The World Is Full of Hard Businesses. You Should Probably Avoid Investing In Them.
A few evenings ago, I was sitting at my home study desk going through the pile of annual reports that have been arriving over the past few weeks, all of which I’ve been too busy to read. I was halfway through the 10K filing of an engineered products manufacturer, in which I still own a few shares as a result of a spin-off I received my freshman year of college, when I shut it and went on to the next.
Why? It is a hard business. The world is full of hard businesses that face daunting challenges. That’s fine. The world needs those businesses. They provide vital products and services. They employ people. They generate tax revenue. They aren’t right for me because what I want is a cash profit on my investment. I want money deposited into my CCDA, constantly flowing in over time, in ever-increasing amounts, protecting itself naturally against inflation, wars, politics, and social upheaval. That sort of perfect investment doesn’t exist but there are some that come much closer than others. Manufacturing cyclical products, such as engines for the United States Navy or sealing gaskets for coffee makers, is not the best way to build long-term wealth unless you get a very good price. It’s great for short-term trading opportunities, and it may yet defy the odds, but why bother? Life is too short. For every Southwest Airline there are dozens upon dozens of airlines that have declared bankruptcy multiple times.*
The world is full of hard businesses like steel mills. As a general rule, it is best to avoid them if you want to make a lot of money given that they tend to involve more risk due to lower returns on capital, weaker balance sheets, higher indebtedness, and a host of other factors. Exceptions sometimes apply, especially for sophisticated investors, but it typically holds true.
If you want to get rich young, or at least faster than the general public, the best place to start is in an area that lends itself to high returns on non-leveraged equity, scalable expansion, and in which you can protect your profit margins through some sort of durable advantage that is hard to replicate, be it trademarks, patents, protected trade areas, unique market niches, or geographic limitations. You have much better odds at growing generational wealth running a software company than you do a steel mill. That’s just the nature of the business models themselves.
Signs You Are Investing in a Hard Business
Obviously, a hard business is the opposite of a good business. What are some signs of hard businesses?
- A hard business requires ever increasing capital invested at low returns on non-leveraged equity.
- A hard business isn’t able to raise prices easily with inflation without getting a lot of fightback from customers.
- A hard business isn’t scalable.
- A hard business has a lot of stakeholders fighting over a limited pie; be it unions, governments, vendors, or shareholders.
- A hard business requires you to be smart all of the time. A single mis-step can destroy years of work.
- A hard business offers commodity-like fungible products with no differentiation in the market.
- A hard business requires lots of short-term liabilities to fund long-term assets.
As Nancy Reagan said in her war on drugs, when it comes to a hard business, “Just say no.” When my sister worked for one of the biggest airlines in the world, I never allowed her to buy a single share of stock in her employer. Today, the stock of her employer has lost almost 75% of its value since she worked there. Yet, her retirement accounts are up materially. Why? Because I had her buying shares of consumer product giants, candy makers, oil refiners, tobacco growers, and a host of other quality businesses purchased at attractive prices. The dividends were reinvested tax-free. If you want your financial cattle to grow fat, it is best to graze in green pastures.
* The read was worth it, though. I have been studying 524(g) trusts, created in bankruptcy as a way to resolve claims against companies and other institutions. There was a useful discussion about 100 pages into the report that I’m glad I found.
Reader Comments (7)
Comments are presented chronologically, with replies indented beneath the comments to which they respond.
Jacek Janiszewski
April 15, 2012
>the best place to start is in an area that lends itself to high returns
on non-leveraged equity, scalable expansion, and in which you can
protect your profit margins through some sort of durable advantage that
is hard to replicate, be it trademarks, patents, protected trade areas,
unique market niches, or geographic limitations.
IP patents are killing the industry. Patenting abstract interface methods or solutions in a vague and non-specific way is killing competitiveness, forcing companies to either buy patents or develop hacky workarounds. Supporting IP patents is moraly abhorrent. Being a coder myself I can see the damage being caused by software patents and can only express contempt for patent trolls and the broken system which allows this to go on.
That said trademarks and non-software patents certainly have their place and do their role in encouraging investing into R&D. I hope you meant the latter kind, not the former.
Joshua Kennon
April 15, 2012
Replying to Jacek Janiszewski
I was thinking of pharmaceutical companies developing a life saving drug or an inventor creating a device to cook bacon better, like that young girl did who then sold it to Walmart and made millions in junior high. The patent prevented competitors from knocking off her original design, which allowed you to cook bacon while cutting down the grease substantially.
Truth be told, I haven't thought very much about technology patents except that I constantly see news about Google or Microsoft buying up blocks of them.
