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As Warren Buffett once said:

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.

In my experience, many fundamental investors focus on the financials without knowing much about the economics of the business. It’s true that the economics of the business affects its profitability and hence, just looking at the financials can give us an insight into the economics of the business. However, just looking at the financials means that we may not appreciate the true nature of the business. Appreciating the true nature of the business can help us foresee how the business will be like in the years to come.

Price elasticity of demand

Price elasticity of demand refers to buyers’ responsiveness to a change in price. Knowing how responsiveness the demand for a good is in relation to a change in its price will give us a good idea of how much power sellers have to raise prices in the future should their costs increase. This means that we can count on their profitability to continue. This is why Warren Buffett once famously said that he couldn’t take on Coke even if he was given a billion dollars to do so. It also explains why Old Chang Kee can sell their curry puffs (But NOT drastically more!) for more than any simple ‘ol curry puff stall in a market.

Market Structure

In general, there are four market structures that firms can operate in. The market structure refers to the environment that firms are competing in. This affects firms’ profitability because in general, any industry that earns supernormal (or economic) profit will attract more competitors. More competition means that there is less chance that the incumbents’ profits will remain high for a long period.

However, some markets are not as competitive as others. Knowing what keeps competitors from entering the industry means we can make a good guess what the likelihood of a firm earning its current level of profits is in the near-term.

For example, SPH is the only licensed newspaper publisher in Singapore. This gives it very high profit margins and has shielded it from competition. Of course, in this digital day and age, technology has upended many markets that used to have high barriers of entry (e.g. Uber and Grab have changed the taxi industry, Airbnb has disrupted the traditionally high capital requirements of the hotel industry etc.)

Obviously, knowing economics alone is not enough to be a good investor but without knowing the economics of the business, we can’t guess whether the numbers as reflected in the past financial statements are likely to persist, grow or decrease. That will ultimately affect the valuation of the company.

 

If you like this post on economics, please like our Facebook page and follow us for more fundamental posts on economics. Really Good Economics also provides small-group tuition for economics. Please visit our website for more details.

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