The Value Chain is a sequence of inputs that are utilised in creating a final product or service. It can also be observed from an industry value chain perspective that makes an entire sector functional. A value chain comprises several business activities and processes that a company must undertake to sell a finished good or service to the end customer.

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What is the Value Chain?

Value Chain Analysis is a process that various stakeholders, such as business management, investors, financiers, analysts, and competitors, use to identify all the activities that enable a company to sell its end product or service. By understanding each of the inputs, stakeholders can learn a great deal about a company’s underlying cost drivers and discover competitive advantages.

Whether it’s management looking to improve the flow of the value chain or seeking cost improvement, stakeholders can analyse each of the inputs and understand the company’s workflow. By understanding each of the inputs that allow a company to do what it does, we can better understand the strengths and weaknesses of that business and how it stands among its peers.

However, we will not delve into Value Chain Analysis in this post because we are looking at it from an investment perspective and not focusing on the cost drivers of an individual company. Understanding the cost makeup of all the key components that go into a business is an important aspect of in-depth analysis. Nonetheless, we are focusing on the Value Chain concept as a way to find alternative investments that may surface while we investigate or “Scuttlebutt” our way around ideas.

I find it useful to use the Value Chain concept to gain an overview of an entire industry. This helps in creating an “Industry Map” of all the crucial factors that allow that industry to function. With this map, we can identify potential investment opportunities that offer higher returns on capital and are less volatile.

Following the Value Chain and exploring different areas often uncovers unknown companies that we would have never come across otherwise.

Understanding the Profit Pool in an industry?

The process of Industry Value Chain analysis involves identifying all the key activities that enable an industry to function. Once this is done we can start following the money and determining the profitable areas of the industry, which is called the Industry Profit Pool.

The Industry Profit Pool refers to all the profits earned within an entire industry across all stages of the Value Chain. These profits are divided among all the participants that make up the industry. However, certain sectors within an industry may not be profitable, and larger, well-known companies may not necessarily make the greatest investments. Sometimes, smaller, lesser-known businesses that form one component of the entire value chain can be a better investment.

Let’s take the Airline Industry as an example. The graph below (IATA) shows the share of the industry’s gross profit. It is a well-known joke among the investment community that the airline industry, especially airline carriers, airports, lessors, and manufacturers, are poor wealth builders. However, there are a few small sectors within the airline industry that boast higher returns on invested capital and are profitable. Without these smaller sectors, the entire airline industry value chain would not function.

For instance, Central Reservation Systems is important software with challenging switching costs that the industry needs. Online travel agents with low upfront capital to start are highly profitable. Catering and food-providing services are also profitable. In contrast, an Airline carrier often has negative Return on Invested Capital (ROIC) and poor profit margins.

Investors often do not go to this extent to find investment ideas or research entire sectors. By dissecting entire industries, conducting deep research, and finding the flow of profits, you can find ideas that may be out of site from other investors.

Investing downstream of the Value Chain.

Understanding the flow of profits within an industry and following the value chain can help investors gain a greater understanding of the industry in question. It’s essential to identify companies upstream and downstream and understand the competitive landscape. By examining profit pools and the value chain, we can discover a range of companies involved in the process.

To begin, we need to know whether the company is public when investigating value chains. If we come across a public company that we want to invest in, we still need to evaluate how that company compares to all known peers, whether they are public or private. Private companies can still pose a threat. The goal is to own the best-in-class, whether public or private.

If a publicly-listed company that you discover downstream of the value chain is not the best in the industry, it may not be a wise investment. If the company struggles to capture market share and profits within its industry, it may not be a good investment opportunity overall. I’ve held off investing in a public company because a private competitor was growing, taking market share and being the better candidate.

Map the industry out and follow each Value Chain input.

When analysing an industry, it’s important to consider all the inputs, collaborators, and participants involved. This approach, known as Value Chain investing, is helpful when investing in emerging trends and thematic themes. However, investing in new entrants to an emerging theme can be risky. To mitigate such risks, it’s essential to break down the value chain and identify areas that align with the theme, but with a lower degree of risk.

To evaluate an industry effectively, it’s crucial to determine where the profits flow. Who is reaping the maximum profits in the industry? Every industry has multiple inputs, and by analysing them, you’ll discover certain areas with business models that are more advantageous than others.

Let’s take a closer look at the Real Estate Sector and the various contributors that make up the vast industry Value Chain. Some participants are more significant compounders due to their business model, competitive edge, and low capital intensity that drives their business.

• Real Estate Investment Trusts
• Property Developers
• Engineering and Architecture firms
• Design Software
• Property Management Software.
• Internal Fit-out providers (Office furniture, appliances, light fittings)
• Real Estate Agents (Sales, Leasing, Management)
• Facility Management companies.
• Service Providers (HVAC, Elevators, Cleaners, Security Companies)
• Builders and Subcontractors.
• Construction Service Providers: (Formworks, Scaffolding, Forklifts)
• Materials Companies (Cement, bricks, steel, paint)
• Manufacturers (Window makers, lock parts, tiling and timber floors)
• Insurance and Finance (Who lends money and insures buildings)

Look at each of the sectors and ROIC and profit margins within each industry sub-category. Whilst this can be exhaustive, if you quickly map out all the Value Chain players, and then look at the profit flows between them, the last part is easy once you discover the hidden gems. Which ones are publically listed?

In Summary…

It is essential to have a global perspective when researching ideas across the Value Chain. As we discussed in “Searching Around the World,” the Value Chain brings up companies across multiple exchanges. For instance, a company listed in the US could have a valuable input that is necessary for its operation. This key input could be a publicly listed company in Europe. This is particularly true when looking at unusual parts, highly profitable, and specialized MOAT companies that operate in specific niches (boring non-sexy companies).

It is crucial to aim for the best in class and not settle for the 2nd or 3rd best in an industry. Just because a company is publicly listed and the only viable candidate for investment doesn’t mean it’s a great investment opportunity if it’s not the best in its field among all the players, private or public.

The idea of Value Chain hunting in the Investment Process is not widely adopted, but it should be. The approach is beneficial in many ways, not just for unearthing investment ideas. It provides an excellent understanding of an industry, and the drivers of those businesses, and forces you to think more innovatively.

The Value Chain researching method has led me to discover some unusual foreign companies that were excellent investments. I would have never discovered them if I hadn’t broken down an industry into all the key components that made it up. All though this approach may be an unorthodox way of breaking down Value Chains, it can be very rewarding.