Picking an Industry and Crafting an Investment Thesis
Traits of a Good Industry for Acquisitions:
- Fragmented industry (over 50% of market share under small business control)
- High margins (over 15% EBITDA margins are good, over 20% is quite good)
- An industry that’s stable / increasing in demand / grown over the last 3 years, 10 years, and 20 years
- A business you can get passionate about or have experience in
- Ideally, there are lots of potential acquisition targets and motivated sellers
- Large discrepancy between perceived customer value and cost to produce the product or service
- Reoccurring revenue model and stable, long-term contracts
- Low customer concentration
- Industries with low customer turnover (hard for customer to change products or services)
- Good exit options
- Bonus: an industry that qualifies for SBA and/or Fanny&Freddy / government financing
- Bonus: an industry with an intrinsic “moat” (i.e. mobile home parks have government restrictions that largely eliminate new supply, Sam Zell’s bridge to Tijuana Intl. Airport – monopoly)
- Bonus: businesses with intrinsic value (ie. land, buildings, proprietary / trademarked value)
- Bonus: businesses devoid of lots of depreciation / machinery costs / capex costs (many service-based businesses avoid lots of these costs)
Traits of a Poor Industry for Acquisitions:
- Declining or negative growth (contraction) in the industry (it is hard to grow in an industry growing below GDP, not impossible, but harder). It is harder to take customers from competing business than it is to gain customers as a result of a growing industry.
- Competitive industries with little barrier to entry
- Unpredictable and significant external factors (factors out of the control of business owners like payment/reimbursement risk in healthcare, government intervention, litigation, constant technological change and innovation, seasonality or cyclicity that could cause a default on payments, and the list goes on).
- High customer pricing power
There is no perfect industry, but the famous line from Warren Buffet usually holds true:
“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
To read about industries use:
- www.ibisworld.com – If you can afford it, they have great reports for virtually every industry with profit margins, growth predictions, multiples, historical numbers, market share, barriers to entry, technological change in the industry, demand and supply determinants, etc. There are other companies that provide these reports as well and many accounting/PE/consulting firms and other companies will release industry reports in sectors they practice in. If you are a student you may have a free subscription through your school’s library database.
- Government data
- Shareholder reports for publicly traded companies in your industry
- Conversations with industry experts (use LinkedIn or pick up the phone)
- Google (search “Candy Shop Industry Report”)
- Blogs, books, YouTube videos
- Maybe the most under-utilized method of reading about industries is reading annual reports of public companies in your industry (if any). If there aren’t any, then you may have found an industry that is perfect for consolidation because no one has done it yet; or, that may be an indication that consolidation is difficult in this industry. Sooner or later, you’ll find out. At the end of the day, the sooner you and your team get to reading about the industry, looking at the financial statements, income statements, cashflow statements within that industry, the sooner you can (1) understand what a good business looks like so you can pull the trigger on a company and/or (2) decide whether or not you need to pivot into a different subsector or industry with better economics.
Here is a list of industries for consolidation in no particular order (there are many more than are on this list – technically, you can buy anything, everything is for sale at a certain price).
- Accounting Firms
- Alternative Healthcare Providers
- Ambulance Services
- Biotech / R&D
- Blood & Organ Banks
- Cannabinoids/Medicinal Marijuana
- Car Washes
- Carpet Cleaners
- Cell Phone Repair Shops
- Child care
- Coffee shops
- Cosmetic / Beauty Clinic and Spas
- Data Informatics Firm – Many companies are looking for data analysis / integration. *This is heavy into computer engineering.
- Dental Insurance
- Dental Laboratories
- Earth Metals
- Emergency & Other Outpatient Care Centers
- Family Planning & Abortion Clinics
- Florist Shops
- Food trucks
- Funeral Homes
- Furniture store
- Genetic Counsellors
- Gravel Companies
- Grocery stores
- Healthcare Staff Recruitment Agencies
- Home Builders
- Home health care services
- Home Medical Equipment Rentals
- Hospices & Palliative Care Centers
- In-Home Senior Care
- Laundromats and/or dry cleaners
- Law firms
- Life insurance
- Liquor Stores
- Logistics / Trucking
- Medical Claims/Billing Processing Services
- Medical Couriers
- Medical Device Cleaning & Recycling
- Medical devices, equipment, and hospital supplies manufacturers
- Medical insurance, medical services and managed care
- Medical Practitioners & Healthcare Professionals
- Mental health and residential developmental handicap facilities
- Mobile Home Parks
- Moratoriums / Cemeteries
- Multifamily Real Estate
- Nail Salon
- Nursing and residential care facilities
- Nutritionists & Dietitians
- Oil and Gas
- Packaging plants – cardboard, meat, raw, polyethylene, etc.
