#6 Investing 101: Businesses To Avoid
So far, we have established that investing is best when it's about buying exceptional companies at attractive prices. Some businesses, however, can hardly be exceptional and you should avoid them.
I am going to tell you something that may surprise you:
I have made most of my money not on stocks that I thought would be big winners, but on stocks that I thought wouldn’t be losers.
Put another way: Investing is more about avoiding losers than picking the winners.
This is not a mere platitude, it’s supported by math:
You need 233% gain to make up for 70% loss in a position. Meaning, a big loser in your portfolio can easily create a disaster for your portfolio even if your other picks were good.
Imagine that one big loser being your biggest position… Your portfolio will be underwater regardless of others’ performance unless one of them hits the jackpot.
To the contrary, even if all your positions deliver mediocre returns, one big winner can create wonders.
Avoiding bad businesses is as important as picking the good ones.
It’s so simple: The worst thing you get from a good business is underperformance but a bad business can result in a permanent loss of capital.
So far in this email course we predominantly talked about:
How to spot exceptional businesses?
How to buy them at attractive prices?
How to minimize the risk we take by picking businesses?
Now we are going to talk about how to avoid bad apples so they don’t ruin your portfolio of exceptional businesses.
Luckily, a story of one of the worst investments of Warren Buffett includes all three essential lessons to avoid lousy businesses! We will go through this story and extract these lessons one by one.
So, let’s cut the BS and dive in!
I divide investors into two groups:
Those who know buying Berkshire Hathaway was one of Warren Buffett’s big mistakes and those who don’t know it.
Don’t believe me? Hear from the master himself:
The question is simple: Why does Buffett think buying Berkshire Hathaway was a mistake?
Well, let’s go back and look at what Berkshire Hathaway was actually doing when Buffett bought it.
Buffett first started to invest in Berkshire Hathaway in 1962. He was still running the Buffett Partnership back then and was still investing in the way that Benjamin Graham taught him: Buy businesses that trade below their net current asset value.
The essence of this strategy is very simple:
Net current asset value = Current assets - Total liabilities
If the per share stock price is lower than the per share net asset value, the business is basically trading at an absolute discount. Meaning, if you buy the whole business and quickly liquidate it, you will get more money than you paid.
Thus, downside was very limited in this strategy and upside was high because the business could turn around, start making more money and the stock price goes up.
In 1962, Berkshire Hathaway was trading below its net asset value. Amazing fit for Buffett Partnership’s portfolio. Buffett started buying it at $7.50 per share.
It was a troubled textile business that sold fabrics and other raw textile materials. It was closing some of its mills.
In 1958, North Adams Transcript had announced Berkshire’s closing of its mill in Adams County, Massachusetts:
High costs and a changing mode of living were the two major factors in sealing the doom of the Adams operation, [Berkshire Hathaway President Seabury] Stanton said. He explained that there has been a marked shrinkage in the use of the type of goods made at the Adams mill, which he described as always having been "a high cost mill."
"The demand for the goods made at Adams has slumped substantially," he said, "because those goods do not lend themselves to the wash-and-wear finishes wanted by our housewives. They simply will not buy fabrics that they cannot throw into their automatic washing machines. The trend is away from the sheer goods made at Adams, and there never will be a return to the old demand'"
-North Adams Transcript, May 7, 1958.
Closing of mills was the actual reason Buffett bought this business. He anticipated that as the company liquidated textile mills there would come a tender offer when he could sell the shares at a profit. He was basically looking for the failure of the business, not its success.
A year later, in 1963, Buffett had raised his stake in Berkshire to 49%. In 1964, the offer Buffett was looking for finally came: The President of the company, Seabury Stanton, offered Buffett $11.50 per share for his stake in the company. This was 53% higher than his original purchase price. Buffett agreed to the deal.
Few weeks later, Buffett received the official offer in an enclosed envelope. He opened it and instantly got pissed! Why? Because the offer was 13 cents lower than the price they agreed to. Instead of $11.5, Stanton was offering $11.37 per share. This was not a matter of price, it was a matter of principle.
What did Buffett do? He turned on the “GOAT mode.” Instead of selling, he bought more shares, took control of the company and fired Stanton.
There was a problem though: He was left with a controlling stake in a declining textile business.
He could have liquidated it for a quick profit or he could have kept running it and take whatever the business generated in cash-flow and invest it in other business. He picked the latter. He never thought of investing back in the textile business and growing Berkshire’s textile operations.
You are probably asking: What’s wrong with the textile business? Louis Vuitton is essentially a textile business, Zara is a textile business and they are extremely profitable.
Well, the question reveals the answer: Raw textile business lacks what Louis Vuitton has: A brand.
Brands like Louis Vuitton take raw textile materials and put a brand on them, a personality. From there on, the price of the product is not determined by the market forces, it’s determined by how much people want to associate them with the properties of the brand. Brand Name creates “pricing power.”
Companies producing commodities don’t have that pricing power and raw fabric is a commodity. You can’t charge for it much more than what the market dictates.
Imagine you want to buy rice. You go into a grocery store and see 10 different brands offering the exact same type of rice you want. Which one would you pick? Most people pick the cheapest one. Why? Because it doesn’t matter. Once you get it out of the package and serve it as a meal, nobody can see the brand. It doesn’t promise any feeling.
On the contrary, the decision between a Louis Vuitton bag and a similar bag in the discount section of H&M is not a price decision. It’s apples versus pears.
Not many people think it’s stupid to buy a Louis Vuitton bag because it’s 10 times more expensive. But if you buy rice that’s 10 times more expensive, everybody thinks you are stupid.
