A thought exercise. You're attempting to evaluate a business for investment. Here are some of the rough data points you've managed to gather through a quick investigation.
1. Market Size.
This is a situation in which the service offered by the business has helped create a market. It did not exist before. So its size is unknowable.
You have no way to quantify this, but it's beyond evident that it's large. Very large. Many billions. And it's growing.
The service provides a clear value for clients, a point so obvious that it's not even worth debating.
Today, the company holds a dominant share of the market.
2. Competitive Advantage.
The business you're evaluating appears to have several levels of competitive advantage protecting its services in the market.
It's developing a scale cost advantage, though that's not yet established. But it does have the market share lead over competition, and once scale is established it seems highly unlikely it would cede ground to a foe.
It has early brand appeal with customers preferring its services, even in cases when it competes against free alternatives.
And it's establishing a network effect whereby the range of services it offers tie in tightly with customer mission-critical needs. In other words, the more they use it, the more difficult it is to leave it.
The company has a culture of innovation, and it's constantly rolling out new offerings as part of its services. And it likes to surprise customers from time to time by offering the same services, with additional features, but at a lower price point.
3. Economic Model.
While there is scale cost advantage, the scale is not yet sufficient for the venture to be profitable. So it's losing money both from an income statement perspective and in terms of cash returned on invested capital. This could continue for a few more years.
It's a model in which heavy fixed costs must be recouped by a tremendous volume of sales with low gross margins.
But you can reasonably conclude that the business will reach scale and therefore benefit from a profitable economic model (indeed, one with extremely high ROIC), but not before it suffers heavily for these investments.
4. Price.
This business currently has no earnings, and its losses will mount for at least a couple more years. Its assets depreciate rather quickly, so there's no meaningful liquidation value.
That said, investors are assigning it value. The market seems to hold high hopes for its future. Optimism abounds.
*****
So do we put this immediately in the "too hard" bin? Turning up our nose because we wear the VALUE INVESTOR badge, and we only buy cheap stuff come hell or high water?
What of the large and growing market? What of the economic model showing high ROIC...or the ability to compound earnings at a high rate of return as it expands its share of that market? What of those competitive advantages that seem very likely to ensure that the business maintains its market leader position and protects the stream of profits generated from holding the lead?
Each of those variables makes it likely (and you can go out on a ledge and assign a high degree of probability to it) that this business will be large, profitable, and immovably entrenched five years from now.
In the meantime, it will lose money. You will suffer these losses. It's likely to make for a bumpy ride. Volatility will ensue.
But in five year's time, it will be a franchise.
*****
Under that banner of VALUE INVESTING, we often miss the forest for the trees. We fixate on price, convinced that TRUE value investing demands we only place our hard earned dollars behind businesses sporting some low-price valuation measure.
The purpose of all investing is compounding your returns, and when you can do it with low risks...gravy. But is PRICE necessarily the center of the universe? Or is it one variable to consider among others that should hold weight in your decision process?
Truly great businesses are few and far between. They don't often come cheap. That's not to rationalize an expensive purchase. But expensive is only expensive if the value doesn't compound. If the market isn't as big as you imagine, or the economic model as lucrative, or the competitive advantages as deep. But if they are as reliable as your analysis suggests, the power of compounding can make something that appears expensive today seem like peanuts in retrospect.
*****
For the record, I've not invested in the unnamed business considered here. But there's only one reason why...
Optimism. The business is currently awash in optimism for its future. Many people have analyzed it and reached similar conclusions to me.
But I suspect their optimism knows boundaries. The business is certainly engaged in a high wire act in suffering losses to grow its market share and reach scale cost advantage. The price will fluctuate. Earnings will not improve quarter over quarter. And those lacking intestinal fortitude will not enjoy the view of a long drop from the wire.
I'll revert back to this Warren Buffett quote last posted under No Extra Credit for Being a Contrarian:
The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.
I hold out great hope for calamity. My optimism in the market's eventual pessimism knows no bounds! And in the meantime I wait.
No comments:
Post a Comment