- Paid Social Media Advertising
- Physical Therapy
- Portable Toilet Rental
- Property Management
- Psychiatric and substance abuse hospitals
- Recycling and Waste
- Restaurant Industry (low margins, though)
- Roofing Contractors
- Security Companies
- SEO / Web company
- Single Family Real Estate
- Software as a Service or CMS
- Solar Company / Installation
- Specialty hospitals (not including psychiatric and substance abuse facilities)
- Web design & development
There are many more than this so search around if nothing sparks your interest.
Here are the 14 most profitable industries in 2016, ranked by net profit margin (source: Sageworks):
- Accounting, tax prep, bookkeeping, payroll services: 18.3%
- Legal services: 17.4%
- Lessors of real estate: 17.4%
- Outpatient care centers: 15.9%
- Offices of real estate agents and brokers: 14.8%
- Offices of other health practitioners: 14.2%
- Offices of dentists: 14.1%
- Specialized design services: 12.8%
- Automotive equipment rental and leasing: 12.5%
- Activities related to real estate: 12.3%
- Warehouse and storage: 11.6%
- Offices of physicians: 11.5%
- Nonmetallic mineral mining and quarrying: 11.2%
- Oil and gas extraction: -7.6%
- Support activities for mining: 0.6%
- Beverage manufacturing: 0.8%
- Grocery and related product merchant wholesalers: 1.9%
- Lawn and garden equipment and supply stores: 2.0%
- Miscellaneous durable goods merchant wholesalers: 2.3%
- Petroleum and petroleum products merchant wholesalers: 2.4%
- Grocery stores: 2.5%
- Automobile dealers: 3.2%
- Building material and supplies dealers: 3.2%
- Continuing care retirement communities and assisted living facilities for the elderly: 3.3%
- Other motor vehicle dealers: 3.3%
- Home furnishings stores: 3.3%
- Furniture stores: 3.4%
- Beer, wine, and liquor stores: 3.4%
Note: The average for all industries was 7.7 percent, and the data excludes taxes but does include owner compensation in excess of market-rate salaries.
PUBLISHED ON: NOV 7, 2016
There are many more than this so search around if nothing sparks your interest.
Here are larger lists of industries:
Crafting Your Investment Thesis:
When crafting your investment thesis, use the points (“traits”) listed above to objectively sell the industry and why it is profitable to your board members, banks, investors, and future employees. Learning a lot about an industry will be the first key to doing a deal. First, in terms of valuing companies. Second, in terms of bonding with the seller.
Here are some other questions you can ask yourself to develop your investment thesis:
- Who are the competitors in the industry? What is their competitive advantage (if any)? How much of the industry is fragmented into “mom and pop” owners? How do the owners in this industry behave? Are they gun-slinging, wheel-and-deal oil barons? Are they medical professionals? Are they mostly baby boomers or a younger generation? You need to build rapport with these sellers and the easiest way to do that is to act just like them. You also should know how your competitors behave because you’ll be competing with them!
- How is the industry trending in terms of price, innovation, size, and volume? Where is the ceiling of growth? What are the risks in the industry?
- What drives sales in the industry? What does revenue model look like? Money upfront, cash or credit, reoccurring or more transactional? What are the contracts like?
- What are the expenses like for companies? Lots of capital expenditures? Do expenses create a barrier to entry? How can you minimize expenses?
- Who are the buyers of my product and how can we make them happy?
- Who are our suppliers and what makes them happy?
- What kind of companies within the industry are we going to target? What makes a good acquisition in this industry?
- How is the access to financing in the industry?