Table of Contents



Preface

  1. What is Reflections of an Allocator?
  2. Why Pursue Investing?
  3. About Me/Contact Me

Overarching Themes & Principles
  1. Want to Predict the Future? Look at Incentives.
  2. Culture Really Matters.
  3. People, People, People = A Winning Formula for Success.

Asset Allocation & Risk Allocation

  1. Where Have All the US Public Companies Gone?
  2. Why Invest in Private Equity?
  3. Creating a Private Equity Investment Strategy.
Manager Selection & Co-Investing

  1. Creating a Manager Selection Framework.
Direct Investing & Security Selection

  1. Creating a Business Quality Framework. (Part 1)
  2. Creating a Business Quality Framework. (Part 2)
  3. Creating a Business Quality Framework. (Part 3)
  4. Creating a Business Quality Framework. (Part 4)

Business & Industry/Sector Research

  1. Aggregators in the Public Markets (Part 1): TransDigm Group.

Creating a Business Quality Framework. (Part 2)




Preface

This is a continuation of the Creating a Business Quality Framework series I am working on. Click here for Part 1.

Favorable Position in Value Chain:


A strong position in the value chain enhances a company's ability to maintain its competitive edge, protect profit margins, and sustain growth over the long term. I’ve divided the elements into four key areas: competitors, clients, suppliers, and new entrants. Each area highlights factors that can strengthen a company's market position and overall business resilience.

1. Competitors

A favorable position relative to competitors involves several factors:
  • Leading Market Share Locally: Dominating market share in a local or specific market segment provides a competitive edge and pricing power.
  • Unique Competitive Advantage(s) to Peers: Distinctive strengths, such as proprietary technology, brand reputation, or cost leadership, set the company apart from its peers.
  • Consolidated Industry: Operating in a consolidated industry with fewer competitors reduces the intensity of rivalry and price wars.
  • Consolidating Industry: If the industry is in the process of consolidation, it may offer growth opportunities through mergers and acquisitions.
  • Stable Market Share Trends: Consistent market share indicates a solid competitive position and effective customer retention strategies.
  • Competitors Have Acted Rationally: Competitors that focus on profitability over reckless expansion or price-cutting help maintain industry profitability.
  • Stable Industry Capacity: An industry with stable capacity reduces the risk of overproduction, price drops, and reduced margins.

2. Clients

A favorable client position includes:
  • Mission Critical and/or Differentiated Offering: Products or services that are essential to clients' operations or provide unique value reduce the risk of substitution.
  • Small Percentage of Client Cost Structure: When the company’s products or services represent a small portion of the client's total costs, clients are less likely to seek alternatives based on price alone.
  • Relative Lack of Substitutes: A limited number of substitute products or services strengthens the company’s market position.
  • Low Product Cycle Risk: Products or services that have long lifecycles face lower risks of obsolescence and require less frequent reinvestment.
  • Historical Pricing Power: The ability to raise prices without losing customers is a sign of a strong market position.
  • Low Customer Concentration: Diversified customer base reduces reliance on a few major clients, decreasing the risk of revenue loss due to client attrition.

3. Suppliers

A favorable supplier position is characterized by:
  • No Powerful Suppliers: When suppliers lack significant bargaining power, the company can negotiate better terms and protect its margins.
  • Fragmented Suppliers: A large number of suppliers means less dependency on any single supplier, providing flexibility and reducing supply chain risks.

4. New Entrants

A favorable position against potential new entrants includes:
  • No New Entrants / VC Money: Lack of new competitors or venture capital funding reduces the threat of market disruption.
  • New Entrants Have Failed Before: Historical failures of new entrants indicate a high barrier to entry, deterring potential competition.
  • No Buggy-Whip / Tech Risk: The company’s products or services are not at risk of becoming obsolete due to technological advancements.
  • No Threat of Disintermediation: There is little risk of intermediaries (such as distributors or platforms) being bypassed, preserving the company’s role in the value chain.
  • No Well-Funded Player Likely to Enter via M&A: The absence of potential acquisitions by well-funded competitors reduces the threat of sudden market shifts.

Resilient to Externalities:


Externalities are factors outside the company’s direct control that can impact its operations, profitability, or valuation. By minimizing exposure to these external risks, a company can maintain stability and performance even in volatile or uncertain environments. Each characteristic listed contributes to a company's ability to withstand external shocks, ensuring more consistent long-term growth and profitability.

Key Factors Contributing to Resilience to Externalities

1. Lack of Commodity Risk (in Sales & Costs)

Commodity risk refers to the potential negative impact of price fluctuations in raw materials or other commodities on a company's sales or costs. Companies that are not heavily dependent on commodities—either as inputs for their products or as the primary goods they sell—are less vulnerable to sudden changes in commodity prices. By avoiding significant exposure to commodity risk, such companies can protect their margins and maintain stable cost structures, regardless of market volatility in commodity prices like oil, metals, or agricultural products.

2. Lack of Exposures (GDP, FX, Rates, China, Oil)

Minimizing exposure to macroeconomic factors such as GDP growth rates, foreign exchange (FX) rates, interest rates, and specific geopolitical or economic regions (e.g., China) shields a company from unpredictable external shocks. For example:

  • GDP Exposure: Companies not heavily dependent on overall economic growth are better positioned to weather recessions or slowdowns.
  • FX Exposure: Limited exposure to foreign exchange risks protects a company from fluctuations in currency values that could affect revenue or costs.
  • Interest Rate Exposure: Companies with low sensitivity to interest rate changes are less affected by tightening or loosening monetary policies.
  • Geopolitical or Regional Risks: Companies with limited reliance on specific markets, such as China or oil-producing nations, are less vulnerable to localized disruptions or geopolitical tensions.

3. Policy / Regulatory / Stroke-of-Pen Risk

Policy or regulatory risk, also known as "stroke-of-pen" risk, refers to the potential impact of government decisions, regulations, or policies on a company’s operations. Companies resilient to this risk have limited dependence on government contracts, subsidies, or regulatory approvals. They also avoid operating in highly regulated industries where sudden policy changes could significantly affect their business models, costs, or market access. By minimizing exposure to regulatory risks, these companies reduce the chances of facing sudden operational disruptions or compliance costs driven by new laws or government directives.

This concludes Part 2, click here to continue to Part 3.