Notes on long term thoughtful investing

Tag: Operating Leverage

Part 3: Summing it up!

This post is the final part of the topic that was started sometime back. Part 1 and Part 2 are available here and here. So we now know what makes some of the businesses ‘gruesome’ – a combination of high operating leverage, volatility in demand and presence of intense competition is surely not a good recipe for long term wealth creation. But if so, then why study them in the first place? For the simple reason that market from time to time offer these businesses at throwaway prices – like selling a dollar bill for twenty-five cents! And this is when things become exciting.

Even if underlying earnings or manufacturing capacity increase modestly, change in market’s perception – as it does happen from time to time – of the business offers a 4x opportunity in itself to the stock holders as twenty-five cents regresses towards its dollar mean. Though it is not as easy as it sounds. One needs to understand the situation well and remain patient for not just for some months but most of the time, a couple of years.

Doing your valuation work right is the most critical thing when it comes to investing and more so in these cases where underlying business conditions are fickle. Yet, it is interesting to think about how little emphasis some of the ‘professionals’ place on understanding this part of the equation. And that’s probably a topic for discussion on some other day.

The discussion which follows requires deeper effort and is a bit dry. So its time to buckle up 🙂

‘Invert, Always Invert’

Jacobi, a German pioneer in algebra, knew that some hard problems are best solved backwards. Charlie Munger took this concept from the domain of algebra and explained to us how this principle could be used at a variety of places.

Peter Bevelin documents further explanation of it given by Munger in his book Seeking Wisdom. This is what Munger said –

The mental habit of thinking backward forces objectivity – because one of the ways you think through backward is you take your initial assumption and say ‘let’s try and disapprove it.’

We can try to use this concept to analyse the case in hand. So instead of answering what all things we need to do right in order to have a positive outcome, we can ask ourselves what all things one needs to do in order to lose all or substantial portion of his money in such stocks.

  • Owning the highest cost producer: We know that businesses here go through considerable period of stress when supply overshoots demand – which is also a common, recurring feature here as there is hardly a prolong period of equilibrium in these industries. And if supply is considerably higher than demand and is expected to remain so for quite sometime, there would inevitably be production closures. And it is most the inefficient producers who go out of business since they are ones which are generating below average earnings to sustain their operations during a very stressful period for the industry. Owning a company which falls in the bottom quartile of the cost curve is surely a good bet to lose all your money in highly over supplied industry.
  • High levels of debt: During the period when demand is outpacing supply, these businesses make significant profits. This, when combined with a scenario of further acceleration of demand, induces the producers to add further capacities. Some of the producers, displaying excessive dosage of confidence, come up with aggressive expansion plans in order to corner higher market share for the projected future demand. Needless to say, they are generally funded by their credulous lenders who blesses company’s demand projections & profit estimates. And when clock strikes midnight, music stops and party is over. It is then that these companies (and their lenders) find themselves in knee deep troubles.

It is not surprising to know that steel sector today contributes a significant portion of overall NPA of the banking sector as a whole. Getting in businesses which along with high operating leverage also has higher levels of financial leverage is a sure shot way to risk losing all your money

  • Extrapolating current earnings and thinking them to be sustainable: We know that earnings of these businesses are highly volatile. Given that industry is rarely in an ‘equilibrium’ kind of a situation, earnings too are not in their stable state of affairs for long. So mistaking current earnings to stay so for next five years during the boom times (and vice-versa during stressful periods) would lead to erroneously valuation. And acting based on that can hardly be considered wise.
  • Mistaking structural changes for cyclical ones: While no one can accurately predict what could be the demand situation one year or three down the line, if the demand supply mis-match is not acute i.e. it is in a ‘comfortable range’ of say something like 75 or 80 (demand) to 100 (supply) kind of a ratio and if demand is on a generally rising ‘trend’ such that after averaging the peak and trough demand over the cycles would tell us that industry is growing on something like 7-8% in volume terms each year and after taking stock of future supply increases, one may not be wrong to expect that demand could exceed supply or be atleast be in more favourable range over next 3 to 5 yr period and hence could look into the situation on those lines.

Here the inherent assumption is that demand is cyclically weak but it is structurally strong – as the trend would suggest.  However, sometimes that may not be the case necessarily. So if tomorrow there is rising adoption of cleaner-greener solar energy, coal demand could face structural headwinds. Another example could be that as cost of making and operating electric car falls, we may not need as much oil as we are consuming today. All this means that trend may no longer be growing and infact, it could be shrinking. And thereby escalating the problems in an already oversupplied market. Investing in such situations, instead of staying ten feet away from them, is another way to lose money.

  • Entrusting your money to bad capital allocators: There are some exceptional managers who despite being running their business in such hostile conditions manage to create significant wealth for their shareholders over a long period of time. Generally, these are ones which have an excellent understanding of their business and exercise strong discipline in terms of where & how they spent their efforts and resources. Investing in companies which are polar opposite to these kinds is just the right way to let them squander your funds.


The list of don’ts rightfully exceeds that of do’s. How I generally proceed to arrive at a go/no-go decision is first trying to understand underlying demand supply situation, rank how efficient is the company in terms of its cost competitiveness (and hence its staying power), avoid the ones which have higher levels of debt, look for managers which have intense focus on cutting down costs and go through their capital allocation track records.

