Latest / How Canadian Markets Work / Episode 79: Industry Analysis (The Quality of the Neighborhood)

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Episode 79: Industry Analysis (The Quality of the Neighborhood) · How Canadian Markets Work

0:00
Imagine running, like, a flawless company. I
0:03
mean, your management team is brilliant, your
0:05
product is exceptional, and you just execute
0:08
every operational strategy perfectly. Right,
0:10
you do everything by the book. Exactly. And despite
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all of that, you still go completely bankrupt.
0:15
Which is wild, but yeah, it happens all the time.
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Why? Because you were playing a perfect game
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in the wrong arena. Yeah. We actually touched
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on the edges of this in our last deep dive. Oh,
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right, when we looked at Meridian. Yeah, Meridian.
0:27
Yeah. They had that brutal five -year story of
0:31
declining gross margins, shrinking from 42 %
0:34
down to 35%. And when you see a number like that...
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I mean, the instinct is to immediately blame
0:40
the executives, you know? Totally. Which is completely
0:43
natural because we spend so much time analyzing
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companies in isolation. We look at their internal
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mechanics and just assume they control their
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own destiny. Right, but they don't, do they?
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No, they really don't. The ultimate reality check
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is that a brilliantly run company operating in
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a terrible industry will, well, it will very
1:01
often lose out to a mediocre company operating
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in an excellent one. Yeah, the industry is the
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arena. and the management team is just the gladiator.
1:09
Exactly. The competitive structure of an industry
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sets the absolute range of possible outcomes.
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Management simply determines where within that
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range the company actually lands. I mean it doesn't
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matter how skilled your gladiator is if the rules
1:24
of the arena require them to fight with their
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hands tied behind their back. Yeah you're just
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not going to win that fight. So for you the listener
1:29
your mission in this deep dive is to learn how
1:32
to actually map that arena. Right the landscape
1:35
they're fighting in. Exactly. We are going to
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unpack the economic weather so cyclical defensive
1:42
growth sectors. Super important concepts. Yeah
1:45
and we will explore competitive structures from
1:47
perfect competition all the way to monopolies
1:50
and how to actually spot a structural moat. The
1:53
invisible walls. Yep and finally we'll dive into
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a deeply personal frankly uncomfortable tension
1:59
for Canadian investors regarding highly concentrated
2:02
sectors like telecoms and banks. Oh, yeah, that
2:05
is a massive topic. But to map the arena, you
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really first have to understand the economic
2:11
weather blowing through it. Right. Before you
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even look at a company's product, you have to
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look at what the broader macro economy is doing
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to its customers. The foundational category here
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is the cyclical sector. Meaning they follow the
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cycle. Exactly. For these companies, their revenues
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move in lockstep with the economy. Think about
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auto manufacturing, heavy construction, discretionary
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retail, or airlines. Basically the stuff you
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buy when times are good. Yeah, when the economy
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is expanding, employment is strong, wages are
2:43
up, consumer confidence is soaring, people buy
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the big ticket items, they upgrade the SUV, they
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renovate the kitchen, they book the expensive
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vacation. But the second a recession hits, or
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honestly even just the rumor of a recession,
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those are the exact expenses that get postponed.
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Absolutely. You can just drive the old car for
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another three years, you don't remodel the kitchen.
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Revenue for a cyclical company can collapse incredibly
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quickly just because the psychological weather
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of the consumer changed. And that extreme volatility
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is just built into the business model. It's unavoidable.
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But the opposite end of that spectrum is the
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defensive sector. These are businesses where
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demand is highly inelastic. OK, let's unpack
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this. Because if cyclical companies are riding
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the waves of the economy like a surfboard going
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way up and crashing way down, then defensive
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companies are like submarines. They operate steadily
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beneath the surface, completely ignoring the
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storm above. That's a great way to think about
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it. We are talking about groceries, utilities,
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health care, consumer staples. Because if the
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economy contracts and you lose your job, you
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cancel the trip to Europe. But you don't stop
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buying groceries. Right. You don't stop taking
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your blood pressure medication. You don't turn
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off your home's electricity. Demand for those
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goods is just incredibly stubborn. Makes sense.
