HOW WE VALUE SHARES:
A USEFUL FRAMEWORK

Back in 2019, we set out how we assess a company’s quality and growth prospects through gaining a proper understanding of its sustainable competitive advantage. We continue to use this approach when we examine companies, but we’re always looking for ways to improve and refine our process, and make it more repeatable.

We recently completed an exercise where we examined all the major SA-listed companies using the Porter’s Five Forces framework – a simple model developed by renowned economist Michael Porter and first published in Harvard Business Review in 1979. While the model, used to identify the main forces behind industry competition, is standard fare in business schools, we suspect it’s generally used more for strategy assessment than for stock selection.

DETERMINING FAIR VALUE

First, a note about valuation, which is central to our long-term investment philosophy at Sanlam Private Wealth – we seek to buy shares in companies at prices below our assessment of their true value. This means we’ll pay different valuation multiples for different businesses, depending on their individual characteristics (not to be confused with value investing, which is simply looking to buy investments at low multiples).

Vital in the process of determining our fair value for a business is understanding both its ability to deliver growth over many years, as well the risks associated with the company’s business model. Since all valuation models are limited by the appropriateness of the initial inputs, we spend considerable time ensuring these inputs are as correct as possible.

While, in our view, our sustainable competitive advantage framework is highly effective, it does have some shortcomings, particularly around determining overall industry dynamics rather than company specifics. We therefore believe that Porter’s Five Forces model serves to augment our existing approach.

THE FIVE FORCES

What are the five forces Porter refers to? In a nutshell, they are:

• Supplier power – how easy it is for a company’s suppliers to drive input prices higher. This depends on the number of potential suppliers, switching costs of moving suppliers and the uniqueness of the supplier. A company like Barloworld (which relies on Caterpillar) would see high supplier power, while AB-InBev would not be subject to material supplier power.
• Customer power – how easy it is for customers to drive a company’s selling prices down. This depends on the number of potential buyers, customer acquisition costs and customer lifetime value. A company like Tiger Brands, which sells most of its volume to the major supermarket chains, is constrained by high customer power. Conversely, a retailer like Shoprite serves many customers and thus is not subject to customer power.
• The threat of new entrants – how difficult it is for a new entrant to join the market in which a company participates. This is determined by industry barriers to entry, the uniqueness of a company’s products and whether the industry has attractive returns on capital. A company like Vodacom, which is protected by both a licence for limited spectrum and the high capital intensity of the telecoms industry, has a far lower threat of new entrants than do asset managers like Ninety One or Coronation, where new entrants are a constant reality.
• The threat of substitution – the scope for customers to move to a different product to serve their needs. This is a function of how similar the substitute products are to those of the company in question, and how easily the need could otherwise be fulfilled (think beef versus chicken). Companies with limited threat of substitution include those in the banking sector, while Tiger Brands’ Jungle Oats has multiple substitute threats from other breakfast foods and Sappi’s graphic paper for magazines is being threatened by the internet.
• Rivalry among existing competitors – this comes from both the number of competitors in the market and how capable they are. The JSE, for instance, has negligible competition, while the rivalry between banks is high – the players within the South African market tend to be of similar competence.

SURPRISING OUTCOME

We scored all the companies in our investment universe based on these five forces, and the outcome was in some cases obvious but in others, surprising. Given its near-monopoly status, the JSE scores particularly well, and Naspers (effectively Tencent) is also a superior business. Poor scorers include companies like Sappi, KAP and Tiger Brands. Insurance companies score surprisingly well, while business-to-business models like those employed by Bidvest less so – which suggests its ‘quality’ may not be as high as many investors believe.

Given their Five Forces scores, it is unsurprising that Tencent, Richemont and AB-InBev typically trade at multiples far higher than those of Sappi and KAP.

What Porter’s framework doesn’t capture is whether an industry is growing, how the dynamics are moving within a given industry and the impact of regulation. This is why we don’t use it in isolation, but as an additional tool in conjunction with our sustainable competitive advantage model. It is encouraging, however, that the output from our Five Forces work is largely in line with our scores for companies’ sustainable competitive advantages.

IDENTIFYING OPPORTUNITY

At Sanlam Private Wealth, valuation will always be at the core of the investment thesis around a particular asset or share. The various quality assessment tools referred to above all help to determine the key growth and risk inputs into our valuation-driven approach. Arriving at a Five Forces score is one of the ways in which we seek to better understand an asset and ensure we have the correct long-term perspective. Having thus identified what we think a company is worth, we can decide if its market price offers an opportunity for investors to make market-beating returns.