May 22, 2008|
Analyzing companies the Sun Tzu way (Part I)
About Sun Tzu
Six hundred years before Christ, there was an era when seven states of China fought for their survival and control over each other. It was during this time an Army General known as Sun Tzu rose from the state of Ch'I in China. He had extraordinary ability to win battles and this gained him name, fame and power. Sun Tzu had gained from his years of battles and recognised the importance of strategy and handed down his wisdom in a book - The Art of War. This is one of the oldest books on military strategy in the world. This book had a huge influence on Eastern and Western military thinking, business tactics, and beyond.
Today, Sun Tzu's appeal has extended beyond the military realm to the world of business. Because business by definition deals with competition and Sun Tzu's principles are ideally suited to competitive business situations.
How you can use the ‘Art of War’ in investing?
In the present era, business is like warfare - it is a contest of wills, it is dynamic, based on both morale and machines, and deals with the effective and efficient use of scarce resources. As an investor, you can analyse a potential investment target (stock of a company) the Sun Tzu way and see whether the company is competent enough to emerge as winner and subsequently give you multiple fold returns over the next few years. Or you can find out whether it has the traits of a loser, and an investment in the same can possibly wither away and subsequently wipe out your hard earned money.
According to the Art of War, the most crucial factors in winning a war is the assessment of the ‘terrain’ and ‘weather’. Similarly, it is critical for an investor to assess the industry and business outlook so as to align his strategy towards getting the most out of his investments.
There are two important elements mentioned in the Art of War to understand the industry and market condition i.e., the terrain and the ground. The terrain configuration is a fixed factor once the war begins, while the ground is the battlefield ground the general chooses to pick in waging his war. In business parlance, ‘terrain’ is identical to the type of industry that a company is engaged in and ‘ground’ is the changing market conditions. The terrain or industry is a fixed situation, whereas the ground or market situation is more dynamic. As explained in the book, there are six types of terrains and nine kinds of ground situations. These are enlisted and explained as hereunder.
Understanding an industry as a reflection of ‘terrain’
Accessible terrain (terrain which can be freely traversed): It is analogous to the industry where there are low entry and exit barriers, and where capital and technology are readily available without major obstacles. Examples are consumer products, retail industry, food service and personal services industries. To win in this type of a terrain, the company has to be ahead of its rivals and need to occupy the sunny spots or top position, and carefully guard its line of supplies or its logistics system. As an investor, if you are looking for investing in such an industry which has low exit and entry barrier, then you should invest in a company, which is a leader in its respective industry and has sound logistics and supply channels.
Entangling terrain (wetlands such as marsh and swamps): This is analogous to an industry where it is easy to enter but difficult to get out - industries with such entangling characteristics are businesses requiring high capital investment such as exploration, mining, construction and large manufacturing units. The key to survival in this terrain is preparation, if entered unprepared then the company will get trapped. Only those companies can survive this terrain that have tight financial management, and corporate culture that manages employer-employee relations well. You as an investor should invest in those companies that have entered this industry with a solid research backing and preparedness and that are equipped with tools to reduce the uncertainty and risk inherent in the industry.
Temporising terrain (like the peak of hills, or the river behind a forest): This is kind of terrain where it is difficult to enter, and once entered also difficult to exit. This type of industry reflects business situations where the competitive advantage is very narrow and there is not much advantage in taking the initiative. The pharmaceutical business possesses temporising characteristics. Investor should take care in selecting companies and bet on companies that are cautious, as this is the best policy in this kind of industry. In a temporising terrain, the threat outweighs the potential profit (like the legal suits that pharma companies enter, if lost can have big impact on their profits). In such an environment, it is better to invest in a company that is cautious and capable to retreat and lets another organisation take the lead if needed.
Narrow passes (terrain flanked by rivers at both sides, or situated at the top of a mountain or cliff): Industries analogous to this terrain are the ones that have limited client base, such as the luxury products business. To survive in this industry, companies need great concentration and patience. In this terrain, winning means occupying more customer mind share. If a competitor has obtained mind share leadership in a certain position or a certain product category, it is difficult to compete head on with it. As an investor, you should invest in company that has ability to position itself uniquely in its industry.
Precipitous height (high slippery slopes leading to the peak of the mountain): This is reflection of an industry in which players are standing at uneven ground. The industry is very much capital intensive in nature. Here, high levels of capital and technology commitments are normally associated with higher position and better competitive advantages. Airline industry is one such example. In this kind of an industry, players have to look out for niche segments (like low cost airlines) rather than competing against the dominant ones. With respect to such kind of industries, an investor should invest in a company that has carved a niche in a bigger market and caters to the needs of a particular segment. These companies are those that have identified their core competencies and are focusing on them with utmost perseverance.
Expansive terrain (position at a great distance from the rival): This is analogous to a situation where due to structural changes in the industry, a company drifts apart from its key competitors to an entirely new set of competitors. For example, the advent of Internet and e-commerce has suddenly brought retailing portals as a more potent competitor to retail companies than their brick and motor peers. In such industries, investors should invest in companies who are able to spot their distant competitors and are able to combat them as efficiently as their immediate competitors.
This was an explanation of what you, as an investor, need to look into an industry before selecting investment targets (companies) from the same. The second and final article in this series will discuss about the ground situations (market conditions) that companies operate in and how should you go about studying them.
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