In business school, you learn about two costs of capital: First there is the cost of debt, which is a function of interest rate and principal and time. Additionally, there is the cost of equity, which is a function of the opportunity cost of capital, or what you could earn investing the capital somewhere else (side note, there is a theoretical problem with the concept of cost of equity being opportunity cost of capital from the investee's perspective - that only works from the investor's perspective. That is another article). Next there is the weighted average cost of capital which is a way to average the two and create a hurdle rate for your projects, that you should exceed if you want to be profitable.
Capital in business is actually slightly more nuanced than that.
You can raise capital in other ways - for example, through revenues and profits. Tesla raised about $400,000,000 by collecting $1,000 deposits from customers toward the yet-to-be-produced Model 3. That is neither debt nor equity - instead Tesla is borrowing revenue from its customers with the promise to deliver them value in the future. Tesla's cost of capital is high in this regard in terms of implied promises to its creditor-customers, but that won't appear in any WACC calculation. If Tesla is able to deliver, the strategy will pay off. If it is not it could be disastrous for its goodwill and economic moat.
Amazon borrows from its suppliers by delaying their payments. Amazon is able to do this because it is a large and powerful platform.
There is also the marginal cost of increasing revenues, which is a test of the stickiness of your product. How much marketing does it take to produce 1% revenue growth? 10%? 20%? If little or no marketing spend is required to grow your revenues at a profitable level, and the business model is not easily copied, that is the sign of an excellent business worth investing in. (Note - sometimes that is just a sign of a novel business or business model which is not necessarily worth investing in. Think Groupon.)
Cost of revenues can also be in the form of declining prices and declining margins. Will lowering your price 10% result in a revenue increase of more than 10%? If it will, you likely sell a product with elastic demand and you may not be in a good business with strong long-term economics. For example, an airline could dramatically increase its revenues by dropping its prices, but not at a profitable level.
Finally, the worst way to raise capital is through borrowing from your loyal customers, but many businesses do this. BlackBerry is an example. Each of their last 7 or 8 product launches has been released at a very high price point to a dwindling number of core fans. BlackBerry makes steep marginal profits on their original products sold to those core fans. Unfortunately, there is little demand outside of the loyalists, so the phone or tablet must quickly see steep discounts in order to maintain revenues. Essentially, what BlackBerry is doing with this strategy is borrowing from its customers, with their loyalty as security for the loan. BlackBerry is saying, you have to pay us full price to get your phone when it comes out, but if you had waited two months you could have gotten it for $200-$300 less. That extra $200-300 that BlackBerry is collecting from its loyalists is no different than a short-term loan, which the customers pay to BlackBerry in hopes that its product will be good quality and have high demand. When BlackBerry was unable to repay those loans in the form of sustained product popularity in 2011-2015, it faced dire consequences because the loyalty that was "security" for those customer loans began to disappear. It would have been better for the company to reward its loyal customers by starting prices lower rather than higher, even though that would have had an immediate negative effect on its bottom line.
Friday, April 28, 2017
Monday, April 24, 2017
Profit Margins and Deadlines to Buy or Sell
One of the important things that determines whether a company is consistently profitable and earns high returns is how much pressure it has to sell its product quickly.
Each transaction in business involves a buyer and a seller. If the seller has to sell his items by a deadline or quickly, with low marginal cost to selling the items, the seller will be forced to cut prices toward the end of his selling deadline. This kills profit margins and creates a bargain-hunting concept among buyers. Two examples are (1) a hotel or airline, which must sell plane tickets before the cutoff time for the flight or the nightly stay; and (2) a produce company, which must sell its bananas before they turn brown.
If the buyer has to purchase items by a deadline, and the seller is under no obligation to sell by such a deadline, the seller will tend to have higher profit margins and higher return on investment, especially when the seller's products are unique or differentiated from the competing brands. Examples include a potato chip company such as Lays: The buyer has to purchase chips before he has people over to his house. He is under a deadline. The seller does not have to sell his chips by a specific time because he can control the supply and the items will last for weeks on the shelf without going bad. The seller is under no obligation to lower prices to get a quick sale, while the buyer is obligated to pay whatever sellers are charging when he needs the chips. So the seller has more power in this transaction and will command higher profits and return on capital.
