Industry Profit Pools can be defined as the collective profits accrued at every stage along the value chain within an industry. Profit pools differ from profit margins, which focus on individual companies. Profit pools simply indicate where the real money flows within an industry. The concept was first introduced by Orit Gadiesh and James Gilbert, both from Bain & Co.

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What is a Profit Pool?

We previously discussed industry Profit Pools in relation to Value Chains as a way to generate investment ideas. Let’s delve deeper into Industry Profit Pools why they are an excellent means of identifying exceptional companies.

Companies utilise this concept as a strategic model to concentrate their efforts on the most profitable components within their industry. Instead of focusing solely on market share, management emphasises profit share. By comprehending the industry’s entire value chain, management can spot opportunities to establish new, profitable divisions of the business.

To illustrate, I was invested in a spirits beverage company that produced vodka and gin. In this industry, the value chain was extensive. It encompassed glass bottle manufacturers, lid makers, label makers, and botanical and ingredient suppliers.

We discovered that the real profit within this industry wasn’t in producing and retailing the spirits, but in supplying ethanol. This segment was tightly controlled, highly profitable, and difficult to compete in.

By understanding the industry’s value chain, we realised that among all the components allowing the business to focus on its core business activity of distilling and selling bottles of spirits, this particular segment was, in fact, the least profitable.

While this is a simple example, the same concept and strategic thinking can be applied to companies of all sizes and can also be utilised as a framework by investors.

Why are Profit Pools important?

Understanding profit pools can be just as valuable for investors as it is for the management teams that use them. Gaining a rich, in-depth knowledge of an industry and its profit structure gives investors the ability to invest in the companies that often make up the strongest part of the industry.

To understand why profit pools are important, let’s understand why they are helpful to companies. This can provide insights to investors who should also think more businesslike.

1. Identify and Focus on Profits: Companies use profit pools to help identify profitable areas as opposed to chasing revenue growth. Improving and maximising profits should be the long-term goal of all companies.
2. Identify Opportunities: A business can use this framework to create new profit opportunities as well as improve existing ones. By understanding where the profits are concentrated, a business can make strategic moves to capture some of the pooled profits.
3. Deep Insights into Sector: If a company understands the industry profit pools, they can gain valuable insights into the competitive nature of the sector and the industry structure as a whole.
4. Guide Business Strategy: Management can use profit pools to help make better strategic decisions and moves. This can be anything from project development, cost structures, and whether they should enter into new segments or divisions.
5. Creating a Competitive Edge: If a business understands the industry profit pools, it can look to gain an edge over its peers and look for ways to outperform.

For the same reason management uses the strategy, investors can also leverage these ideas to find attractive companies within an industry. Investors can understand if a business can create sustainable profits and drive long-term growth or maybe it’s not in the right pool to begin with.

How to map Profit Pools?

To use this framework, a few important steps are required to map out the industry profit pool. Each stage will help the investor gain more knowledge of the industry structure as a whole.

🎯 Define the Pool:

The first stage is to define the pool, which is simply mapping out all the moving parts within an industry. This can be done in a variety of ways. From an industry perspective, you can understand all the different segments and divisions that make up the industry. Another way is to look at an end product or perhaps a big company playing to a theme. Then think about what goes into this company being able to do what it does.

Similar to the spirits business example, the end product or activity was the finished product. Now we can reverse engineer all the parts, processes, and stages into what was involved in getting that end product. We want to know where the start of the value chain is and where the ending is. Creating a map is quite an interesting process in itself. Think of any industry and what goes into making this industry run.

🍰 What is the size of the pool?

The second stage is to look at the size of each of the value chain inputs in comparison to the whole industry. Going back to our spirits example, the distilling and retailing of spirits was a large component of the industry. Then the glass manufacturers, label makers, bottle cap makers, distilling equipment, ingredients made up a large chunk. Then finally, the ethanol, although highly profitable, made up a much smaller portion of the overall industry.

This can be very helpful, as a lot of industries where the profit pool is concentrated are often in unknown, hidden companies that are hard to find. This process may take you on a global search and across both public and private companies. Everyone knows the end product of say, the electric vehicle industry, i.e. car brands. When you go down the rabbit hole of value chains and profit pool analysis, you will find all sorts of companies that investors often wouldn’t think about. At least I have.

🧾 What do the numbers say?

The final stage is about understanding the margins within each of the value chain segments. This will start to bring all the research together. You will find profit margins are higher where the profit pools are being pooled.

