Value Investing – Industry Standards (Lesson 13)

Industry Standards

Quality means doing it right when no one is looking.  Henry Ford

Have you ever wondered how the measurement of length called a ‘meter’ came to be? It is simply the distance light travels in a given time period. The key isn’t the actual definition; it is whom dictates this time period of travel. Some authority states that this is the definition of a meter (also written as ‘metre’). It is currently the International Committee for Weights and Measures based out of France. It is an 18 person task group promoting uniformity with units of measurement. This committee is the authority.

This same principle of authority exists in business. Every industry has their own authority or set of principles promulgated by an agreed upon group of individuals or a leader within that group. For value investors, understanding the authority for the respective industries is essential to measuring success for each member company within the pool of potential investments. Once a value investor recognizes what is the standard of production or performance, it becomes easy to compare their respective investments and then equate this into financial value. There is a hierarchy of authority for all industries. In almost all cases, the number one authority is a governmental institution or law. Other levels of authority at the next level include academia, associations, journals, books, white papers and committees. The third level of authority include experts and company level affiliations. The final level of authority is the leader in the respective industry.

Each of the following sections explore these different levels of authority. In each section, there is an introduction to the various resources the value investor may wish to use when investigating their respective industry. The key to this lesson is to understand that higher levels of authority are the standard setters. Value investing is about having facts to support a buy/sell position with each member of the pool of investments. The stronger the authoritative position of the standard setter, the more accurate the buy/sell trigger points can be calculated.

Industry Standards – Government Authority

The government gets its authority from the citizens it represents. There is a high level of trust between the citizens and the government to properly create law, regulations and monitoring systems to enforce the laws and regulations. In turn, the government creates a hierarchy of authority within its bureaucracy. Since every industry traded on the market participates in interstate commerce, the federal government is the authority to turn to for standards related to the respective industry.

At the federal level, the Federal Code is the law as passed by Congress. The Federal Code is divided into 54 titles. In turn, each title is supported by a set of regulations, the actual law passed by Congress. To augment regulations, each agency of the government creates rules and these are published in the Federal Register and posted to the agency’s website. If regulations or rules are challenged, court rulings (case law) and opinions act as the next level of authority.

In addition, these rules, rulings, and opinions are further supported by agency interpretations, determination letters and examples.

With respect to standards, each agency creates standards and guidance for corporations and individuals to follow. In many cases, committees are created as a public/private affiliation to provide guidance, opinions and suggestions to agency management in order to advise Congress when creating law.

It is within this organizational structure that value investors will find the highest level of authority related to industry standards. The most common section of the U.S. Code used by value investors is Title 15 – Commerce and Trade. However, some industries are governed and monitored by other titles of the Code. For example, banking and finance is controlled under Title 12 – Banks and Banking. In some cases, there may be more than one section of the Code that governs an industry. For example, railways are governed by several Titles:

  • Title 15 -Commerce and Trade
  • Title 45 – Railroads
  • Title 49 – Transportation

For those readers interested in the U.S. Code breakout, go here: https://www.law.cornell.edu/uscode/text.

Each agency will have a subagency or department specifically dedicated to the particular industry that is the pool of potential investments value investors create. For example, within the Department of Transportation, there is a a department that governs railways. It is the Federal Railroad Administration. It is here that a value investor will find guidance and standards as it relates to railroads. Within the research and development section, an investor can find all sorts of library information including research papers, technical reports, and results.

One of the benefits the government provides are audits of certain industries and their members. Some industries are highly regulated to the point where the government frequently audits their financial performance. For example, banks are highly regulated. Under the Federal Deposit Insurance Corporation’s Law, Regulations and Related Acts, Section 5000 for Policies and Procedures:

“In accordance with Section 36 of the Federal Deposit Insurance Act, as implemented by 12 CFR Part 363, each insured depository institution with $500 million or more in total assets at the beginning of its fiscal year is required to file with the FDIC and the appropriate federal banking agency, an annual report, including its financial statements which have been audited by an independent public accountant, and a management report and independent public accountant’s attestation concerning both the effectiveness of the institution’s internal controls for financial reporting and its compliance with designated safety and soundness laws. In addition, each such institution is required to have an audit committee consisting entirely of outside directors who are independent of management. For state nonmember banks subject to Section 36 and Part 363, these audit and audit committee requirements take precedence over the provisions of this Statement of Policy.” 

This information is publicly available. In addition, the data is compiled for a peer group average. This average is tiered for banks of certain sizes in terms of assets. Thus, an average standard is generated in these reports for comparative purposes. This data is compiled by the Federal Financial Institutions Examination Council and is retrievable from that agency’s website.

This further substantiates why it is so much better to only consider high quality top 2000 companies for investment purposes. In most cases, strict governmental regulation is required for these companies. This further reduces their respective risk of default which in turn improves the safety margin of investment. Therefore, when a value investor discovers an investment opportunity, the associated risk is reduced significantly as there is more public information available to protect the investor. Remember, the first of the four principles of value investment is risk reduction. The government information also augments the calculation tied to intrinsic value, the second principle of value investing.

A good perfunctory requirement of value investing is to research the respective governmental authority related to the industry you select for your pool of investments. The three existing pools of investments on this website have their resources page included in that pool’s directory. There are many supplementary articles written for certain governmental standards with each pool. You must be a member of this site’s Value Investment Club to access this information.

The next level of authority customarily comes from the industry’s associations, consortiums, and academia.