Generally, whether the buyer or seller gets the better deal depends on the time that each has to buy or sell the item and the supply and demand for the specific item in question. These factors determine the seller's pricing power.
The concept of supply and demand as it relates to products that spoil is a fascinating concept. Take, for example, a cable company. The cable company in theory has a product that is constantly spoiling. Every day that a customer does not sign up for the cable company's service is a day of lost revenue for the cable company. But in most areas, there are only two or three cable companies available for customers to choose from. Therefore, demand exceeds supply and the cable companies have pricing power, which will bring them long-term profits. The same holds true with cell phone companies, which need valuable spectrum to be able to offer products to customers. Alternatively, could you imagine the low profit margins that would exist if there were 20 or 30 cable companies in each market offering the same channels? You would see extreme price wars among the companies, with customers being the only winners.
Sellers can differentiate their brands enough to overcome the negative pressures associated with selling deadlines so long as demand for the seller's product exceeds supply within the deadline time period. The key is the ability to limit supply. For example, the Four Seasons Hotel (should be) largely profitable despite the constant spoliation of its product because it has such a good reputation that the demand to stay in its hotel exceeds the average supply for most of its hotels on a given night. That means it has pricing power and therefore high returns on capital.
Each transaction in business involves a buyer and a seller. If the seller has to sell his items by a deadline or quickly, with low marginal cost to selling the items, the seller will be forced to cut prices toward the end of his selling deadline. This kills profit margins and creates a bargain-hunting concept among buyers. Two examples are (1) a hotel or airline, which must sell plane tickets before the cutoff time for the flight or the nightly stay; and (2) a produce company, which must sell its bananas before they turn brown.
If the buyer has to purchase items by a deadline, and the seller is under no obligation to sell by such a deadline, the seller will tend to have higher profit margins and higher return on investment, especially when the seller's products are unique or differentiated from the competing brands. Examples include a potato chip company such as Lays: The buyer has to purchase chips before he has people over to his house. He is under a deadline. The seller does not have to sell his chips by a specific time because he can control the supply and the items will last for weeks on the shelf without going bad. The seller is under no obligation to lower prices to get a quick sale, while the buyer is obligated to pay whatever sellers are charging when he needs the chips. So the seller has more power in this transaction and will command higher profits and return on capital.
Generally, whether the buyer or seller gets the better deal depends on the time that each has to buy or sell the item and the supply and demand for the specific item in question. These factors determine the seller's pricing power.
The concept of supply and demand as it relates to products that spoil is a fascinating concept. Take, for example, a cable company. The cable company in theory has a product that is constantly spoiling. Every day that a customer does not sign up for the cable company's service is a day of lost revenue for the cable company. But in most areas, there are only two or three cable companies available for customers to choose from. Therefore, demand exceeds supply and the cable companies have pricing power, which will bring them long-term profits. The same holds true with cell phone companies, which need valuable spectrum to be able to offer products to customers. Alternatively, could you imagine the low profit margins that would exist if there were 20 or 30 cable companies in each market offering the same channels? You would see extreme price wars among the companies, with customers being the only winners.
Sellers can differentiate their brands enough to overcome the negative pressures associated with selling deadlines so long as demand for the seller's product exceeds supply within the deadline time period. The key is the ability to limit supply. For example, the Four Seasons Hotel (should be) largely profitable despite the constant spoliation of its product because it has such a good reputation that the demand to stay in its hotel exceeds the average supply for most of its hotels on a given night. That means it has pricing power and therefore high returns on capital.
Friday, April 21, 2017
Operational Moat vs. Intrinsic Moat
A lot has been made of "moat" in the last decade and how it protects a company's return on invested capital.
Moat is the guard that stops other companies from stealing your profits.
Any company that consistently generates above-average returns on invested capital has some kind of moat. If it did not have a moat, then others would jump into the same business and take the profits and the return on invested capital would decrease.
