Mail Bag: Why Would an Investor Ever Buy an Asset Intensive Business?
If asset intensive businesses are inferior investments, why would any rational investor ever buy one?
Hi Joshua,
I’ve been reading about capital-intensive businesses and from what I gather, their cash guzzling nature makes them inherently unattractive for a long-term investor who would expect significant cash flow. Warren Buffett has been snapping these up because he already has fountains of cash, but what of the average investor? Personally I would hate it if my holdings were diluted as the company needs more capital. Why would anybody want to invest in these for a decade or two at all? Your comments would be a great help. Thanks!
Akshay
As you correctly point out, the wealthier you are, the more sense a capital intensive business can make because it has barriers to entry that protect your investment. There are several reasons someone might invest in a capital intensive business under certain circumstances.
First, imagine an environment when interest rates are high, and have been high for a long time. Businesses that require a lot of capital often have a lot of expensive debt. If you knew there was a good chance interest rates would fall over a longer period of time (e.g., with interest rates through the roof during the Volker era, as inflation began to moderate, it was a good bet that things would correct to the mean at some point, though the actual timing was impossible to predict), buying a large stake in such an asset intensive business might turn out to make a lot of sense if you’re looking quite a ways out to the horizon. As interest rates come back to Earth, the business might have an opportunity to substantially lower its cost structure as it refinances high-rate debt into low-rate debt, all that excess money dropping to the bottom line. This can substantially, sometimes shockingly, increase owner earnings, resulting in a much higher intrinsic value. While this is also true of non-capital intensive firms, the effect is not always as large.
Second, certain types of businesses are inherently more stable than others, offering a quasi-bond-like annuity stream. A successful start-up company – think Starbucks, which turned $100,000 into $10,000,000+ over a couple of decades – is amazing but had a Great Depression hit in those early years, the local water company would have been safer, pumping out (literally) money upon which your family could live. In some cases, these stronger, asset intensive businesses could even be the thing providing the dry powder for you to increase your ownership of better businesses during times of distress. Owning a mix of assets can make a lot of sense because you don’t know what tomorrow holds.
Third, asset intensive businesses can sometimes provide protections against inflation depending on the type of assets that sit on the balance sheet. Machinery and equipment? That’s bad. Real estate? Probably fantastic if the currency goes to hell. If you own a 14,000 acre farm of some of the best land in the country, even if the currency falls apart, you still have wealth. The land is wealth. Sure, your cattle operation might not be returning as much as a comparable investment in Microsoft but you can live off the beef, grow vegetables, grow staples such as cotton, build shelter, and more. Iowa farmland, by way of example, has actually mirrored the S&P 500 results over the past few generations. If you made it a policy to buy more whenever you had the chance, expanding your family’s farm, you’d have done very well despite what appeared to be low returns on capital. I think it’s a bit in the overpriced territory at the moment, but it’s a compelling asset class if you buy it for the right reasons and plan to pass it down indefinitely.
Fourth, sometimes asset intensive businesses experience a fundamental transformation that makes them no longer quite as asset intensive, which means intrinsic value grows, or the economic characteristics of the product/service sold changes, making them more lucrative. Look at the railroads over the past 25 years. Massive productivity gains from double-stacked cars and improved scheduling with the aid of technology has allowed a lot higher returns on underlying capital for the major lines. That has shown up in the net worth of owners.
Fifth, sometimes an asset intensive business holds a very valuable subsidiary that can be released during a restructuring. One of the best investments in the past century was Kansas City Southern, a railroad that started a mutual fund company. The mutual fund business ended up being a gold mine for a time and some people got very rich by paying attention to the hidden gem on the balance sheet before other folks noticed.
Sixth, sometimes an asset intensive business can be faster to grow with limited equity because you can borrow money more easily as the lenders take the assets for collateral. Gaining the benefits of scale quickly can be transformative to an entrepreneurial family. Think of a hotel in a desirable location. If you build a hotel, sure the return on assets isn’t as good as a chocolate maker, but the fact you can borrow 60% or 70% of the purchase price, maybe even use mezzanine financing, and be in business in fairly short order might make it a good decision on an opportunity cost basis, especially if you have the foresight to know that a particular area is going to be built up in the future. Yes, it’s riskier, but a good operator knows when to take risk and when to avoid it.
Seventh, sometimes a firm-specific problem may make an asset intensive business cheap. Buying a mediocre company at 5x normalized earnings growing at 3% under the right circumstances can be a better option over a 3-5 year period than buying a great business at 30x earnings growing at 6% under the wrong circumstances. Where that dividing line happens requires a lot of math, accounting, and good judgement (it’s almost always better to go with the superior business) but it does exist.
Reader Comments (8)
Comments are presented chronologically, with replies indented beneath the comments to which they respond.
Gilvus
August 20, 2014
On your first point: If we flip the situation (i.e. low-interest rate environment regresses to the mean), would owner earnings take a hit as low-rate debt is retired and the company assumes higher-rate debt to continue operating? Or maybe the companies would increase prices industry-wide, thereby preserving owner earnings?
David
August 21, 2014
Hey Joshua, I had a question about something that appears to be of a similar nature that would concern a private operator.