Result? In price sensitive industries, it’s hard to make a lot of money if you are not the lowest cost supplier.
Beyond that, even if you are the lowest-cost supplier, you don’t consistently make more money over the long term. Why? Because the lowest-cost supplier position is hardly defensible. Somebody will come up with a cheaper real estate, he will pay less to his workers, and will underprice you.
When you look at a business, do this hypothetical test: Ask whether the business will lose significant business if it hikes prices 10% overnight.
If the answer is yes, be very cautious and, if possible, avoid that business.
So, we have our first lesson:
Lesson #1: Avoid price sensitive industries.
The rest of Berkshire’s story reveals another very important lesson about the businesses to avoid.
You just need to look at what Buffett did after he acquired the control of the company.
As we mentioned above, he had two choices:
Liquidate the company.
Take out the cash-flow and reinvest in other companies.
He picked the latter.
Why? It goes back to the first point: If your prices are dictated largely by the commodity market, it’s really hard to generate a decent return on investment so the business keeps growing in the long-term. Competition is a big limitation.
That applies to some other good businesses too. Example? Newspapers.
Until the age of the internet arrived, newspaper businesses, especially the local newspapers were amazing businesses.
Why? Simple. If you are the dominant newspaper in town, your future cash flows are largely guaranteed. It’s because:
People don’t read 10 newspapers a day.
People don’t change their newspaper often.
All the talent tends to accumulate in the dominant one.
If you owned a dominant local newspaper in the 1970s, you could slightly increase your price every year without losing many readers. That would have given you solid and consistent growth for decades.
There was a problem though: You couldn’t reinvest the excess capital back in business and expect a high return.
What would you do? There are only so many people who could read a local newspaper. If everyone is already reading yours, you don’t have anywhere to go.
Buffett had this problem first with Berkshire. What did he do? He bought better businesses with the money Berkshire generated. He bought Buffalo Express, a dominant local newspaper in Buffalo, NY.
That was a terrific investment. Buffalo generated more than $1 billion in dividends for Berkshire. The problem? You couldn’t invest that $1 billion back in a local newspaper and expect +20% return. This was a problem and he learnt that he shouldn’t invest in businesses that can’t generate sufficient incremental return on investment.
If the business is able to earn high return on capital, and if it deploys larger amounts of capital generating the same high return, it’s an exceptional business.
As Buffett puts it ‘such a business becomes a compounding machine.’
Buffett’s acquisition of GEICO demonstrates all these virtues:
Unlike Berkshire, it can earn high returns on capital.
Unlike Buffalo News it can keep reinvesting ever growing capital and generate high returns because car insurance is a huge market and not limited to a geographic area.
Profitable businesses are good, businesses that can generate high return on capital are better, the ones that can generate high returns on ever larger capital deployed are exceptional.
This makes the second lesson self-explanatory:
Lesson #2: Avoid businesses that can’t generate high returns on capital.
Just as the second lesson is connected to the first one, the third lesson is also connected to the second one.
You should have already realized it if you watched Buffett’s speech about return on capital to its end.
The business should generate high returns on capital but it’s really hard to do if maintaining existing operations eats away most of the cash.
Think about it: Which one costs more to maintain: A steel factory or a soda business?
Don’t need to speculate. Let’s go through the balance sheets of US Steel and Coca-Cola:
In the last twelve months, US Steel generated $16 billion revenue and spent $2.5 billion in capital expenditures, 15% of the revenue.
In the same period, Coca-Cola generated $46 billion revenue and spent $2.1 billion in capital expenditures, a minuscule 4% of the revenue.
US Steel’s revenue is nearly 1/3 of Coca-Cola’s revenue yet it spends three times more on capital expenditures than Coca-Cola.
Result? Coca-Cola has way more cash to invest relative to its earnings than US Steel.
Even if we assume that both companies generate the same return on investment, capital light one will compound at a faster rate than the other because it simply has more money to invest relative to its size.
Buffett emphasized this many times in his speeches:
If the maintenance of the business doesn’t require much capital, you can use the free cash to invest in many ways such as expanding operations, acquiring new companies, breaking into new markets etc…
And given that, in the long term, your returns on your investment in the company will be similar to what the company makes on its own investments, lesson three manifests itself obviously: You don’t want to own the businesses that require a lot of capital just to maintain its operations, you want to own the ones that can profitably invest their free cash.
Lesson #3: Avoid businesses that require huge capital expenditures.
🏁Conclusion
It’s amazing that one story from the greatest investor of all times can reveal many important lessons about what to avoid in the market.
It’s especially interesting given that one essentially bad investment is now what he is best known for.
This is the beauty of investing though. You can make mistakes. As long as you learn from your mistakes and don’t repeat them, investing can tolerate many mistakes.
Buffett made one big mistake but he learnt three critical lessons:
Avoid price sensitive industries.
Avoid businesses that don’t generate high return on capital.
Avoid businesses that require huge expenses to maintain business.
It’s great that we have an opportunity to learn from the mistakes of great investors.
You don’t have to repeat his mistakes to learn. Whenever you look at a business ask yourself:
Is it price sensitive?
Does it generate low return on investment?
Does it require huge capital expenses to maintain operations?
If you answer “yes” to one of those questions, you probably will be better off looking at other opportunities.
There are endless opportunities out there, you don’t need to own a specific company to create miracles in the market. Just look elsewhere, you will find something!
Great piece! The key takeaway is to invest in companies that can continuously deploy capital at high return on investment.