Supply – How to find quality businesses

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#1
Source: https://musingzebra.com/supply/

What differentiates a good business that earns a long-term above-average return from a mediocre business that, at best, only earns a return close to its cost of capital? A good business can control its supply while a mediocre business can’t. 


Take Ferrari. Ferrari has a 24% operating margin with above-average return on capital, higher than most car manufacturers like Porsche, McLaren, and Lamborghini. Economics 101 teaches you supply follows demand. If there is a high demand for Ferrari cars, then the industry will increase supply to fulfill those demands. Eventually, Ferrari’s return on capital and operating margin should fall in line with other manufacturers. But you know this won’t happen. Only Ferrari can produce a Ferrari. Other car manufacturers can’t do it no matter how much capital they have. If you want the latest Ferrari model, you have to get it from Ferrari. And chances are you won’t get it. 

Ferrari controls the number of cars they produce each year to ensure that demand always exceeds supply. It is a deliberate strategy. Ferrari stated that “We pursue a low volume production strategy in order to maintain a reputation of exclusivity and scarcity among purchasers of our cars and deliberately monitor and maintain our production volumes and delivery wait-times to promote this reputation.” You can pursue scarcity only if you have control over supply.
 
To extend this further, Ferrari can control supply because they have a differentiated product. The exhilarating driving pleasure coming from the V12 engine sound, the prancing horse logo, and the design are experiences that cannot be replicated by others. And a business that can control its supply possess pricing power to raise selling prices over time due to demand inelasticity. 

There was a story where Tom Russo, a partner of Gardner Russo & Gardner, was on a flight and his colleague ordered a Jack Daniel’s, “the steward informed him that they only had Jim Beam, another brand of whiskey. His colleague replies: “No thanks, I would rather have water.” Russo argued that if the steward came back and said “Yes, you can have Jack for a dollar more than Jim Beam”, his colleague would not have minded.”

Warren Buffett once made a speech on the power of differentiation, “if you walk into a drugstore, and you say ‘I’d like a Hershey bar’ and the man says ‘I don’t have any Hershey bars, but I’ve got this unmarked chocolate bar, and it’s a nickel cheaper than a Hershey bar’ you just go across the street and buy a Hershey bar.”

Through supply control, these businesses create a barrier that prevents competitors from copying them. But most businesses don’t possess the characteristics found in Ferrari, Jack Daniels, or Hershey. In Security AnalysisBenjamin Graham and David Dodd wrote:

A business which sells at a premium does so because it earns a large return upon its capital; this large return attracts competition; and generally speaking, it is not likely to continue indefinitely. Conversely in the case of a business selling at a large discount because of abnormally low earnings. The absence of new competition, the withdrawal of old competition from the field, and other natural economic forces, should tend eventually to improve the situation and restore a normal rate of profit on the investment.

The wide-ranging return of most businesses tends to converge towards the normal rate of profit over time with no excess return (or economic profit) because profit is shared equally by all the players. This is common for businesses selling undifferentiated and commoditized products or services. For example, if you’re a steel manufacturer and you wanted to buy iron ore, you don’t specify whether you want iron ore produced by BHP Billiton or ArcelorMittal. If a miner asked for a higher-than-market selling price, you just get them from the cheaper one next door. 

In saying that, there are some price-takers selling commoditized products who have the ability to earn an above-average return. These businesses rely on cost advantage instead of differentiation to control their supply. In Strategic Logic, Carlos Jarillo explains the reason why there are so few oil companies in the world despite them earning a generous margin selling petrol which is a commodity is that “the amount of money necessary to carry out these activities is enormous, as is the scale on which these activities must be carried out to obtain costs comparable to those of the current competitors.”

This is why companies like Costco have earned an excess return of 15% over the past 30 years despite selling the same products as other retailers like Walmart (with the exception of their own private label Kirkland). Costco relies on keeping its business as efficient as possible to reduce gross margin and pass all the savings to their members. Therefore, creating a flywheel effect where customers’ loyalty increases scale economies that leads to lower cost and selling price which begets more loyalty. Other retailers who have a higher cost structure have to sell at a loss just to match Costco’s gross margin. GEICO uses the same low-cost business model to sell car insurance as well. 

Or consider Hartalega, one of the largest glove manufacturers. No hospitals are going to pay an extra penny for gloves produced by Hartalega over other manufacturers. Despite this, Hartalega still managed to achieve the lowest production cost per glove through innovation and efficiency, allowing them to earn a higher margin than its competitors. 

