Saturday, April 25, 2015

Controlling the value chain

“You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well.”

Warren E. Buffett

Ability of a company to control the value chain is a testament to the management of the company and is exhibited by high profit margins and high returns on capital.  There are 3 components to a firm’s economics:

  • Customer side
  • Supplier Side
  • Productivity

On the supplier side empirically I have found that companies who don’t maintain high creditor balances (under 15 days) are typically able to control the supplier side economics better. Tight control systems with strong internal audit procedures are required to control supplier side economics. Even a company like Reebok in India found that their control systems were not good enough to control pilferage in the supplier & stores value chain. Depending on the type of business the supplier economics matters more or less. If you are a software services provided supplier economics probably does not matter much. If you are Astral Polytecnik making CPVC pipes, having a deal with Lubrizol, your supplier side economics matter more than anything to your returns on capital.

Customer side economics is the same thought process at the willingness to pay for a brand and has been covered in detail in the article on valuation of the brand.

Productivity can be seen by the company increasing per capita pay and yet being able to reduce the employee cost as a percentage of sales. Typically a very high quality company will be hiring the best talent available in the market and running them through the best possible training program out there. Over time this massive pool of potential leaders are the people who drive growth in the future. If you study companies like Hindustan Lever or Nestle you will find that they routinely recruit the best talent from all colleges and business schools. And several of these highly talented people end up become CEOs of even other companies. This is why I recommend studying the average compensation of an employee in the company after deducting from the total the compensation of top management, directors and promoters. This gives you a sense of the quality of people in the company. And over time higher quality people are likely to do better.

This article is a continuation of the following: