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Why are soft asset businesses better than hard asset businesses?


scorpioncapital
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Seems a simple question but I could not answer well for a friend.

Why is higher return on investment better? Why is 1 Percent on a billion dollars worse than 10 percent on 100 million when it's the same profit ?

 

Why is making money with no assets the paradise business? Is it a question of efficiency or resource utilization even if result is same at the bottom line ?

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Seems a simple question but I could not answer well for a friend.

Why is higher return on investment better? Why is 1 Percent on a billion dollars worse than 10 percent on 100 million when it's the same profit ?

 

Why is making money with no assets the paradise business? Is it a question of efficiency or resource utilization even if result is same at the bottom line ?

 

Will you take 1% interest rate on your bank deposit or take 5% interest rate?

 

It's clear that you will take 5% interest rate.

 

You will prefer 5% interest rate if you have 10K in bank.

You will prefer 5% interest rate if you have 50K in bank.

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.............................................................................

 

You will prefer 5% interest rate if youo have 5B in bank.

 

 

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Seems a simple question but I could not answer well for a friend.

Why is higher return on investment better? Why is 1 Percent on a billion dollars worse than 10 percent on 100 million when it's the same profit ?

 

Why is making money with no assets the paradise business? Is it a question of efficiency or resource utilization even if result is same at the bottom line ?

 

Forgot to answer the second part. Imagine you have two businesses.

 

First one produced 1 dollar when you deploy 100 dollars.

Second business produces 50 dollars when you deploy 100 dollars.

 

To get 100 dollars of income , first business has to deploy 10,000 dollars. Second business has to deploy only 200 dollars. Second business requires very little capital to grow and it will be easier to grow. In first business, you have to deploy too much increamental capital to generate additional earnings. Capital is not free. If inflation is 2% then first business is actually losing your money.

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Seems a simple question but I could not answer well for a friend.

Why is higher return on investment better? Why is 1 Percent on a billion dollars worse than 10 percent on 100 million when it's the same profit ?

 

Why is making money with no assets the paradise business? Is it a question of efficiency or resource utilization even if result is same at the bottom line ?

 

10% on $100M invested capital is only better than 1% on $1B in invested capital if you can reinvest the earnings and increase the invested capital at hopefully the same  return.

 

If you can’t grow your invested capital, I would argue that  1% on $1B in invested capital is equal or better than 10% on 100MBIT, because there is a chance that you can liquidate $1B for face value or even a bit less and come out way ahead.

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Saying the same thing in another way:

 

If you have a billion dollars, better to invest only $100MM and earn 10 percent, then take  the other $900MM and go buy some islands.

 

Rather than invest the entire for 1% and have zero islands :(

 

I vote islands.

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Why would a low-margin business (a grocer earning 3%, for example) invest in expansion rather than the market (earning 7%)?

Margins and return on invested capital is not the same. A grocer can earn high returns (plus 20 pct) with low margins, high volume.

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Seems a simple question but I could not answer well for a friend.

Why is higher return on investment better? Why is 1 Percent on a billion dollars worse than 10 percent on 100 million when it's the same profit ?

 

Why is making money with no assets the paradise business? Is it a question of efficiency or resource utilization even if result is same at the bottom line ?

 

10% on $100M invested capital is only better than 1% on $1B in invested capital if you can reinvest the earnings and increase the invested capital at hopefully the same  return.

 

If you can’t grow your invested capital, I would argue that  1% on $1B in invested capital is equal or better than 10% on 100MBIT, because there is a chance that you can liquidate $1B for face value or even a bit less and come out way ahead.

On the last part, I get what you say. But even a no growth business needs to invest to maintain status quo usually, so high returns on "maintenance" capex usually means more FCF can be returned to owners. Lots of bad businesses where net income is a far cry from FCF.

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From what I understand here, it may be easier to incrementally earn some required (or higher) return with few assets than with many (the problem of eventually needing maybe even all the assets in the country, etc..) and I found it interesting the part about capital being or not being free. Would this imply that when money is 'cheap' as might be today then hard asset businesses become more desirable because the major constraint of cost of money is reduced? Now if rates increase, then potentially a business with no assets that makes money is not as encumbered by the costs associated with raising capital? I also imagine that when we talk about hard asset business we talk about borrowed money as the sums are so huge few people have the capital to own them outright?

