Choosing the businesses with strong economics- Part 1: avoiding poor economics businesses

October 15th, 2008

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Yesterday, in Two uncertainties of valuing a business- risk & earnings, we mentioned that risk and earnings are the two uncertainties in valuing a business. As we said in that article,

However, not all businesses are the same. Some are so straightforward that it is very easy to have a very accurate estimate of their future earnings. Others are so complicated that any attempts at estimating their future earnings are at best rough guesstimates.

Today, we will start off with a mini-series about choosing businesses that have strong economics. Such businesses have relatively lower uncertainties regarding their earnings and are also much less risky. Businesses with weak economics are much more difficult to value because of their higher risks and earnings uncertainties. For today’s article, we will look at identifying such businesses to avoid.

First, what are businesses with poor economics? They are the ones in price-competitive industries. As this book, The New Buffettology explains,

A price-competitive type of business manufactures or sells a product or service that many other businesses sell and competes for customers solely on the basis of price.

Example of such business is steel making, agriculture and manufacturing of mass generic products like clothes hangers. If you see a businesses in which its customers’ strongest motivation to buy is price, then you know it has poor economics. For such businesses to survive and defeat their competitors, they have to beat their competitors in costs. To beat their competitors in costs, they have to continuously engage in ruthless cost-cutting measures and improvements in techniques to keep their businesses competitive. This often requires additional capital expenditures and energy to keep the wheels running non-stop, which translate to more long-term debt and less distribution of profits to shareholders. Often, cost-cutting measures and improvement techniques are easily replicated. Therefore, businesses in price-competitive industries end up under-cutting each other continuously, which erodes profit over time. For such businesses, good quality and intelligent management is crucial to keep the business profitable. Also, they are more prone to strokes of bad luck.

So, to be a successful investor, the first step is to avoid businesses with poor economics.

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  • Nixda

    I would certainly disagree with this. Take for example Wal Mart, Aldi or Ikea. The brothers running the privately held supermarket chain Aldi are allegdly the richest persons in Germany.

    I?d argue that cost-cutting measures and improvement techniques are quite often NOT easily replicated. In many businesses the cost cutting is complex a difficult too identify where to cut costs without impacting the value of your product to your customer.

  • Nixda

    I would certainly disagree with this. Take for example Wal Mart, Aldi or Ikea. The brothers running the privately held supermarket chain Aldi are allegdly the richest persons in Germany.

    I?d argue that cost-cutting measures and improvement techniques are quite often NOT easily replicated. In many businesses the cost cutting is complex a difficult too identify where to cut costs without impacting the value of your product to your customer.

  • Hi Nixda!

    Of course there are always exceptions.

    Another way to look at it is that the ‘products’ that Wal Mart sells is not ‘things’ that they manufacture. Rather, they are in the business of import-export price arbitrage in which they have a durable competitive advantage.

    The generic clothes hanger that the Chinese factories manufacture (and Wal-Mart import to sell) is the business with poor economics. Wal-Mart, just arbitrage the price between American clothes hangers and Chinese clothes hangers.

  • Hi Nixda!

    Of course there are always exceptions.

    Another way to look at it is that the ‘products’ that Wal Mart sells is not ‘things’ that they manufacture. Rather, they are in the business of import-export price arbitrage in which they have a durable competitive advantage.

    The generic clothes hanger that the Chinese factories manufacture (and Wal-Mart import to sell) is the business with poor economics. Wal-Mart, just arbitrage the price between American clothes hangers and Chinese clothes hangers.

  • Pete

    Short but helpful article, thanks Ed 🙂

    Nixda, I think you may have missed the point a bit. The point was more that certain companies may be more vulnerable to global economics than others, and in this article, companies that make profits based on price competition for products or services that are widely available.

    If Woolworths decides to drops it’s prices to compete with Aldi in Australia, how do you think Aldi would fare? Sure, Woolworths would need to completely restructure the way it does things, who it employs and probably take a huge cut on sale profit margins. However this is possible.
    The fact that Aldi is almost a lone star in the Australian supermarket field by competing solely on price rather than product variety or ‘freshness’, etc, makes it profitable ‘at the moment’. If Aldi came across a strong price competitor, it would likely end up quite nasty, as stated in the article, whereby the two competitors would undercut each other and go into debt, etc. At the moment, Aldi in Ausrtalia is safe because it has a bit of a niche market all to itself.

    I think the point to the article is really to say that companies that compete solely on price for fairly regular goods, are quite vulnerable to global economic shifts, as one small change may be enough to completely erode their margin of profit and make them unprofitable.
    Ed’s example being coathangers and Wallmart, so the arrangement Wallmart has buying coathangers may fall apart if there is a large shift in ‘terms of trade’ between the US and the manufacturing country, China. In this case, Wallmart’s competitor may have an advantage as they may source their coathangers from another country (say Mexico) where the terms of trade remained stable.

    The moral of this story, to me, is to avoid companies with poor economics, and to also avoid companies with slight and perilous profit margins that may be affected by global or domestic shifts in supply or demand. This is a good point, because it is not necessarily something that is factored in to ‘analysts’ forecasts of companies, due to their typically ‘stable’ outlook on global economics.

  • Pete

    Short but helpful article, thanks Ed 🙂

    Nixda, I think you may have missed the point a bit. The point was more that certain companies may be more vulnerable to global economics than others, and in this article, companies that make profits based on price competition for products or services that are widely available.

    If Woolworths decides to drops it’s prices to compete with Aldi in Australia, how do you think Aldi would fare? Sure, Woolworths would need to completely restructure the way it does things, who it employs and probably take a huge cut on sale profit margins. However this is possible.
    The fact that Aldi is almost a lone star in the Australian supermarket field by competing solely on price rather than product variety or ‘freshness’, etc, makes it profitable ‘at the moment’. If Aldi came across a strong price competitor, it would likely end up quite nasty, as stated in the article, whereby the two competitors would undercut each other and go into debt, etc. At the moment, Aldi in Ausrtalia is safe because it has a bit of a niche market all to itself.

    I think the point to the article is really to say that companies that compete solely on price for fairly regular goods, are quite vulnerable to global economic shifts, as one small change may be enough to completely erode their margin of profit and make them unprofitable.
    Ed’s example being coathangers and Wallmart, so the arrangement Wallmart has buying coathangers may fall apart if there is a large shift in ‘terms of trade’ between the US and the manufacturing country, China. In this case, Wallmart’s competitor may have an advantage as they may source their coathangers from another country (say Mexico) where the terms of trade remained stable.

    The moral of this story, to me, is to avoid companies with poor economics, and to also avoid companies with slight and perilous profit margins that may be affected by global or domestic shifts in supply or demand. This is a good point, because it is not necessarily something that is factored in to ‘analysts’ forecasts of companies, due to their typically ‘stable’ outlook on global economics.