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Course 201
Understanding a Business

Introduction

Investing in what you know may not be as easy as it sounds. Legendary mutual-fund manager Peter Lynch popularized the concept of investing in businesses we see around us, such as those at the local mall. If your toddlers love Toys 'R' Us TOY, if your teenagers dig Nike NKE, if your spouse does business with PeopleSoft PSFT, grab the annual report and think about buying some shares. The more hands-on experience we have with a company, the more astute we'll be as investors. That's true as far as it goes. The problem is, our kids can't tell us whether Toys 'R' Us earns a respectable return on capital. Our teenagers may be a year behind the fashion curve as they continue to lace up their Nikes. And the sales representative we deal with from PeopleSoft may not be representative of the rest of the company. What investing in what you know really means--or should mean, for serious investors--is investing in businesses the economics of which you understand. What does it mean to understand the economics of a business? The following are some of the key issues. We'll use Starbucks SBUX as an example, since it's a company many of us at Morningstar visit all too regularly.

Barriers to Entry

If you decide to go into business, you don't want a bunch of imitators slurping away your business. You want barriers to entry. Utilities, brand-name powerhouses such as Coca-Cola KO, and newspapers are the best examples of companies that enjoy nearly impregnable competitive positions. Starbucks, on the other hand, is in an industry with low barriers to entry. In trendy neighborhoods of most large cities, there's a coffee shop (or two, or three) on every block, most of them opened since the beginning of the Starbucks craze.

Price Elasticity

Sounds complicated, but price elasticity is just a ratio of how much the quantity of goods sold changes when prices change. Say a company raises prices. If the price elasticity is high, that company loses a lot of business. Fast-food restaurants and manufacturers of economy-size cars are good examples of firms with high price elasticity. If the price elasticity is low, as it is with cigarettes, a company can hike prices and not lose a lot of business. Starbucks charges a dime or quarter more than most other shops and raises prices in line with shifts in coffee prices, which suggest the company enjoys some elbow room when it comes to pricing.

Substitutes

If exact substitutes for a firm's goods are readily available--as they are in commodity businesses such as sugar, paper, and online booksellers--a company will have no pricing power. Price elasticity is high and in some cases could even approach infinity (a price hike wipes out all a company's sales). Starbucks has close substitutes, but none close enough to prevent it from getting that extra dime from many pockets. Plus, the company is having success branding its products: Lots of people specifically want Starbucks-brand coffee.

Capital Intensity

The ideal business is one that gushes revenues but requires little investment in hard assets such as factories or stores. (Think Microsoft MSFT.) The more capital you must employ in order to generate an additional dollar in sales, the less attractive the business is. (That said, capital-intensive companies such as utilities and oil companies, once they get really big, have a built-in barrier to entry. What budding entrepreneur wants to raise the billions needed to compete against Alcan Aluminum AL or ExxonMobile XOM?) Like most companies in the service sector, Starbucks is not very capital intensive. It generates more than $1 in sales for every $1 in assets.

Market Penetration

If you start a business, you want a plentiful supply of untapped customers waiting for you and your products. Philip Morris MO is selling cigarettes hand over nicotine-stained fist in the developing world. That's why it is able to grow despite a saturated U.S. market for smokes. Chewing-tobacco maker UST Inc. UST, on the other hand, focuses solely on the U.S. market and thus has no growth outlets. Once companies saturate their markets, cyclicality sets in. Sales rise when times are good. They fall when times are bad. Starbucks is nowhere near saturating its markets. There's plenty of room to expand in the United States and huge potential overseas.

Regulation

If you go into business, you want the freedom to earn as much profit as you can. The key is whether your company can raise prices when it needs to. Utilities historically have not been able to. Cable companies have to set prices with one eye on the regulators. Credit-card companies run up against usury laws in many states. Such restraints on pricing really hurt when inflation jacks up costs, because it becomes harder to pass those costs on to consumers. As for Starbucks, aside from zoning laws, there aren't any major regulations that affect the coffee-retailing business. Most of this information--the list is by no means exhaustive--simply comes from thinking about a company, determining who its competitors are, and checking its financial statements. And yes, it helps to be a customer of the company. Other bits of information--concerning regulation, for example--can be gleaned from the 10-Ks on file with the Securities and Exchange Commission (and available on the SEC Web site ). With a little detective work, it's not hard to uncover the economics of a business. And it's a bit safer than trusting your 10-year-old.

Quiz 201
There is only one correct answer to each question.

1 When a company's price elasticity is high:
a. Raising prices cause sales to go down significantly.
b. Raising prices doesn't have much of an effect on sales.
c. Prices tend to be inherently unstable.
2 Which of the following is <em>not</em> a highly capital-intensive business?
a. Consolidated Edison.
b. ExxonMobile.
c. Microsoft.
3 Which of the following is true of commodity businesses such as sugar and paper manufacturers?
a. Their price elasticity tends to be very high.
b. Their price elasticity tends to be very low.
c. They have very high barriers to entry.
4 Which of the following is one way for a company to combat the existence of close substitutes for its products?
a. Raising its prices.
b. Successfully branding its products.
c. Spending a lot of capital.
5 A company like Starbucks:
a. Is very capital intensive.
b. Faces high barriers to entry and is highly regulated.
c. Faces relatively low barriers to entry, is not very capital intensive, and has room to expand.
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