 

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Why would a low-margin business (a grocer earning 3%, for example) invest in expansion rather than the market (earning 7%)?

Margins and return on invested capital is not the same. A grocer can earn high returns (plus 20 pct) with low margins, high volume.

 

Thanks, but how does that differ from market investing using leverage?

 

Was the grocery business thought so stable that one could use greater leverage? (I assume it is not thought so anymore.)

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From what I understand here, it may be easier to incrementally earn some required (or higher) return with few assets than with many (the problem of eventually needing maybe even all the assets in the country, etc..) and I found it interesting the part about capital being or not being free. Would this imply that when money is 'cheap' as might be today then hard asset businesses become more desirable because the major constraint of cost of money is reduced? Now if rates increase, then potentially a business with no assets that makes money is not as encumbered by the costs associated with raising capital? I also imagine that when we talk about hard asset business we talk about borrowed money as the sums are so huge few people have the capital to own them outright?

 

Yes, I believe that low interest rates favor hard assets, especially those  where cash flows keep increasing with inflation (real estate) or those that tend to  their buying power (gold). For real estate, low interest rates atemlos, because you can lever them up cheaper and generate FCF. For gold, the opportunity cost to forgo interest payments on financial assets is lower.

Assets similar to real estate with stable cash flow like utility stocks, airports, pipelines . These arenas business that borrow a lot, should benefit twice with lower borrowing cost and increased multiples.

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From what I understand here, it may be easier to incrementally earn some required (or higher) return with few assets than with many (the problem of eventually needing maybe even all the assets in the country, etc..) and I found it interesting the part about capital being or not being free. Would this imply that when money is 'cheap' as might be today then hard asset businesses become more desirable because the major constraint of cost of money is reduced? Now if rates increase, then potentially a business with no assets that makes money is not as encumbered by the costs associated with raising capital? I also imagine that when we talk about hard asset business we talk about borrowed money as the sums are so huge few people have the capital to own them outright?

Funny to me. You are describing Brookfield businesses. And the why higher interest rate is the main risk they are facing

Yes, I believe that low interest rates favor hard assets, especially those  where cash flows keep increasing with inflation (real estate) or those that tend to  their buying power (gold). For real estate, low interest rates atemlos, because you can lever them up cheaper and generate FCF. For gold, the opportunity cost to forgo interest payments on financial assets is lower.

Assets similar to real estate with stable cash flow like utility stocks, airports, pipelines . These arenas business that borrow a lot, Sontheimern benefit twice with lower borrowing cost and increased multiples.

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Different business models - most hard asset businesses have inventory, higher obsolesce, and distribution costs - that a soft asset business does not. Physical inventory has a monthly working capital cost, & loss to 'shrinkage'. B2B physical movement costs to/from premises, and B2C costs (Amazon delivery), are additional.

 

If I didn't have these costs - I'd look great too!

 

SD

 

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Why would a low-margin business (a grocer earning 3%, for example) invest in expansion rather than the market (earning 7%)?

Margins and return on invested capital is not the same. A grocer can earn high returns (plus 20 pct) with low margins, high volume.

 

Thanks, but how does that differ from market investing using leverage?

 

Was the grocery business thought so stable that one could use greater leverage? (I assume it is not thought so anymore.)

 

Totally unrelated.  Borrowing to invest in the market expecting to earn a rate higher than your cost of debt is not the same as a business with low margins and high turnover.  It doesn't necessarily require debt.  A 3% profit margin that is achieved six times a year is a roughly 18% return on capital. 

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Why would a low-margin business (a grocer earning 3%, for example) invest in expansion rather than the market (earning 7%)?

Margins and return on invested capital is not the same. A grocer can earn high returns (plus 20 pct) with low margins, high volume.

 

Thanks, but how does that differ from market investing using leverage?

 

Was the grocery business thought so stable that one could use greater leverage? (I assume it is not thought so anymore.)

 

Totally unrelated.  Borrowing to invest in the market expecting to earn a rate higher than your cost of debt is not the same as a business with low margins and high turnover.  It doesn't necessarily require debt.  A 3% profit margin that is achieved six times a year is a roughly 18% return on capital.

 

Retail (Grocery and Food) Margin 1.86% ROC 8.77%

 

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/mgnroc.html

 

Seems a lot of work v buying an index fund.

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