When you want to find out if a business can earn an above-average return (or excess return) over a long-time, the first thing to do is to find out if they have a differentiated product. And the litmus test for that is “can they raise their prices over time?” If a business doesn’t have a differentiated product, then the next question is “are they the lowest cost producer?” A business only has the ability to build a moat and earn an above-average return by controlling their supply, either in the form of differentiation, that is, the impossibility of others to supply the demanded products (i.e Coca-Cola, American Express, Apple), or through cost advantage, the difficulty of doing so at a cost that would make the effort worthwhile (i.e GEICO, Costco, Hartalega).

Note

Buffett, W. (1991). Three Lectures by Warren Buffett to Notre Dame Faculty, MBA Students and Undergraduate Students. Tilson Funds. Retrieved from https://www.tilsonfunds.com/BuffettNotreDame.pdf

Fernand, L. (2018, March 6). Tom Russo: Good investors must have the “capacity to suffer”. Morningstar. Retrieved from https://www.morningstar.com.au/learn/art...fer/165669

Graham, B. & Dodd, D. (2008). Security Analysis: McGraw-Hill Education

Jarillo, J. (2003). Strategic Logic: Palgrave MacMillan
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#2
Rainbow 
Thanks R.

I had read a few of your articles and I really appreciate your effort in sharing your thought and your thought process.
Usually, I will go thru your articles with my core and see how did they fair.

Most of the time, they gel like what you says (with a bit twist).

Today, I thought of using Micro-Mechanics as an example of how I see it fit this article.

Cost Differentiator
#1 Ferrari = Only a Ferrari can produce a Ferrari
X nope. Micro-Mechanics make consumable products which can be easily produce by mom-and-pop shops.  As far as I'm aware, Micro-Mechanics does not have Intellectual Properties, Patents or branded trademarks.

#2 Jack Daniel/Hershey = Differentiator 
X nope. Micro-Mechanics uses raw materials such as aluminium and rubber to make commodity products like rubber vacuum cups - small vacuum cups use for automated machines to pick up IC chip/device (prolly 5mmx5mm size) and pace to another stations.  These rubber vacuum cups are very low cost as they mass manufacture 1 same design then use machining to cut to size.  Off the shelf cups easily sold for S$9 upwards.  Customized ones $30 upwards.  Again, unlikely there is any differentiator that any mom-and-pop shops can't produce.

Cost Advantage
#3 Costco/GEICO = Flywheel effect
X nope.  Not Micro-Mechanics.  These company relies on keeping its business as efficient as possible to reduce gross margin and pass all the savings to their members.  Therefore, creating a flywheel effect where customers' loyalty increase scale economies that leads to lower cost and selling price which begets more loyalty.  Other retailers who have a higher cost structure have to sell at a loss just to match their gross margin aka low-cost business model.
Micro-Mechanics high gross margin target of >50% does not sounds like it is aiming for low-cost business model to me.

#4 Hertalega = Largest glove manufacturer
X nope. Not Micro-Mechanics.  No hospitals are going to pay an extra penny for gloves produced by them over other manufacturers. 
Micro-Mechanics customers is willing to pay a premium over other manufacturers (see #1 and #2).  What ever goods that Micro-Mechanics can produce, those mom-and-pop shops can produce them too.

In summary, I felt that Micro-Mechanics uses 
- commonly available raw materials to make 
- commodity products which could be 
- easily produced by mom-and-pop shops. 

Cost differentiator? 
Nope. It does not have the Ferrari nor Jack Daniel/Hershey differentiator but strangely, it has a pool of loyal customers, willing to pay a premium.
Cost advantage?
Nope. It does not necessarily using low-cost business model. I mean, it's customer will not switch to another manufacturer who offer the same rubber vacuum cup for a penny cheaper.

Thanks for reading, ya.

Stay home and stay healthy, everyone.
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#3
The first name that immediately comes to my mind midway thru the article: Rolex.
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#4
(01-09-2020, 11:41 PM)¯|_(ツ)_/¯ Wrote: Thanks R.

I had read a few of your articles and I really appreciate your effort in sharing your thought and your thought process.
Usually, I will go thru your articles with my core and see how did they fair.

Most of the time, they gel like what you says (with a bit twist).

Today, I thought of using Micro-Mechanics as an example of how I see it fit this article.

...

If what you state is truly the case -- that MM is not the lowest cost producer, does not reduce cost to pass savings to customers, and its products are undifferentiated from competitors -- then maybe the reason why MM has been doing well is only because the market for its products is still growing.

But no market grows (without interruption) forever. And a high-growth market -- especially where the product is essentially undifferentiated -- will eventually get crowded with new players. 