4:00
Because defensive sectors don't fall as far in
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an economic downturn. They offer enormous portfolio
4:05
protection. But... You know, the trade -off is
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completely symmetric. They also don't rise as
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far in a booming economy. Right. They're built
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for stability, not explosive upside. Exactly.
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And sitting apart from both cyclicals and defensives,
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you have growth sectors. The tech companies,
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usually? Yeah, mostly. These are driven by market
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adoption and technological expansion, rather
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than the broader economic cycle. A disruptive
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software company's revenue growth is about capturing
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new market share and fundamentally changing consumer
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habits. I mean, it doesn't really matter if the
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GDP only grew by 1 % last quarter if their product
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is suddenly indispensable to everyone. Exactly.
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But that doesn't mean they are immune to the
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weather, does it? Because if defensive companies
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are submarines and cyclicals or surfboards, growth
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companies feel more like hot air balloons. Oh,
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that's interesting. They can fly incredibly high,
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but they are highly sensitive to a completely
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different type of weather, which is interest
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rates. Yeah, that is spot on. And what's fascinating
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here is how the valuation mechanics actually
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pull that balloon back to Earth. Right, the discounting.
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Yeah, a true growth company's valuation is heavily
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tied to distant future cash flows. They might
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be operating at a massive loss today, but the
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promise to the market is that they will generate
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billions in free cash flow a decade from now.
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And finance relies on discounting those future
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dollars back to their value today. Exactly. So
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when interest rates rise significantly, the present
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value of those distant future dollars shrinks
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dramatically. Wow. The underlying software business
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might still be capturing market share and ignoring
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the economic cycle completely, but the share
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price just gets crushed by the interest rate
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cycle. Which actually brings up a massive complication
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for our submarine analogy. How so? Because if
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a growth stock gets crushed by interest rates,
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what happens to a supposedly safe defensive stock
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like a utility company when rates spike. I mean,
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if the submarine dives too deep, the structural
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pressure can still crack the hull, even if the
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storm on the surface didn't touch it. That is
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such a crucial point. The word defensive describes
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companies' revenue, not necessarily its share
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price. And that distinction catches a lot of
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investors off guard. Take utilities. The revenue
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is absolutely defensive. Everyone keeps the lights
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on. But running a national utility grid is incredibly
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capital intensive. Building nuclear power plants
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and laying thousands of miles of transmission
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lines requires taking on massive amounts of corporate
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debt. Oh, I see where this is going. Yeah. When
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interest rates rise, the cost of servicing that
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massive debt load goes up. Their stable defensive
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revenue suddenly has to cover much higher interest
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payments. And there's an even more direct mathematical
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mechanism at play there, right? Yeah. Because
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utilities are often treated as bond proxies.
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Yes, exactly. If I am an investor and I can suddenly
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get a guaranteed risk -free 5 % return from government
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bond, why would I accept a 4 % dividend from
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a utility company that carries actual operational
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risk? You wouldn't. The utility stock price has
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to drop until its dividend yield goes up enough
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to match or beat that government bond. The market
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mercilessly reprices them. Absolutely. A utility
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stock can fall sharply just because central banks
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moved rates, even though their actual consumer
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demand never wavered. Wow. So the economic weather
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impacts all companies in a sector in some way.
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But what determines if an industry actually allows
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a company to keep the profits it generates? Well,
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that comes down to the competitive structure,
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the arena itself. The spectrum runs from perfect
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competition on one end to monopolies and oligopolies
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on the other. OK. Let's start with perfect competition.
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perfect competition you have many sellers offering
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essentially identical products. Think of agricultural
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commodities or basic mining. No single company
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has any pricing power. Because if you raise your
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price for a bushel of wheat by a single penny,
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the buyer just walks to the farmer next door.
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Exactly. Economic gravity pulls profits away
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instantly. In a perfectly competitive market,
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if any single operator figures out a way to make
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excess profits, new competitors immediately flood
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into the arena. They increase the overall supply.
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Yep. And drive the price right back down to the
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absolute cost of capital. You are basically running
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on a treadmill just to survive. Sounds exhausting.
