Why You Can't Outperform without Picking the Right Industry

Imagine it’s 2004. You’re picking between investing in the four major U.S. airlines: Southwest, United, American, and Delta.

How would you decide which airline to invest in?

Perhaps the one poised to experience lots of sales growth. In that case, you might want to bet on Delta, which will triple sales.

Perhaps the one with the strongest competitive advantage. In that case, you would want to bet on Southwest, which is known for having a low-cost advantage.

Or perhaps the one with the highest gross margin by the end of the period. In that case, you would want to bet on United, which will earn gross margins of 34%.

Or maybe even a diversified portfolio of all four airlines. Why not? You have each of their financial statements for the next 15 years, so you know that each of them will at least double or triple

their sales volumes.

But here’s the catch.

None of them actually made sense to invest in.

If you invested in any of the major airlines over a 15-year- period from 2004 to 2019, you would have underperformed the market. American Airlines only grew 23% over the period, compared to 189% for the S&P 500. Delta Airlines and United Airlines underperformed the S&P 500 by 16% and 34%. The only airline that outperformed was Southwest Airlines, but by just a couple percent annually.

In addition, virtually every single one of the hundreds of airlines in all of America have performed poorly throughout history, according to several studies.

Contrast the airline industry with the credit card industry.

Not long ago, I was researching the major credit card companies: American Express, Discover Financial Services, and Visa. My initial feeling was that it wouldn’t make sense to invest in any of the major credit card companies. None of them had an edge over the competition. No one says,

“American Express is much better than Discover Financial Services.” No one says, “Visa charges much lower fees than Mastercard.” If none of the credit card companies have an edge,

how can they be a worthy investment? I asked. But my conclusion couldn’t have been farther from the truth.

The reality is that nearly every single credit card company hasperformed well throughout history. In fact, many of them have even been some of the best investments in the entire stock market over the past decades.

If you bought Visa and Mastercard at the end of the financial crisis, you would have outperformed the S&P 500 by 9% and 7% per year, respectively. If you invested in American Express at the same time Buffett bought it during the 90s, your investment would have grown more than 30x times to date.

Even if you invested in Discover Financial Services right before it crashed 70% during 2008, you would have still outperformed the market.

The airline and credit card industries illustrate an important

lesson: industry matters.

You can be right about the company, but you’ll still lose

money if you’re wrong about the industry (airlines). But you

also can be wrong about the company and right about the

industry, and still make a fortune (credit cards).

A study once looked at the performance of more than 3,000 companies. They wanted to understand what factors drive a company’s level of profitability. Does having a smart CEO drive a company’s success? Does company culture drive success? Or something else? What they found is that that industry matters more than anything else.

In fact, the study pointed out that the average software company outperforms the leading construction companies because the software industry is so attractive. As the study concluded, “it’s better to be an average company is a great industry than a great company in an industry.”

If someone found an investment vehicle that they knew would earn just 2% more than the S&P 500 every year, they would be excited to invest in it.

But getting into the right industry can make as much as a 17% difference in returns per annum. (If you invested across the major airlines for the past decade, you would have earned -2.9% per year. By contrast, you would have earned 14.1% per year by investing across the major credit card companies. That’s a 17% difference. Every. Single. Year).

People get excited if a mutual fund can improve performance by 2% per year. Yet no one gets excited if getting in the right industry can improve performance by 17% returns per year.

That doesn’t make sense.

Don’t be the typical investor. Be different. Be smarter. Be

better.

First make sure you’re in the right industry. Second, try to find the right company in that industry. Not the other way around. Never research a company without first asking yourself, “is this company even within an attractive industry in the first place?”