Gilvus
April 15, 2012
Hi Joshua, what if it's a hard business that's being sold at a huge discount? I'm looking at an alcohol manufacturer that only owns two factories and offers a fungible product without branding power. However, it's been shunned by investors and now has very sexy-looking fundamentals. In particular, the share price fulfills Ben Graham's "67% NCAVPS rule."
Joshua Kennon
April 15, 2012
Replying to Gilvus
Over long periods of time - if you are talking about buying something that you can compound for decades - a business will ultimately grow at around the rate of its Return on Equity, no matter how big the initial discount you got on it. The longer you hold it, the closer it will revert to that figure. (If you originally bought it at 50x earnings and it adjusts down to 15x earnings, you are going to under-perform the ROE figure as the compounding rate adjusts for the collapsing valuation multiple and visa versa; if you bought a great business at 5x earnings and it eventually reached 15x earnings, you would experience a return higher than the long-term ROE as it adjusted upwards. Once you get past 20, 25+ years, that becomes almost a rounding error, though.)
If you were running a portfolio of super cheap, bad businesses bought at huge discounts, you would want to own several, wildly diversified names. Unlike a good business, which you can add to your portfolio and expect it to do well, some bad, cheap businesses will fail, but the ones that don't should make up for that. Ben Graham compared it to running a car insurance company, where some policies will produce big losses as they are totalled or drive off cliffs, but enough good policies will make up for it and produce a profit.
If you have enough cheap businesses in a wildly diversified portfolio, and you think the discount is large enough, the most rational course of action would be to buy-and-trade. It is very hard, if not impossible, to get rich buying a company that earns, say, 5% or 7% on equity over long periods of time, no matter how big the initial discount. If it ever got near my estimate of intrinsic value, I'd dump it in a heart beat. Those are my thoughts.
What makes it difficult is that occasionally, a cheap, bad business becomes a great business. It is about as rare as Haley's Comet but it does happen. Look at Apple. The 10 years prior to the most recent decade were a debacle. Returns were terrible. Then, the products changed. Innovation happened. They began minting money and every $1 invested back then is now worth $100.
Joshua Kennon
April 15, 2012
Replying to Gilvus
P.S. I should also point out that buying bad businesses at a discount is a much harder operation than buying good businesses at reasonable (or cheap) prices. Although I've obviously done very, very well compared to the average American, the only time we've experienced losses of note have been in our activities buying super-cheap businesses that are inherently bad. On the whole, it has worked out for us and the losses are a rounding error compared to the money churned out each year by our businesses and other investments, but it requires a broad enough diversification base to make up for the occasional implosion. The case study I did of the Borders Group bankruptcy is an example.
In contrast, when we owned shares of quality companies, we didn't have to worry about them even during the meltdown. If I had put my entire net worth in Coca-Cola or Procter & Gamble at 15x earnings, it wouldn't matter to me if it fell to 5x earnings for several years, provided I had no plans on selling for 20+ years. But I have that luxury because we have other things churning out streams of cash to take advantage of situations like that. That is a huge part of our strategy.
Gilvus
April 21, 2012
Replying to Joshua Kennon
Thanks for the feedback. I'll keep it in the front of my mind when I make the final decision.
Dheeraj
August 18, 2013
Replying to Joshua Kennon
as pure academic interest ............ if we are betting (that is general saying ) on a biz. with moat & a potential of attracting decent amt. of profits on it's capital employed for ...lets say 10 yrs.. at slightly beaten down price. how should one hold these businesses ? through direct stock ownership or some options that can be vested in next 10 yrs. throughout period of 5 yrs. ( so that stock can be on weighting machine of mr. market )
assumptions being that if co. is earning decent monies and is have prospects of maintaining those earnings it shall be reflected in stock price ( and the prices of those options over a long term ) ......... as anything less then 15% is considered low probability ....... if it is possible that we got to pay low cost of options for such high anticipations for valuations. is it worth of trouble to find someone to supply us with such options ... does price we pay have such impact on money we get in our pocket at end of investing lifetime spent on piking extraordinary businesses ?
the question came to my mind was aroused by this .......... munger says on the line of that ... even brk.h dropped by more then 50% from top since they took over ..... in hindsight we can see that both not so known and well known investors had seen great potentials in some businesses ( sees, amex, coke, starbucks, walmart) when they were either nascant or beaten down by street
...... when elders made the bets by buying common stocks they said effectively (in my view) "we think this security is mispriced below intrensic value "
but is there a way of saying through your money that " i think this security is mispriced ... because it is not only a great business but also will stay a great business"
why it wouldn't work ? your thoughts please