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It is. But on the other end of the spectrum,
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you have monopolies or oligopolies, a single
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firm or a tightly knit handful of firms just
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dominating a market. The dream scenario for a
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business. Totally. They can sustain sky -high
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returns on invested capital for decades because
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they are protected by barriers to entry. The
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invisible walls around the arena. And if we are
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looking for those walls, we aren't just talking
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about brand loyalty, are we? No, no. We are talking
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about massive structural advantages. Capital
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requirements are a classic one. You can't just
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casually decide to start a new national railroad,
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you know? Right. The physical cost of laying
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track across a continent is unthinkable. Exactly.
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Network effects are another huge one. A platform
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becomes exponentially more valuable simply because
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everyone else is already using it. Which makes
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it near impossible for a startup to pull users
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away. Yep. High switching costs also act as a
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massive barrier. If migrating a massive enterprise
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from one cloud software provider to another requires
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millions of dollars in a year of downtime, the
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incumbent provider can steadily raise prices
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without fear of losing the client. Because the
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pain of leaving is worse than the price hike.
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Exactly. These structural barriers are what prevent
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that flood of new competitors that normally ruins
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a profitable party. But if you were analyzing
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a company, how do you actually spot that barrier
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on a financial statement? I mean, if I am looking
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at a 10K, I don't see a line item for network
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effects. No, you don't. But the mathematical
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footprint of a barrier to entry is persistently
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high gross margins. Oh, interesting. If a company
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can charge a customer substantially more than
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what it costs to produce the good or service,
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and they can do that year after year without
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new competitors showing up to undercut them,
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then something structural is keeping those competitors
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out. Persistent pricing power only exists if
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there is a barrier to entry. Exactly. So what
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does this all mean for a company like Meridian?
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We saw their gross margin compressed from 42
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% down to 35 % over five years. Right. If high
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gross margins are the numerical proof of a moat,
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does five years of shrinking margins mean Meridian's
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moat is actively washing away, or is the whole
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industry sinking? Well, the only way to answer
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that is to compare Meridian's margins to its
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direct competitors over that exact same five
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-year window. Wait, so if I look at Meridian's
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peers, And their margins all dropped from 42
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% to 35 % at the exact same time. Then it's an
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industry problem. Yeah, that tells me the water
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level of the entire lake just dropped. A new
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low -cost international competitor flooded the
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arena, or maybe the cost of raw materials permanently
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shifted. Exactly. But if the competitors held
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steady at 42 % and only meridians sank to 35
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%... Then they just have a hole in their own
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boat. Yep. It's a company -specific failure versus
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an arena shift. If it's a company -specific hole
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in the boat, a new management team can theoretically
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patch it. Right. You just fire the CEO. Pretty
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much. But if the entire lake is draining because
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the industry structure changed, no CEO on Earth
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can fix it. That is a brutal reality check. It
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really is. So having established that high barriers
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to entry create highly profitable oligopolies,
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we really need to look at what happens when an
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entire country's economy is heavily weighted
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toward these fortresses. Here's where it gets
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really interesting. Because if you look at the
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Canadian market, this isn't just an abstract
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theory, you know. It is the defining characteristic
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of the entire economy. Oh, absolutely. A tiny
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handful of massive firms account for the vast
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majority of the market in several major sectors.
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Telecommunications, banking, airlines, groceries,
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railways. You can essentially name all the major
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players in those spaces on one hand. And this
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extreme concentration is driven by deep structural
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realities unique to the country. First and foremost,
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geography and demographics. The map itself is
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a moat. It really is. Canada has a relatively
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small population spread over a truly massive
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geographic area. Providing infrastructure heavy
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services across that kind of landscape, like
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a national 5G cellular network or a grocery supply
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chain that reaches remote northern communities,
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it requires immense economies of scale. Right.
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A highly fragmented market with 50 regional cell
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phone providers simply could not afford the fixed
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costs of building towers across thousands of
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miles of wilderness. Exactly. The market naturally
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gravitates toward a few massive players who have
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the scale to absorb those costs. Then you layer
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on top of that a history of strict foreign ownership
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restrictions in sectors like telecoms and banking.
