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Favorable Industry

Q. I’ve decided to buy a small company. I have the money and I know how to run a business. I plan to keep the management team intact, so I’ll have the expertise I need. Therefore, I’m industry agnostic. However, I know that some industries are better than others are. What characteristics define a good industry?

A. Three characteristics define a favorable industry. It should be growing, profitable and low risk. The reason is straightforward. The value of your business will only increase if it grows and/or profitability increases. Lower risk is better because you want the growth and profitability to continue. We’ll describe each attribute in more detail below.

1. Growing – No industry can grow at a rate that exceeds the GDP growth rate forever—say 2 to 4 percent in the United States. However, many industries will exceed this growth rate in the short term. We suggest choosing an industry that is growing. A rising tide floats all boats.

Avoid industries that are being or are likely to be overtaken by new technologies. For example, we wouldn’t suggest getting into the business of manufacturing CDs. They are obviously going the way of the vinyl record.

2. Profitable – Industries that are likely to be profitable in the long run share several characteristics:

• High barriers to entry – Profitable industries tend to attract new entrants. The new entrants will compete the profit away. High barriers to entry protect industries from new entrants. It may be an industry that is costly to enter, one that requires rare, specialized skills or one with protected intellectual property. Regardless, high barriers to entry will protect an industry’s profitability. Of course, the downside is that these industries may be more challenging for you to enter.

Low barriers to exit – If the time comes when there is excess capacity in the industry, companies need to be able to leave. If companies can’t leave, they will compete away all of the profit as too many businesses chase too little volume. Low exit barriers allow marginal operators to leave the business rather than making the industry unprofitable for everyone.

Ability to differentiate your product or service – In a true commodity business, one in which you cannot differentiate your product or service, the winner will typically be the competitor with the lowest cost. Small, growing businesses can rarely maintain a low cost position. We advise choosing an industry where you can differentiate your product or service. Then focus on the segment of the market that values the things that make your offering different. You’ll also want to make sure that competitors can’t easily copy the thing that makes your product or service different.

• In a position of strength vis-à-vis suppliers and customers – Suppliers will want to charge as much as they can. Customers will want to pay as little as they can. Obviously, if suppliers and customers are successful, profit will evaporate. Instead, look for a situation where suppliers compete away the profit in their industry by selling to you at low prices and where customers are willing to pay a premium for your offering. Choose an industry where the participants are in a position of strength so that they can maintain good profit margins.

3. Low risk/low volatility – Businesses that are currently profitable and growing can become a nightmare if the situation changes quickly. Look for industries that are stable and low risk. Examples of risks to avoid are:

• Regulatory risk – New regulation can destroy an industry’s profitability overnight. For example, Obamacare threatened to put independent health insurance brokers out of business. In the end, this didn’t happen, but many in this industry were fearful. Avoid industries that are likely to face new regulation.

• Spoilage risk – If unsold product becomes worthless, competitors may cut prices significantly to sell the product rather than lose it. Airline seats are a good example. Once the plane’s door closes, unsold seats are worthless. Airlines have a significant incentive to cut price rather than fly with empty seats. As a result, profits in the airline industry are notoriously volatile.

You won’t find the perfect situation. You’ll have to accept some compromise. However, try to find an industry that meets as many of the above criteria as possible. It will improve your chances of success.

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