If so, how long more will it be before MM will face pressure on its margins?
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#5
Rolex is definitely good.
[Image: 960x0.jpg]

Actually, MM is a really strange company.
It has a lot of business strategies that defied common-sense.

Back to the topics of it's industries and markets.
A) Cyclical vs long term growth trends
MM falls under the category of SemiCon.
This is a notorious industry filled with lots of boom and burst due to the nature of in-elasticity.
When the demand for semicon (Wafer, CPU, RAM, etc) increased, the price will increase and margin will improved.
Competitors come in but new factories will takes at least months if not years to burn in.
Even same factory will needs a few months to deploy another production line.

As the price continued to soar and margin rocketed, the new supplies finally caught up and then the burst cycle began.

The in-elasticity of long lead time for new factories and production line to burn-in, resulted a highly cyclical industry is rather obvious and notorious.

However, there is a silver-lining in this space.
With the increasingly ubiquitous electronics gadgets inserted into our life, our work life and our entertainment/pleasure space secured the long term trends of a growing Semicon industry.

All the hottest buzzwords that we heard supports this long term trends: Cloud, AI/ML, 5G, Smart Nation, cyber, Block Chain, IoT ...

So, MM operates in an industry which is highly cyclical, yet with a sustainable long term growth.

B) Extremely Capital intensive
Again, Semicon industry is notorious for being capitial intensive aka need a lot of $$$ to startup/setup the business.
Two things that we already know:
1) the factories and production line needs to be very high spec eg clean room, automation/robotics, QC quality control process
2) a lots of product innovation eg. every year, iphone will launch a few new models without fail. With the frequent product obsolescence, new production line will need to be setup to support these new business requirements

MM operates in this industry and will not be shielded from these constant changes.
It will need to spend $$$ in R&D, buy new equipment to make/drill sub-nano meter holes and these cost a lot of $$$.
However, after doing all these (new factories, production line, equipment buy), we realised that situation might not be so bad for MM.
Despite all these capital intensive investment, MM is still able to edge out a decent net profits, excellent cash flow without any debt.

In another word, either MM do not need a lot of capital to fund for it's future grow (aka it's actually not capital intensive), or it's management is very prudent in spending it's $$$, or both.

C) My Theory
MM is actually not operating in the Semicon industry but rather it is supporting the Semicon industry.

We learned from the Oil & Gas industry (which is notorious for being cyclical), that when the boom happened, the oil major revenue and profit raise quickly.
However, if we look at the O&G support company (eg. our favorite PIL), their results (in term of %) will be even more impressive during these boom period.
The simple answer is when the demand surged, O&G companies will want to do things fast fast with good quality.  They do not mind paying a little bit extra to get the fast and good services from their suppliers (eg. PIL).
This "carelessness" caused the better margin for O&G support companies (eg. PIL).

With this, its clear that MM plays a supporting role to the semicon industry and hence does not inherit all the notorious ill effects of semicon industry. eg. MM is less cyclical, subject to lesser product obsolescence and require less capital to run.

D) High grow?
I doubt so. Sustainable long term growth is more appropriate.

Once we are clear that MM is not a semicon product company but rather it makes products that support semicon company, then we can start to appreciate exactly what MM produce and how it support it's customers ever changing requirements.

It has 2 products:
1. Tools
2. Custom Parts

Tools (eg. rubber vacuum cup) which fixed on a robotic arm to pick up a chips from wafer(right hand side of video) and place it into a holder. 



MM tools is just a tiny rubber tip fixed to the robot picker arm.  Of course, after repeated usage, the rubber tip (supply by MM) will wound off and need to change with a new part.
That's why people keep mentioning that Micro-Mechanics made consumable product.
These tiny rubber tip has certain specification in term of usage (cycle time), eg. every 10,000 pickup then must be replaced to maintain it's performance standard.
So long as the production line is running, MM tools will be needed.

It's also worth taking note that MM tools is used at the end/later stage of a semicon process.  
The chips at this point is very sensitive to environment and static electricity.
Customer do not mind paying a little bit extra to get a quality product (rubber vacuum tip) from a reliable supplier (eg. MM).


2) Parts
Parts business is distinctively different to the tools business.
Parts is like, for example spare parts for the robot.
Customer will provide the specifications and MM will use raw materials like aluminum to craft out the parts.
Typically, high precision is needed otherwise customer won't need to buy from MM aka buy from mom-and-pop shops.
Sometime, you will also hear people saying MM is a precision engineering manufacturer because these custom parts that MM produced is expected to meet a stringent dimensions otherwise it will shorten/damage the expensive equipment used in the semicon industry.
(click to watch Micro Mechanics automation)

Thank you for reading.