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And you get these impenetrable domestic fortresses.
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Which creates a deeply uncomfortable tension
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for you, the listener. Let's look at this from
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an investment perspective first. These concentrated
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industries with massive barriers to entry produce
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incredibly strong, durable returns for shareholders.
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Because they are structurally protected from
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fierce price competition, their profit margins
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are immensely reliable. They pay out rock solid
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dividends. Exactly. They compound capital predictably
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and they are the absolute bedrock of Canadian
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retirement portfolios. They rarely fail and they
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provide incredible stability to the broader financial
13:29
system. But Bibi, that durability, that wonderful
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safety in your investment account is a direct
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mathematical consequence of the fact that customers
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have limited alternatives. The flip side of the
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coin. Yeah. The pricing power that makes them
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a great stock is the exact same pricing power
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that frustrates a consumer trying to get a better
13:51
deal on their monthly internet bill or their
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weekly groceries. Right. It creates this bizarre
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dual identity. You might be happily collecting
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dividends in your retirement account from the
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exact same telecom or grocery margins that you
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angrily complained about at the checkout counter.
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Your retirement is essentially funded by your
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own high bills. It's an inherent friction. As
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an analyst, you have to recognize that resolving
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this tension is a public policy debate about
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competition, affordability, and national stability.
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But from a pure investment analysis standpoint,
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understanding the mechanics behind this tension
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is the priority. You have to understand why the
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profits are so durable in order to accurately
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price the risk to those profits. Which brings
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us to the cracks in the wall. While these concentrated
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Canadian fortresses seem completely impenetrable,
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their greatest strength is actually their hidden
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vulnerability. And this raises an important question.
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What happens to a moat that was built by a government?
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Ooh, that's a good question. Right. If your barrier
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to entry is the physical capital cost of building
14:53
a transcontinental railroad, that barrier is
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tangible. It is real. You can touch the tracks.
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Exactly. But if your barrier to entry is a regulatory
15:03
framework that prevents foreign telecom giants
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from entering the market, then your moat is made
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of paper. It can be legislated away with a single
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vote in Parliament. Investors who treat Canadian
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banks and telecoms as perfectly safe, permanent
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monopolies are drastically underweighting regulatory
15:19
risk. Just assuming the rules will never change.
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Yeah. If public frustration over pricing reaches
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a political tipping point, the government can
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change the rules of the arena overnight. They
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could just open borders to foreign competition.
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Or they can mandate aggressive wholesale network
15:33
access for smaller players. Or they can overhaul
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banking fee structures. Because their excess
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returns depend entirely on limited companies,
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competition, these companies are deeply dependent
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on public policy remaining exactly as it currently
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is. That is a massive concentration risk layered
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right on top of the sector risk. Exactly. A huge
15:53
blind spot to assume an arena's rules are permanent
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just because they've been favorable for decades.
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And that actually connects perfectly to another
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devastating blind spot when it comes to misreading
16:04
an industry, which is the cyclical trap. Oh,
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this one is brutal. It catches so many people
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who only look at the math and completely ignore
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the economic weather we talked about earlier.
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Let's really dig into this because it destroys
16:15
portfolios. It does. The cyclical trap is arguably
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the most dangerous psychological illusion in
16:20
investing. It happens when investors rely blindly
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on the price to earnings or P E ratio without
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factoring in where an industry sits in its economic
16:29
cycle. OK, let's set up a scenario to show exactly
16:32
how this works. Imagine a lumber company. A classic
16:35
cyclical business, yeah. Right. In a normal mid
16:38
-cycle economy, maybe the stock trades at $30
16:41
a share, and they earn $2 a share in profit.
16:45
So at a P -E ratio of 15, standard reasonable
16:48
valuation. Exactly. Then a massive housing boom
16:52
hits. Interest rates are low, everyone is building
16:54
new homes, and the demand for lumber skyrockets.
16:58
Suddenly, this lumber company isn't just selling
17:00
more wood. They are selling it at record high
17:03
prices. Their profit margins just explode. Yeah.