Industry Standards – Academia, Journals, Associations and Industry Boards

In the prior section, the government was cited as the absolute best authority tied to standards for industry. The government gets its authority from the public. The public is willing to spend the necessary resources to research and compile information allowing Congress to formulate law, regulations and agency rules to best serve the public. The next level of authority gets its backing from historical knowledge and industry data compiled from years of activity. The industry creates associations and authority boards to assist in better understanding the industry. All these sources provide needed research and guidance to their members.

Within the industry you select, do your research to find supporting authorities from this second level of dominion. 

One of the pools of investments used by this site’s Value Investment Fund is Real Estate Investment Trusts. The resources page within this pool’s information base covers several second level authorities. 

  • The National Association of Real Estate Investment Trusts (NAREIT)Nareit® is the worldwide representative voice for REITs and publicly traded real estate companies with an interest in U.S. real estate and capital markets. Nareit’s members are REITs and other businesses throughout the world that own, operate, and finance income-producing real estate, as well as those firms and individuals who advise, study, and service those businesses. National Association of Real Estate Investment Trusts® and Nareit® are registered trademarks of the National Association of Real Estate Investment Trusts (Nareit).”
  • New York School of Professional Studies – NYU SPS Schack Institute of Real Estate REIT Center is a forum for the study of real estate investment trusts. 
  • Wharton School of Business, University of Pennsylvania has a program “Assessing Commercial Real Estate Investments …” whereby the current market issues are raised and the forces that impact real estate investments are explained.
  • REIT Magazine as written and printed by NAREIT. 
  • Journal of Real Estate Research
  • Global Real Estate Standards Board (GRESB) assesses and benchmarks data about real estate investment trusts to the capital markets.

The key here is that a few hours of research online will provide the necessary resources for your respective pool of investments. You will have to dig into each site’s source data in order to determine what is applicable to your particular pool. The overall end result is a greater understanding of your industry and confidence related to your buy/sell decision model.

There are other authorities before utilizing the standards from the standard bearer within your pool of investments.

Industry Standards – Experts and Company Level Affiliations

With each industry, there are experts; individuals that have written extensively about the respective industry. In effect, they have been exposed to all the impact factors and variables associated with the respective industry. Many have committed their lives to the subject matter and often teach advanced courses about the respective subject. These experts are excellent sources of information especially for someone learning about a particular industry.

As an example, with Real Estate Investment Trusts, Su Han Chan is considered an authority on the subject matter. She has written extensively about the subject matter and is a professor at John Hopkins University. This is her Curriculum Vitae. There are many others, but it is best to use someone with credentials to back up their respective position as an authority on the subject.

Other sources include company level affiliations. These can be associations, data centers, conference presentations, and private collection centers. For example with the railways industry, here is a list of company level affiliations used for that respective pool of investments:

  • Association of American Railroads
  • Railinc.
  • International Union of Railways
  • American Public Transportation Association
  • Surface Transportation Board
  • Progressive Railroading (publication)
  • The Railway Educational Bureau

All of these lower level authoritative sources assist value investors with answers to peculiar and uncommon questions. Often, their knowledge supplements or provides additional confidence with the decision model constructed for the respective industry you select. 

In some cases, the lowest level of authority is often the best. As stated multiple times throughout this series of lessons, finding a standard bearer within your pool of potential investments is an excellent standard to use.

Industry Standards – Industry Leader

Within each industry there is a leader. Just as in sports, medicine, politics etc. there is always someone or some organization that stands out among the crowd. In business, leadership is a result of a long history of profitability, outstanding performance, good management, and strong ethics. Leaders follow the rules, not just the law and regulations, but the core business principles that exist within that industry. Your job as a value investor is to discover that leader within that group.

Often, it is easy to find the leader; in general, they are the most profitable and have a long history of good profits. Other indicators include superior valuation ratios, positive news about the company, extensive annual and quarterly reports, and well designed informative website. A simple comparison table of different metrics will reveil the leader within the industry.

Once known, a value investor gets well versed with this company’s activities, performance and goals. Learn why they are the leader, what makes them superior to the other members of the pool in this industry. 

Once the industry leader is selected, learn how they are viewed from the other authorities in the heirarchy above. Do the others consider this company the leader in that industry? If indeed the company is the leader, then their performance standards are the ones to use when evaluating other members of the pool. Gauge whether the other members are improving towards that standard or having troubles achieving the respective metrics. Those that are improving will have faster improving price recovery periods whereas those having difficulties will take longer to recover to a good market price. This has a significant bearing on overall return for the respective investment. Remember, the longer it takes to achieve price recovery, the lower the overall return on the investment.

Summary – Industry Standards

Each industry is different with the performance and financial metrics. The key is to understand how the particular industry makes money and turns a profit. Find the top three performance indicators and focus in on those three. The standard bearer will provide the answer. Furthermore, the various levels of authority will assist with disclosing and/or reaffirming the top performance metrics for the industry. Use the various authorities to aid you with finding and getting answers to what makes this industry tick. Once there, each member within your pool should have a table of these metrics and indicate whether their trend line is improving or having issues. This assists the investor with setting the buy/sell points for the respective investment.

During Phase Two of this program, developing these three top performance indicators and evaluating them are explained in detail along with several examples and illustrations to help the value investor perform thorough research for their model. In addition, during Phase Two, spreadsheets, formulas and simple decison models are provided to assist the investor with their goal. Act on Knowledge.

Value Investing Episode 1 – Introduction and Membership Program