like:
Real estate development is a largely transparent commodity market with no barriers of entry. Real estate developers need to bear the risk of cost and schedule overruns, worker and supply shortages along with bureaucratic delays, municipal fees and erratic regulation. The gross annual return of 11% reflects the cost of capital for such a risky business. Leverage can boost the return on equity to 25%, reflecting the insolvency risk of time-based financing in the face of heightened cost and schedule uncertainty. While lacking the vanity appeal of development, two other parts of the value chain are more promising:
- construction: potential barriers of entry for local teams; insulated from delays and shortages which plague the developer; and
- financing: secured lending against equity cushions with high interest rates for presumably short terms; immune from delays; with possible scale in loan servicing.
The vast industry spans development, construction, marketing, property ownership / management and mortgage ownership / servicing across numerous geographic and segment niches.
Of interest are:
- Melcor seems to have barriers of entry in locally-focused land (not housing) development in Alberta;
- but its return on capital is dragged down by it's property ownership segment;
- Bridgemarq as a brokerage franchise business seems to have high returns, suggesting some barriers of entry; and
- First National seems to have network effects amongst mortgage brokers and scale in mortgage servicing.