Stay home and stay safe, everyone.
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#6
Just want to say that it's usually idea AND execution. It takes years if not decades to be a premium product that the quality and service is worth paying for. And sometimes the vanity.

Apple has always been a premium product yet it flopped in the 90s due to execution. And now it is the largest market cap company going back to using their own proprietory Processors. The idea remains the same but the environment, capacity and execution is very different.

Differentiation can also be value provided vs cost. In corporate environment especially, it's not the cheapest will get the job. In fact if you are too cheap it is suspicious. It is more whether you can solve the problem so that I as an employee don't have to solve it, packaged as "solution provider". Basically an employee wants minimal problems not minimum cost; not the same mindset as management. So that's where management has to fill the gap of execution, process and cost containment.

As societies progress even consumers will look for such value rather than in developing countries it is usually about cost. People will seek repair or say knit in the latter societies. The opportunity cost to do these in developed societies is just too high, which has little direct correlation with differentiation or cost.
Before you speak, listen. Before you write, think. Before you spend, earn. Before you invest, investigate. Before you criticize, wait. Before you pray, forgive. Before you quit, try. Before you retire, save. Before you die, give. –William A. Ward

Think Asset-Business-Structure (ABS)
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#7
Rainbow 
Thanks S.

You reminded me of a story.

ChiaWeeBoon walked out of his office and passed by a small meeting room.
It's well passed office hour and yet he found a sales team working hard on finalizing a proposal for a client.

Wearing a smile on his face, CWB asked what's the Unique Selling Proposition (USP)?
He reminded the team that only when there is a differentiation then there is a chance of winning.
Not saying that cost is not important.
Cost is important but a USP will gives the client a good reason to choose the proposed solution.

With this in mind, we understand a few things about MM:
1. It's strategy does not compete on lowest cost but low cost is definitely one of its value proposition.
2. It does not have a clear product differentiation equivalent of Ferrari, Rolex etc, and also it does not have any visible IP (patent, trademark, copyrights and trade secret).
3. It has a GPM KPI of >50%
4. It does not have any competitor
5. It supports an industry which is notoriously cyclical but sustainable with long term demand/growth potential

Last but not least, it actually has 2 product lines which is rather distinctively different and it has 5 factories with the largest one in SuZhou and the up-and-coming one in USA.

We also know that MM management is very prudent and conservative in term of handling of it's people, financial matters and strategies.

Last but not least, it actually has 2 distinctively different product lines  produced by 5 factories serving common customer/install-base.  The largest revenue is from SuZhou and up-and-coming one is from Silicon Valley (where else, right?).
s
To understand MM business/competitors/customers, we have to look at it's tools and parts product separately.

Traditionally, tools had been the most profitable business and it will continue to be the most profitable business.  The main reason why tools business has a higher margin and also more sustainable was actually bring to the attention by Paul Chew last year.  Paul Chew reported that the consumable nature of MM products does not depend so much on the price of the semiconductor/electronics.  What Paul means is, for example, RAM price will go up and it does not means MM product price will go up, similarly, when RAM price go down, MM product price might not go down.  
In another word, Paul is implying that MM product price is more or less shielded from the price volatility that observed in the notorious semiconductor industry. 
He proposed that Taiwan back end semiconductor volumes as a barometer to measure MM performance.

Make sense to me.
MM is not a lowest cost operator aka it is not a cost differentiator.
However, it's definitely wanted to be a low cost provider.
Suppose, it make a GP of $5/unit when a customer order 10 units of rubber vacuum cup.
Due to efficiency, suppose MM could make a GP of $6/unit with bulk purchase of 100 pieces.  
I would expect MM to return 50cents to customer who brought 100 pieces and kept the rest of 50cents, aka final GP of $5.5/unit.

So, I agree with Paul that MM results will depends more on the volume instead of the fluctuation of semicon/electronics prices.
However, we do have to note that there is a indirect relationship thou.
With the higher semicon/electronic prices, we would expect MM customers to start up new production lines and hence expect higher volume/demand for MM's rubber vacuum cup.
However, the reverse might not be true immediately.
When the semicon/electronic price drop, MM's customers might not be able to slow down or decom their production lines and hence continue to buy from MM until they are able to slow down/decom their production lines.

Again, reverse cycle is true too.
When the semicon/electronic price is high, MM's customers will take time to ramp up their new capabilities and MM could only benefit from the higher volume/sales when these new production lines is burn-in.

In summary, MM performance is less volatile than Semicon industry.
A semiconductor volumes indicator would make sense to predict MM's results.

Thanks for reading.

Stay safe and stay healthy, everyone.
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