QUALIPORT
Substitutes For Your Shares

By Maynard Paton (TMFMayn)
June 30, 2003

Corporate guru Michael Porter outlined five industry 'forces' in his celebrated book Competitive Strategy: the threat of new entrants, the power of customers, the power of suppliers, existing industry rivalry and pressure from substitute products.

For many investors, it is the substitute product that trips up their portfolio. Porter writes: "All firms in an industry are competing, in a broad sense, with industries producing substitute products. Substitutes limit the potential returns of an industry by placing a ceiling on the prices firms in the industry can profitably charge. The more attractive the price-performance alternative offered by substitutes, the firmer the lid on industry profits."

All too often, shareholders focus on direct rivals while losing sight of (typically new) products and services elsewhere. For example, no amount of time investigating the typewriter industry could have saved an investor from the onslaught of personal computers. And no matter what the 'quality' of the passenger shipping company, the advent of the commercial airline would have had an impact. So how does the Qualiport watch list stand up to substitute scrutiny?

Retailers

DFS Furniture (LSE: DFS) faces a myriad of direct alternatives for its upholstered furniture -- as it always has done. But while the materials, designs and fashions may change, it's difficult to see the popularity of the settee and armchair dwindling over time. However, while carpet and Carpetright (LSE: CPR) do not suffer the same fashion element as furniture, substitute floor coverings do exist.

In the Carpetright 2001 annual report, the company referred to the growing UK markets for rugs and laminate flooring, which then totalled £160m each. Carpetright does sell rugs and laminate, but its position is a lot weaker in these 'sideline' areas. Will Changing Rooms and wooden flooring be the firm's downfall?

Another retailer facing plenty of substitutes is Games Workshop (LSE: GAW). Young lads have plenty of diversions for their limited financial resources; football shirts, computer games, music and girls can sometimes tempt even the most hardened gamer away from his miniature soldiers.

Media

Media firms face the threat of one particular substitute, none more so than newspaper publishers like Johnston Press (LSE: JPR) and Scottish Radio (LSE: SRH). The Internet is tailor-made for readers who wish to search the classifieds for cars, properties, jobs and so on. Fortunately, most newspaper publishers have online presences and their familiar titles do provide some sort of cyber-advantage. Specialist publications, such as Exchange & Mart, also serve as classified substitutes.

Consumer magazines, television and radio, as provided by Emap (LSE: EMA), Ulster Television (LSE: UTV) and Capital Radio (LSE: CAP), are less at threat from the online world. They continue to battle with each other however -- as they have done for years -- for the advertiser's pound and the public's attention.

Trading and smoking

Though the London Stock Exchange (LSE: LSE) has a dominant position in domestic share dealing, numerous 'investment' alternatives have arisen in recent years. For instance, derivatives have been increasingly gaining favour, which no doubt prompted the heated battle for LIFFE. Property and savings accounts have also become diversions away from equities.

Tobacco too has its replacement issues. The growing popularity of nicotine patches and the development of nicotine-free cigarettes may affect demand for Imperial Tobacco (LSE: IMT) and Gallaher (LSE: GLH) products in years to come. Of course, there's one real substitute danger here: a healthy lifestyle.

Engineering and ports

Of the watch list firms, probably Halma (LSE: HLMA) and Renishaw (LSE: RSW) are among the best suited to cope with the substitute threat. Though each firm continually upgrades their fire detectors and measuring probes to beat off direct rivals, it's far from obvious how their customers can completely circumvent the usage of such machinery.

But Associated British Ports (LSE: ABP) trumps the lot. It's difficult to think of any worthwhile replacement for a seaport, unless the cost of airfreight got a whole lot cheaper and the size of aeroplanes got a whole lot bigger.

Summary

Successful long-term investing is all about finding businesses that have good moats around their products and are not susceptible to change. Most of the Qualiport watch list companies have products and services that have been around for years and have coped well with the same old substitute possibilities.

There are four firms that could cause some concern. As has been proved by the Pokemon phenomenon, Games Workshop is liable to suffer from short-term, diversionary fads. Longer term, Johnston Press and Scottish Radio could well lose a notch of profitability to the Internet. But then again, newspapers still prospered after the arrival of radio and television. And if some interior designers get their way, Carpetright could find itself swimming against a tide of laminate.

All that said, you have to weigh up the pros and cons of each company individually. For instance, the LSE and the tobacco firms could see their customers drift to substitutes elsewhere, but their super operational franchises more than evens out this risk. In contrast, there's no sign of anything to replace the sofa, yet DFS is the weakest watch list business as it faces a multitude of rivals selling a wide variety of furniture.

More: The Qualiport watch list

The author owns shares in Carpetright, DFS Furniture, Games Workshop, Halma, Johnston Press and London Stock Exchange (and prefers laminate flooring to carpet).