The idea is that a company or brand is so entrenched competitively that it cannot stop making a profit.
Of course this is not true absolutely and on an infinite scale because all companies may eventually lose their competitive edge because of society's changes or poor management, and profit margins are constantly under attack through competition from others.
However it is true that some companies are so competitively entrenched and fortified that it would take years of poor management and poor capital allocation to erode their profit margins. These tend to be the companies with high brand recognition and brand loyalty. Obvious examples being Coca Cola, Pepsi, Doritos, Cheez-Its, Charmin, Dawn, etc.
The idea is that customer goodwill and brand awareness has been built steadily over a number of years, so that the brand will continue to have a positive perception among its customers regardless of current lazy or incompetent management. These brands have intrinsic moat.
On the other hand, companies may also generate high return on invested capital through operational moat. This is the moat generated by the current managers of the company being more competent than the managers of the company's competitors.
Whether a company has operational or intrinsic moat depends on the economics of the business and customer's loyalty to the brand. Businesses in industries with low fixed costs, uniform products, control over their supply, high profit margins and high customer loyalty tend to have high intrinsic moat. It is hard for competitors to take their profits because the businesses have huge marketing budgets and the customers won't easily switch.
In capital-intensive industries with low switching costs, a company that is achieving consistent profits likely has operational moat because of the intelligence of its management. This is a more risky investment, because the operational moat could evaporate if management leaves.
But a sustained period of operational moat can actually turn into intrinsic moat. Some examples: Google - search engine industry has very low switching costs, but through years of operational excellence, Google has built a loyal customer base that only uses Google searches and is unlikely to switch search providers. Apple - through operational excellence and innovation, has created millions of loyal customers who will buy iPhones for the rest of their lives. Facebook - through constant innovation and implementation of new features, has created billions of users that use Facebook as their primary means of online social communication. Wal Mart - a capital intensive retail business that created millions of loyal customers through its low-pricing strategy. McDonald's - another capital-intensive and low-margin business, that created high return on invested capital through years of effective marketing and strategic real estate purchases.
I am only using large company examples here, but many small companies also have moats based on their operational excellence.
Operational moats can result in high return on investment if the management sticks around. Intrinsic moats tend to last longer than operational moats, but not always. No company is protected forever by its moat.
Moat is the guard that stops other companies from stealing your profits.
Any company that consistently generates above-average returns on invested capital has some kind of moat. If it did not have a moat, then others would jump into the same business and take the profits and the return on invested capital would decrease.
The idea is that a company or brand is so entrenched competitively that it cannot stop making a profit.
Of course this is not true absolutely and on an infinite scale because all companies may eventually lose their competitive edge because of society's changes or poor management, and profit margins are constantly under attack through competition from others.
However it is true that some companies are so competitively entrenched and fortified that it would take years of poor management and poor capital allocation to erode their profit margins. These tend to be the companies with high brand recognition and brand loyalty. Obvious examples being Coca Cola, Pepsi, Doritos, Cheez-Its, Charmin, Dawn, etc.
The idea is that customer goodwill and brand awareness has been built steadily over a number of years, so that the brand will continue to have a positive perception among its customers regardless of current lazy or incompetent management. These brands have intrinsic moat.
On the other hand, companies may also generate high return on invested capital through operational moat. This is the moat generated by the current managers of the company being more competent than the managers of the company's competitors.
Whether a company has operational or intrinsic moat depends on the economics of the business and customer's loyalty to the brand. Businesses in industries with low fixed costs, uniform products, control over their supply, high profit margins and high customer loyalty tend to have high intrinsic moat. It is hard for competitors to take their profits because the businesses have huge marketing budgets and the customers won't easily switch.
In capital-intensive industries with low switching costs, a company that is achieving consistent profits likely has operational moat because of the intelligence of its management. This is a more risky investment, because the operational moat could evaporate if management leaves.