You may also find companies with a strong competitive advantage, revealed by high and consistent returns of capital. The profit pool analysis is not necessarily about finding companies with high margins. It just goes with the territory that they happen to be highly profitable.

In my own use of profit pool analysis, I have also found a high degree of companies with MOATs in some way, shape, or form. The best pool is created by companies either doing something better or different, or they play to a structurally advantageous part of the industry. Not always, but more often than not.

Think in terms of Ecosystems…

Mapping out profit pools will take you across a very broad ecosystem where everything is quite interconnected. There will be various revenue streams that you need to break apart. It will also take you across the many facets that make up an industry, from manufacturing to distribution to the software that makes the industry run. There will also be segments of the ecosystem that indirectly add value.

For example, in the spirits business, while there were the key most tangible fields that you could observe, there were many other important services that we could not function without. There was the machinery and equipment that was highly customisable and specialised equipment. There was the software of distilling that was very specialised to the industry. In addition, there was specific accounting and business management SaaS that we used. Even the ingredients and flavour profiles were supplied by highly profitable companies serving a niche industry.

By thinking along this “Integrated Framework,” investors gain a much bigger perspective of what goes into an industry. Say mining, it’s not just pulling rocks out of the ground and that’s it. There is a huge value chain of many moving parts that go into a mine being able to function, some that are far more profitable and lower risk as well.

Investing using Profit Pools.

👏 This is all great, a round of applause for Mitch, but what does it all mean for investors?

In my own case study using Profit Pool analysis, I’ve found it very helpful to draw me closer to the companies with the best characteristics, not only for compounding my capital but also staying around long enough to do so.

Investors can use Profit Pool analysis to not only understand an industry but also look for the “best in class”. I believe it is best to be used when trying to invest in a theme or play to a long-term trend. For example, if you are looking to use a top-down investing approach, such as investing in a theme like Electric Vehicles, you can combine this with a bottoms-up approach by identifying the most profitable opportunities within the segment.

When a new idea of an individual company comes to me, I don’t spend too much time understanding the profit pool as I start with the same basic fundamental analysis. If the company does not meet my initial criteria and Investment Checklist, I usually pass on it. If a company does pass, I will do some lower-level industry analysis to determine the competitive landscape but more so to see if it is playing to a growing industry. Naturally, I am drawn to profitable companies with strong margins, and that usually takes me closer to the concentrated pool of profits.

I’m trying to find the most profitable benefactors within an Industry that are playing to a long term theme.

Where I use this framework is when I believe in the structural growth of an industry, but I want the best within the segment. By understanding how profits are distributed across all the various activities, I get a very good idea of the value chain.

Although revenues are important and something I pay close attention to, profit pools highlight that the company with the biggest revenue doesn’t always convert to the highest profits.

I have found that publicly listed companies that play where the concentration of profits are, have the trifactor you want in an investment. High-profit margins, a competitive advantage that has allowed the company to capture the profits in an industry, all with a long-term runway playing to an important theme. They are not companies that are here one minute and gone the next.

Value Chain and profit pool analysis has led me to boring, unknown companies all over the world, a lot of the time in companies that offer a service that is crucial to the entire ecosystem and unlikely to be disrupted quite easily or replaced with something else.

Understanding where the money is flowing and being made is about investing in the areas with the highest profit potential. As an investment strategy, although it can be complex and based on a lot of research and data, it can be a lucrative way to find the most compelling investments.

In Summary…

Investors should understand the concept further to layer upon their own investment analysis and research. It may be helpful depending on what you are trying to invest in. If you are researching a company in an industry and you have a good grasp of the profit pools, you can align this knowledge with the company’s strategy. If management is talking about transitioning into new segments and developing strategies for untapped markets, this will be great for business.

Having the background research of industries and where profit is concentrated and the distribution of that profit among the value chain, that research stays with you. It evolves over time but stays fairly consistent year to year. So, it’s not like you are researching a changing pool every week.

I’ve used this myself, especially when a company I am researching or holding starts to talk about strategy in a new lucrative market segment that I researched to be highly profitable. I get excited. It’s helpful when sifting through ideas as well. If you have a general idea of an industry after mapping it out, you can quickly sift out bad ideas as you know the profit and competitive advantage is not there.

For example, I think the travel industry will continue to boom but I know the profits are not in running airplanes but they may be in food catering to planes or travel software for booking systems, etc…

The markets are changing rapidly but sometimes those pools within an industry are a lot stronger, so whilst the industry may be evolving, the profit will continue to flow downstream to some stable companies.