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?
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!
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.