But a sustained period of operational moat can actually turn into intrinsic moat. Some examples: Google - search engine industry has very low switching costs, but through years of operational excellence, Google has built a loyal customer base that only uses Google searches and is unlikely to switch search providers. Apple - through operational excellence and innovation, has created millions of loyal customers who will buy iPhones for the rest of their lives. Facebook - through constant innovation and implementation of new features, has created billions of users that use Facebook as their primary means of online social communication. Wal Mart - a capital intensive retail business that created millions of loyal customers through its low-pricing strategy. McDonald's - another capital-intensive and low-margin business, that created high return on invested capital through years of effective marketing and strategic real estate purchases.
I am only using large company examples here, but many small companies also have moats based on their operational excellence.
Operational moats can result in high return on investment if the management sticks around. Intrinsic moats tend to last longer than operational moats, but not always. No company is protected forever by its moat.
Wednesday, April 12, 2017
Value Investing and Mathematical Precision
Traditional value investors tend to be left-brained and logical. They love the precision and certainty of buying an asset for less than it is worth. The "net-net" investment is a favorite of most value investors - buying stock in a company whose assets are worth more than the company's market cap.
This can certainly be a successful way to invest, and it does protect investors from some of the risk that all investors take that the economy could decline while you are holding your investment.
But "net-nets" and value investing are not the only way to invest. Ultimately, investors are attempting to buy a series of cash flows in the future for as little money as possible in the present. Value investors love the precision of being able to calculate the future value of their assets to the dollar or even penny. But precision should not be substituted for certainty.
The best investments involve the compounding returns that come from of investments in a business that grows over time. These cannot be precisely calculated, but they can be estimated. A lot of value investors shy away from the uncertainty of estimating future business performance, preferring to calculate something they are certain about, and they miss many great investments along the way.
There are some general rules we can use to estimate future business performance. This post attempts to list some of them. I am still hammering these rules out, and they will change over time:
1. When in doubt, assume the market has priced an asset or business as efficiently as possible given the available information.
2. Rule 1 is not always true.
3. If you believe an asset or business is priced inefficiently, you must try to find the reason why before investing.
4. People tend to act rationally as a group. You should assume that they will do so.
5. Customers are people. If it is not rational to buy a company's product, over time customers will stop buying it.
6. Brands that have a personality and are differentiated tend to make the most profits.
7. Businesses that get money up front before deciding on how to allocate their costs tend to have higher profit margins than businesses that are required to decide to invest large amounts of capital in their product before they make any sales.
8. Products with variable prices tend to have lower profit margins that products with fixed prices.
9. The market generally does not like uncertainty and lack of liquidity - these are two reasons why a company may be undervalued.
10. Newton found that "an object at rest stays at rest and an object in motion stays in motion (unless acted on by an unbalanced force." Similarly, an unprofitable company tends to stay unprofitable, and a profitable company tends to stay profitable unless acted on by an unbalanced force.
11. All companies are fighting for their share of customers, profits and future cash flows in an evolution-like game.
12. A company must adapt and improve over time, or its future cash flows will be eaten by other companies that offer better services.
13. The laws of thermodynamics also apply to competition in business, with "entropy" being the shift in returns on the capital investments among competing businesses: (1) returns on investment cannot be absolutely created or destroyed forever - they shift from business to business because of innovation and social change; (2) over time, the return on invested capital among equal, competing businesses with similar capital and equally competent management will gravitate toward equilibrium (I will have to think about this one).
10. Newton found that "an object at rest stays at rest and an object in motion stays in motion (unless acted on by an unbalanced force." Similarly, an unprofitable company tends to stay unprofitable, and a profitable company tends to stay profitable unless acted on by an unbalanced force.
11. All companies are fighting for their share of customers, profits and future cash flows in an evolution-like game.
12. A company must adapt and improve over time, or its future cash flows will be eaten by other companies that offer better services.
13. The laws of thermodynamics also apply to competition in business, with "entropy" being the shift in returns on the capital investments among competing businesses: (1) returns on investment cannot be absolutely created or destroyed forever - they shift from business to business because of innovation and social change; (2) over time, the return on invested capital among equal, competing businesses with similar capital and equally competent management will gravitate toward equilibrium (I will have to think about this one).
More to come...
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