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.