This is in continuation with the previous post which can be read here. Basically, in the last post we tried learning what effects could operating leverage, business cyclicality and competition could play on business when they act harmoniously – as they often do. Today we would try to understand a bit deeper that which type of businesses has these as its recurring phenomenon and how should we think (or should not think) about these.
Knowing these businesses
Though I can explicitly spell out of the names of those industries which we know by and large faces these but that is not what we want to achieve. We rather want to understand the factors which make them so. But we can use these ‘infamous’ industries as our examples.
- Fickleness in margins: This is easiest of all to tell. Just look at the trend of operating margins (operating margins is basically revenues which underlying business generates less expenses incurred to earn these). If as a % of sales these show high levels of variations over 5-8yr period, it may be an indicator that the business has relatively higher levels of operating leverage though not necessarily be so.
Remember, our previous example? India cements earned 9.7% margins in 2005 and 14% in 2007. Its long history shows much higher levels of variability in margins
- Commodity-type business: Generally, these businesses would be the producers / suppliers of products which are not differentiated products sold on the basis of weight and where brand name has less to do with. These products are widely available.
Think of how we go about buying potatoes. Do we even care to think which farms are these coming from or who their producer is? We just buy them if they are looking okay. Same goes with cement, steel, milk, etc. We just ensure that underlying quality is not bad. Nothing beyond that. For slightly better-than-average quality of output we may pay a bit of a premium but that is related to the price of the ‘averages’ i.e. price of average quality product act as a reference point for our willingness to pay the premium.
On the other hand, do we ever think on similar lines while buying a Cadbury chocolate or Maggi noodles? Do we compare the MRP printed on those packets with the MRP of other chocolates or noodles available in the market? Probably no. To us, these are distinguished products and something which is not meant to be compared with other ‘generic’ chocolates or noodles available in the market. In other words, these products command pricing power which milk, cement, steel does not command.
- Volatile demand scenario: In point (i) we talked about margins being volatile. One of the reason of them to be so is that their selling prices are quite variable. In India, over last five years we have seen, for example, prices for a bag of cement has been fluctuating between Rs 200 per 50kg bag to Rs 350. Such wide variations in prices leads to volatility in margins. And the reason why prices are so volatile is that demand of the end product is itself quite volatile. So if construction activities are on the rise, supply of cement will fall short, temporarily, of the demand for it. So either till the time new manufacturing capacities become operational or the demand stays at above average levels, one is bound to see cement prices staying at elevated levels.
Generally, in these businesses demand is bound to stay volatile – peaking at some point in time and then falling back to average kind of levels which causes mis-match in demand-supply equation from time to time.
- Competition: Though as consumers, competition is good to an extent. But too much of it plays spoilsports for the prospects of the industry as a whole (and in some cases even lead to adverse consequences the consumers.. remember adulteration? Too much of anything is harmful – even competition. Regulators need to be vigilant for such practices becoming main stream).
Given the commodity nature of these businesses, one is bound to see hundreds of companies operating in the industry leading to intense rivalry being developed amongst them and prices being gravitated to lower levels from time to time taking profits for a hit. Had there being just one or two companies making and selling cement in the country, cement would have been one of the most profitable business to be in – just like oil has been (and would remain to be in the foreseeable future) for OPEC nations. Till the time they have the ability to adjust supply to demand, price is bound to stay in artificially established ‘equilibrium’. It may not work all the time, but it certainly works most of the time.
These are just some general pointers about such businesses which could act as clue for us. A business displaying all of these characteristics would probably fall in the category we are trying to study and which Buffett would probably term as ‘Gruesome’.
Now since we have an approximate idea of how these businesses look like, we can move to the next section of how to go about valuing these and this is what is challenging. Due to the presence of operating leverage, volatile demand of end products leading to wide swing in realisations and cut throat competition, earnings are bound to be volatile.
And if the earnings are so volatile, then how should we go about valuing these? And if its earnings cannot be measured with accuracy, should we leave them aside and not consider owning them?
These are some interesting questions which would need some own space of their own which means there is yet another post to go for us to go before we wind-up this discussion.
Thanks for reading & happy new year!