Did it occur to you some companies in an industry continue to make money while others barely survive. The classic case is that of airline industry where large airlines are accumulating huge losses whereas airline component manufacturers are earning above average returns on capital for last 4 decades

Can we find great investments in lousy industries or industry sub segments?

To answer above one has to construct an Industry map and do a profit pool analysis, let’s take help of Michael J. Mauboussin & Dan Callahan to understand these terms

From their ground-breaking paper on Measuring the Moat

The goal of an industry map is to understand the current and potential interactions that ultimately shape the sustainable value creation prospects for the whole industry as well as for the individual companies within the industry

A profit pool shows how an industry’s value creation is distributed at a particular point in time. The horizontal axis is the percentage of the industry, typically measured as invested capital or sales, and the vertical axis is a measure of economic profitability

Like always we will learn to create them by using an Indian example – In this post we would try to create an industry map for Indian Automobile Industry and a profit pool analysis of Auto Ancillary industry

The Indian automobile industry is one of the largest in the world. It forms an important part of the country’s manufacturing sector, accounting for a large percent of the total manufacturing GDP. The auto components industry has been a high-growth industry in the last decade with multiple players operating across various segments. In recent years due to consumer boom a number of global automobile brands have opened their shops in India

Here is our simple to understand Automobile industry map, while I agree that it is not comprehensive to nth degree of detail, however it does capture major constituents of it

Left to right is how you reach from source to market and automotive fuels being a post purchase constituent

From the above segments our focus for this post would be Auto Ancillary sub industry, which in itself is a huge sector with annual sales of INR 172682 Crores (~USD 30 billion dollars) This sector in India is a highly fragmented sector with large number of small players,across many sub segments, the component making companies tend to be exploited by the automobile OEMs thereby making them vulnerable to pricing pressures while insisting for just-in-time deliveries

Constructing a profit pool of Indian Auto Ancillary industry to see how an industry’s value creation is distributed at a particular point in time

Source : edelweiss.in

First as expected this industry has many mini segments within itself. Tyres have largest sales share accounting for almost 28% of USD 30 billion sales pie followed by Electrical components with a 20% share, however Batteries (24%) and Shock absorbers (21%) have best return on capital employed

On average the industry earns 13% ROCE which corroborates the fact that OEMs are able to pinch auto component manufacturer’s economic returns

Another important insight for me was how  sub segments earning better margins were giving sub-par economic returns

From above take example of Engine parts or Brakes both of them of have good EBIT margins but had below par economic returns (ROCE)

Next we constructed profit pools of the main companies within sub segments to gain few more insights (on right for each image)

 

 

 

With all said and done, how can someone utilise this information to become a better investor ?

I have two fold answers to that

For first I would go to M/s Michael J. Mauboussin & Dan Callahan

Average profitability doesn’t reveal how value has migrated over time. Profit pools are particularly effective because they allow you to trace the increases or decreases in the components of the value-added pie. One effective approach is to construct a profit pool for today, five years ago, and ten years ago and then compare the results over time.

Once you can get a template ready like above you can go in past and understand how few sub segments have created sustained value over years. However most important would be to build this template every year from now on ,that way you are going catch value migration with in an industry

How to spot value migration

Hint (but not limited to)

• You will see expanding ROCE’
• Better cash conversion cycles
• Increasing asset turnover
• Reduction of debt with FCF

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The second answer is,many a times in a crowded industry segments like one above, small firms generating good economic returns are missed by large institutions, This is where you can generate super normal profits by getting in first and then selling to the institutions once they also spot that small firm

Hope you like this post and would start creating industry maps and profit pools on industries you like

Happy Investing