In a comment long ago regarding getting into certain businesses you said:
"Oh, and there is noway in HELL I'd own a gas station. Those are crappy, crappy businesses. Terrible returns on equity. Horrific. Silence of the Lambs horror."
1. In response to this, I would ask what you think about buying a gas station for say 4x earnings? On an ROI basis, it would seem ok for a while, but by your comment are you implying that over time, the capex needs would steadily erode the roi due to the poor returns on capital?
2. And if that is the case, does that mean that in order to make any money buying a gas station you would have to buy it below book value (But, it's just a fools game because eventually the capex needs would mimic the original poor return on equity? - I guess I'm just trying to think about it by comparing the acquisition economics vs the new buildout economics)?
Thanks for any guidance
SFrentier
August 21, 2014
Strange question. Real estate is an, ahem, asset intensive business and is purchased on a regular basis as a successful investment by many individuals, funds and corporations. Many people ( inc. moi) derive our income from real estate, not to mention build substantial equity positions in our assets. Not sure why this is even a question.
Dave
August 23, 2014
Replying to SFrentier
Apples and oranges...
SFrentier
August 30, 2014
Replying to Dave
Why? Both are businesses. Both need to be run optimally to succeed.
Akshay
August 22, 2014
I guess that the returns on the purchase would be determined by the earnings multiple paid and the return on incrementally invested capital. The "safety" aspect would be determined by the demand-supply variations over time. One would have to stay alert for any changes in technology which may render the asset worthless. A perfect example could be a coal-fired power plant, which would only do well if it can produce electricity at a lower price than other sources and there is enough available demand over the long term. This may not be the case if solar/wind energy achieves sustainable grid parity and people begin generating electricity in their own homes. Real estate would be a fabulous asset to own provided that the rental yield is high enough and occupancy is guaranteed for most of the time- no wonder places near NYU command higher prices. Profits don't mean as much in capital-intensive businesses as free cash flows. I believe that over really long period, one would only get a satisfactory return if the return on incremental capital is high. Otherwise, it would be like a cigar-butt investment which would only pay-off initially because of the high earnings yield.
hillspet
August 23, 2014
Replying to Akshay
Very Intelligent thesis, wish more ppl were like that, pros & amateurs alike. I do think though that while FCF is one of the best indicators for any business, eventually profits do matter as well (if not equally as much in the long run). After all a good company should eventually translate all that FCF into steady profits as well. (Again depends on a case by case basis I know) but speaking in general terms.
IMO any business can be a good investment in the right situation & price (lol If you give me 100 shares of Radioshack for FREE by all means I'll take that bet). Even though I agree with your statment that it would only pay off early on, there are MANY cases where selling just because it reached I.V. would have been a horrible idea.
A person buying Exxon Mobil (A very Capital intensive company) after the Exxon Valdez disaster due to the extreme drop in price & selling when it reached close to or at fair value, would have made a TERRIBLE mistake (That's putting it lightly). Also don't forget the first billion dollar company ever was U.S. Steel & it was the Apple of its time, it was a true growth company in its heyday, the same for the fallen giant Bethlehem Steel. If you just ignored these 2 companies because of there capital intensity, you would have missed two great investments. A more recent example would be Nucor Steel. A great low cost producer ina capital intensive industry.
While I would love to own multiple rentals or REIT's they still have inherent risks just like any investment.No one 50 years ago would have belived what would happen to the future of Detroit in property values. Granted it was not overnight, you had to be pretty stupid to never notice what was happening over decades. To the NYU example, if something bad ever happened to NYU, this would take away all the value of the property including the pricing power, and predictablity. Granted, highly unlikey, but the same could've been said of Detroit.
And while I 100% agree with your theory on the coal mine obsolence this EASILY can happen in a low capital company just as much if not quicker. A company like LinkedIn or Facebook are not capital intensive on things like PPE or COGS but can EASILY get wiped out in afew months. (ie Myspace) Or a company like Apple (look no further than Blackberry) & don't forget Apple was on the verge of bankruptcy in the late 90's as well.
Akshay
August 26, 2014
Replying to hillspet
True. That's why it makes sense to invest primarily in those companies with high returns on incremental capital since these would translate into fat profits in the future.
That said, even Exxon is cutting back right now and returning cash to shareholders because it's becoming so hard to extract oil cheaply and profitably nowadays- so its better to return that cash to shareholders rather than invest it for low returns in the future.
I love that you brought up Nucor steel- a perfect example of why low-cost producers always have that extra margin of safety even when there is oversupply and prices are so low that the competition is getting wiped out, generating the environment for bumper profits when demand returns.
While I agree that companies which are not capital-intensive can also get wiped out (faster- if I may add- than coal power plants), the advantage a company like Facebook has is that it can swiftly adapt to the changing environment without investing tons of money- as it has recently with its mobile-first strategy. A coal power plant has already invested billions to set up the facility, chosen a location after years of planning and committed itself to long-term supply contracts- all of which would take years to undo, not to mention several billions of dollars more. Also, good luck to it getting back the money it had already sunk into the original plants.