Sunday, May 27, 2007

The Investing Framework for Marginal Companies:

Today I will theorize a bit on the considerations that should be made when investing in marginal companies. A brief side conversation to define a marginal company because it is important to understand. A marginal company is any company that has a weak or no moat. I have a very strict criteria behind moat- it must be a clear and unassailable advantage. A good advertising campaign would be a weak moat. Apple has done a great job improving its image and increasing its sales of its products, but it is difficult to say whether this image will improve and pass on to other products, or if it will fade away. But at its current price, a continued image growth would be needed to justify its valuation. Other examples of weak moats are management(are they really better, how long will it last, can a competitor match it) and size(in most industries, owning more doesnt mean better), etc. Low cost advantages that can be toppled by capital are also weak. Management's in general will make a huge list of competitive strengths, but in the end a vast majority (95%+) of stocks will fall into the marginal category. Cars, steel, paper, finance, electronics... the list is endless.

The best way to evaluate marginal companies, and by extension most companies, is with a deep Ben Graham approach. An interesting Economist article i recently read discussed Hanson, a famous corporate buyout firm. "The firms they bought had to meet just two criteria: they had to be able to generate enough cash to pay the interest on the debt needed to buy them; and they had to cost less than the total value of their assets. Closures of head offices and mass sackings often followed."

Underlying this simple philosophy are the ideas of economics and Ben Graham. Buying below replacement cost means there is a disincentive for competitors to come into the market because the returns will be weak. Also, it would be cheaper to buy a competitor then to do a direct investment in the industry. In most cases, economics will eventually rationalize the industry and lead to a situation where competition has the incentive to come back in the industry. But at that point, returns have increased and you are making a sizeable return on your original investment cost. You are buying something for less than it is potentially worth under normalized industry conditions or better operation/management.

SFK's management has shown their understanding of this philosophy. They purchased their two RBK mills for a total of about 150 million, when each mill had a replacement cost of 250 million. That is a 70% discount to the cost for a competitor to enter the market. You can, and should, take the analysis much farther than just looking at the cost of assets, and this blog will go much deeper into the additional considerations that should be made. Currently, the Forest industry has many companies that are trading below replacement costs, but I would pass on a vast majority of them. Expect a write-up about a combined Abitibi-Bowater shortly. But for now, hopefully this article will spur you to take a second look at your investment portfolio. With the market average approaching almost 4x book value, chances are that you have not paid a market price below replacement cost for your investments. So you have to truly ask yourself, "How strong are the competitive advantages of your companies, really?"

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