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Instead of earning $2 a share, they're suddenly
17:08
earning $10 a share. Wow. Now, let's look at
17:12
the psychology of the retail investor. The stock
17:14
price has rallied because times are good. Let's
17:17
say the stock doubled from $30 to $60. OK, that
17:20
makes sense. But remember, the earnings, the
17:22
denominator in the P .E. equation went up fivefold.
17:25
from $2 to $10. Right. So if you divide that
17:28
$60 stock price by $10 of earnings, the P .E.
17:32
ratio has plummeted to six. And that single digit
17:35
P .E. is a flashing siren for value investors
17:39
who aren't paying attention to the arena. They
17:41
screen the market for cheap stocks. They see
17:43
a highly profitable lumber company trading at
17:45
a P .E. of six, and they think they found the
17:48
bargain of a lifetime. But the market isn't stupid,
17:50
right? The broader market refuses to pay eye
17:53
-high multiple for those earnings because they
17:55
know the housing boom is temporary. They know
17:58
the denominator is a mirage. The market is pricing
18:01
in the inevitable bust. When the economic weather
18:04
turns, when interest rates rise and homebuilding
18:06
halts, the demand for lumber just evaporates.
18:09
And the price of lumber crashes. Exactly. That
18:13
$10 in earnings per share doesn't just dip, it
18:15
gets wiped out. Suddenly, they are earning 50
18:18
cents a share or even operating at a loss. And
18:20
the moment that earnings denominator vanishes,
18:23
the trap snaps shut. If they're only earning
18:25
50 cents, that $60 stock suddenly has a P -E
18:29
ratio of 120. It's massively overvalued. The
18:32
stock price craters back down to $10 or $15,
18:35
wiping out the investor who thought they were
18:36
buying a safe, cheap stock. If we connect this
18:39
to the bigger picture, falling for a low P .E.
18:42
at the top of a cycle is not a failure of math.
18:45
The math was entirely accurate. Right. Six is
18:47
six. Yeah. It is a failure of industry analysis.
18:51
The investor valued a highly volatile cyclical
18:54
company as though its current temporary moving
18:57
phase was a permanent structural reality. They
19:00
treated a cyclical surfboard like it was a defensive
19:03
submarine. Exactly. In a market like Canada,
19:06
which is heavily weighted toward highly cyclical
19:09
resource, energy, and material companies, falling
19:12
into that trap can inflate generational damage
19:14
on a portfolio. So a PE of four in a cyclical
19:17
sector isn't a bargain. It's often a glaring
19:20
warning light that earnings have peaked. That
19:22
is exactly the takeaway. This entire deep dive
19:25
really forces a critical shift in perspective.
19:28
We've gone from looking closely at the internal
19:29
gears of a specific company to stepping way back
19:32
and looking at the entire battlefield. Which
19:34
is really how you have to look at it. Yeah. To
19:36
wrap this up, I want to leave you with a final
19:38
thought to mull over. We've talked a lot today
19:40
about moats, like barriers to entry. massive
19:44
economies of scale, protective regulations. But
19:47
history is absolutely littered with industries
19:50
that appeared permanently protected by unthinkable
19:54
capital requirements, only to have those impenetrable
19:57
moats instantly dismantled by a sudden shift
20:00
in technology. Oh, absolutely. A moat that held
20:03
off competitors for five decades is never a guarantee
20:06
that it will hold for another year. Blockbuster
20:08
had an unbelievable physical moat of retail locations.
20:12
And it didn't matter when the arena shifted to
20:13
digital streaming? Exactly. The whole arena just
20:16
vanished. Thank you for joining us on this deep
20:18
dive. Our goal today was to show you that a flawlessly
20:21
run company can still get crushed if the economic
20:25
weather turns and the arena is rigged against
20:27
them. Yeah, it's a tough lesson, but an important
20:29
one. I encourage you to look at your own portfolio
20:31
tonight. Don't just view it as a list of individual
20:33
companies or ticker symbols. View it as a collection
20:36
of industries. Think about the arenas. Ask yourself.
20:40
What weather are these companies actually exposed
20:42
to, and how thick are the walls of their arena?
20:45
Until next time, keep diving deep.