A question of perspective

The ability to look at a complex problem from multiple perspectives is a skill useful in many different contexts, none more so than investing. Different perspectives often yield different insights, so if you can effectively combine multiple perspectives, in principle you should be able to materially improve your decision-making. Despite this, as I mentioned in my recent post on contrarianism, there is often a tendency for people to prefer to focus on what they see to be ‘the one true way’, rather than acknowledge the legitimacy of other perspectives.

In this post I talk about a perspective that is highly relevant to investing but often relatively neglected – the ‘external’ perspective of a business.

Investors, like accountants, commonly take the ‘internal’ perspective of assessing a business via its financials. This involves examining the financial health of the business, much in the same way as a doctor might examine the health of a patient. With an internal perspective you carefully probe the cash flows going in and out of the business, make sure that capital is reinvested profitably and check that the balance sheet remains robust. If the business is sufficiently healthy (profitable), you move on to think about whether the valuation is attractive.

Contrast this with an ‘external’ perspective of a business. This way you treat the financial insides of the business as a black box. Instead of examining the business like a doctor, you approach it more like a psychologist or social worker – you try to understand how it behaves within its wider environment and how it interacts with customers and competitors. Instead of asking whether business is financially healthy, you ask whether its market has healthy prospects and whether the business has the competitive edge to be a long term winner in its market. You focus more on the strategic decisions that result in the financials rather than the financials themselves.

As a competition economist by trade, I’m in the fairly unusual position of being a lot more familiar with analysis from this external perspective than I am with company accounts. My job is to investigate the competitive effects of mergers or whether a dominant business is engaging in anticompetitive behaviour against its rivals. We generally have little interest in financials and tend to think of businesses as black boxes – that is, intelligent black boxes capable of strategic decision-making, armed with various commercial weapons and acutely aware of the ‘game’ they are playing against other competitors.

Both the internal and external perspectives are relevant for investors. You could make a reasonable case for either one of them being more important than the other depending on the specific context. I think it largely depends on your investing strategy. On average, the internal perspective is probably the more important one – good financials are probably a more significant predictor of performance when applied across all businesses on average. The bottom line is the bottom line, after all. However, if your strategy is to try to find the small minority of long term ‘super-winners’, the external perspective is probably the more important one. If you can correctly identify the potentially dominant businesses in markets with strong secular growth, then it pretty much goes without saying that their financials will be healthy (and most of the time their prospects will be undervalued by the market). This makes the internal perspective somewhat redundant. But there’s no reason to choose one perspective over another when you can look at both.

As far as I can tell, many investors, particularly professionals, often seem to focus disproportionately on the internal perspective. They recognise that the company’s competitive position and wider market environment are relevant, but consider these aspects in much less detail than the financials. The level of detail is often not much more than simply trust in the story told by management, or is sometimes entirely replaced by blind faith in the quality of the management itself. While some management ‘stories’ yield useful insights about the business’s competitive advantage and long term prospects, more commonly they do not. Separating the wheat from the chaff requires you to look a bit deeper and critically assess the business from an external perspective yourself.

Part of the reason the external perspective gets relatively less attention is simply that it’s much harder to assess than the business’s financials. The relevant information is much less readily available and the right questions to ask are less well-defined. In addition, the kind of insight you can get from this perspective can seem vague and uncertain, which can be pretty off-putting for the more numerically-minded, left-brained investor.

So what kind of information is relevant for the external perspective then? In an ideal world it would be useful to start with a much more top down approach – perhaps even by starting with the candidate market before narrowing down to the candidate investments within it. To do this I would start with the basics of who the competitors are, their market shares and how these have changed over the last few years. Unfortunately, finding even this information is generally very difficult for most investors. As proper market research is prohibitively expensive and investment analysts tend not to focus on this much, you are often reliant on information provided by the businesses themselves. Most of the time they don’t bother. And this would just be the starting point of the analysis. The next step would be to question why the market has evolved the way it has, who has a competitive advantage, why and ultimately what’s likely to happen in the future. All of these questions would require bespoke analysis with information that’s often even harder to find.

Thankfully, it seems you don’t need to do that much to be ahead of the crowd in assessing the external perspective. There are always some useful insights to be gleaned from the qualitative information available and carefully-applied intuition. Zeroing in on the small minority of companies that are more forthcoming in providing convincing evidence-backed narratives supporting why they have a competitive advantage is one option. Another is to take the top down approach I described in the previous paragraph and, rather than businesses, look for markets that have attractive qualities. I’ve identified a lot of decent investment opportunities by looking this way round.

One of the key insights from my experience as a competition economist is that some of the most important drivers of competitive advantage are not specific to the business in question, but rather to the market it is in. For example, where customers are locked in by switching costs (or sometimes just by their own habits or inertia), there can be little competitive pressure on any market player no matter what their market share. There are other market features that can have similar effects of limiting competition, such as highly differentiated products (e.g. powerful brands) or high regulatory barriers (e.g. in healthcare). Because of this, some of the most important questions I ask myself about the quality of an investment are to do with the markets it is in rather than the business itself: ‘do the markets have good long term growth prospects?’ and ‘do the markets function in a way that means competition between the businesses in them is limited?’


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