Instead of valuing them based on their earnings and getting in the ‘prediction game’ (where one has depressing odds of success), I rather look to arrive at an estimate of its replacement cost of the assets it owns, reduce it by the money it owes to outsiders and compare that resulting value to the price at which market is valuing it. If there is a significant mis-match and things on the business side could improve significantly over next 3-5 years, odds of success could be really good. Of course, things could go wrong and this is why one needs to understand the situation well and buy it at significant discount to its fair value.

This discount serves the dual role of cushioning our investment from any wrong assessment we would have made while also serving as significant return contributor if market starts valuing the business efficiently.

Ben Graham said it best when he said every stock is worth owning at certain price and should be sold at some another price. Investing involves understanding underlying expectations of the market and acting if things appear to diverge significantly from underlying reality – as they generally do from time to time. Infact, this divergence is the chief reason behind the bubbles and busts which are a commonplace in the stock markets around the globe.

Such ‘dreadful’ businesses are usually the prime victims of market’s whims & fancies due to their underlying volatile business conditions. And hence a fertile ground for people like us looking for bargains and who are disciplined enough to stick with what we can understand.




Part 2: Dreadful Business Combinations

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’.


The challenge

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!

Part 1: Dreadful Business Combinations!

Let’s start today’s discussion with a short quiz. Which of the following two companies, in absence of any other information, would you like to own?

You might feel as if things are rigged in favour of Company B! But that is what it is. B happens to be better in every aspect as against A. They both operate in the very same industry, at the very same geography, with similar asset & consumer base. Trust me, similarities are abound between these two.. because they are one and the same company! Yes, company’s name is India Cements. Column A has its reported numbers for the fiscal year 2005 and B represents what it did in the year 2007.

Before you think of hitting me, scroll back to the title of the post. We are here to discuss about some ‘dreadful’ business combinations or business characteristics which can (and does) take underlying business for a ride from time to time and how should we think about these as long term owners.


Understanding operating leverage

So what is this thing strange stuff called ‘operating leverage’ and what it has to do with the above example?

Without falling back upon text book definition, let me give you an example about it. Imagine there is swanky new residential complex planned in outskirts of the town. You happen to be the lucky one eligible to receive a permit to build a descent sized general store just opposite to this particular project. So you have your store up and running while the project is just weeks away from final completion after which several families are expected to move here. And after 12-18 months’ time there would be enough guys living in this locality that you start cribbing about traffic jams 🙂

Now, at the very first month of opening the store, your income statement would be quite under red since whether or not customers start flowing in, store rent has to be paid out – just like some other maintenance expenses. And things would continue to be more or less the same over next couple of months. But once the store has celebrated its 2nd birthday, you would be at peace to see the $$ coming. Why so, what has changed? So while your rent, staff cost, electricity and other overheads being more or less the same, increase in footfalls has led to higher inventory off-take which means higher commission earning and your bulk buying from distributors would mean that you are even eligible for some volume discount. And since your inventory are now selling quicker, you are able to convert stock into cash faster than other retailers which means you are paying early enough versus other retailers to your distributors thereby making you eligible for sweet little cash / early payment discount.

As investor, if you were to look at the initial financial numbers of this particular store say of first three months, the losses staring back at you from the income statement would suggest that it was a big time mistake in the first place. And the financials of the last three months before the end of second year would surprise you such that you may find it difficult to tell if they belong to that very store.

There has been no turnaround in the store owner’s fortunes. It is just that his business is such that most of costs are fixed and there is particular threshold of sales over and above which it starts earning money. If footfalls are expected to sustain at its current levels, it would mean that store would continue to earn those returns in the foreseeable future and those initial losses are a history.


Operating leverage, cyclicality in business earnings & intense competition

It is one of the most dreadful combinations in the business world – you can face them individually but together they can take the bottom line for a spin. Remember the example of the ‘two’ companies above?

To explain the point, let’s take our store example further. Your store looks good since its footfalls are expected to sustain at the current levels, margin spread is more or less stable and your location is pretty close to the residential complex. Now, what if there are ten more stores opened up adjacent to your store selling the very same merchandise as your store offer? Competitive rivalry would be intense which means footfalls would turn to quite volatile – fluctuating between 250 walk-ins a day to 25 depending upon the offers you dole out. This would invariably reduce your margins are well. And remember your major cost items, apart from inventory, like rent, salaries, electricity are fixed. And this means that your bottom-line is meant to show severe volatility from bursts of lucrative profits (say due to some differentiated merchandise which takes off and which other retailers don’t currently have) to prolonged period to stress.

This is exactly why this combination is very daunting (and also why you frequently do not see ten store selling same merchandise side by side in a tight locality). But there are some businesses of which these three are more or less the regular factors. Analysing these is challenging for us who are looking to own under-priced securities.

Which are these businesses? What all factors should we consider while evaluating them? How to be sure that we are not over paying for these? These are some of the questions I would try to answer in my next post which I hope would add to our understanding of such businesses.

They aren’t necessarily always bad as ‘investments’ (unlike their underlying tough business conditions), it is just that we need to clear our lenses with which we look at these and set our expectations straight while thinking about them.