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What business would you buy if price didn't matter? (a thought challenge)


PaulD
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I'm curious to get the board's take on a thought exercise I've been working through these past few days. I think it could make for an interesting discussion.

 

Imagine that you get to own the five companies whose characteristics most fan the flames of your capitalist desires. You will own each for ten years.

 

This will take place in a mythical market where there are no prices. Instead, investor returns are magically connected to a company's earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you'll get five percent; 15 percent gets you 15 percent; 30 percent...you get the idea.

 

So, suspend your disbelief and let your mind wander. If you're freed from the constraints of price...if you get to pick any company you want that trades in the public markets...let your brain get excited and greedy over the exercise...what five companies would you pick?

 

My thought is that in eliminating price as the main consideration you force your mind to focus on those variables that drive earnings growth. Namely...

 

1. Market Size. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth;

 

2. Competitive Advantage. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it's not losing business to the competition) and/or margins (competitors aren't finding a toe-hold by under-pricing or otherwise doing battle via price);

 

While putting the following control in place:

 

3. Economic Profitability. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can't buy companies that grow in unprofitable ways...though I doubt many of these could last ten years.)

 

So, is anyone game? What five companies would you pick? Why do you think they could compound at a high rate?

 

I issued the same challenge on my blog, adjacentprogression.blogspot.com as a thought challenge to value investors. I look forward to a spirited discussion.

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Maybe amazon?  I'm probably not smart enough to pick out something like that, but I'm still going to reply to  bump the topic up because I 'd like to hear what others think.

 

If your idea here is to add to your watchlist you might also include businesses that earn high returns on capital but have little opportunity for reinvestment of earnings, and who have managements who realize the limitation and return the excess to the shareholders.

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I would base it on the cash return to me, as the owner.  In no particular order:

 

Exxon or Chevron or RDShell

Walmart

Tim Hortons

Hershey or Mars - private I know but it is a thought experiment

Cadbury - wo Kraft

Coke or Pepsi

Philip Morris - dont like the product

 

Basically, energy, candy, Coffee, and cheap goods. 

 

 

There is a reason these companies are never cheap.

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I would jump into the high return on tangible asset businesses like the ratings agencies, Verisk, Fiserv, etc... Anything with big profits and a fat goodwill entry that grows at a slower rate than earnings. Financial tools and products will be relevant so long as the world economies grow.

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MasterCard/Visa - duopoly.  on a global basis, cash still accounts for 70% of transactions, therefore their is growth opportunities. Brand recognition/trust.  Inflation hedge - as dollars per transaction increases due to inflation, so does MA/V's profit as they take small portion of each of those transactions.

 

ADP - duopoly, high switching costs, provides necessary service, will benefit as economy improves, will benefit from float as interest rates rise (I'm not saying those two things will happen soon)

 

KO - brand recognition, pricing power, economies of scale, global growth opportunities.

 

Watsco - provides a non-discretionary service (air conditioning, heating, refridegeration parts) large, difficult to replicate distribution network. Largest in US but in only 36 states currently.

 

Philip Morris International - addictive product, pricing power (bc of addiction), international growth/focus

 

Colgate - quality brand in non- discretionary space. Razor blade model in oral hygiene segment (toothbrushes).  Strong Latin American growth. To paraphrase Munger: "most people will pay a little extra for a brand they trust when it comes to putting that object in their mouth."

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The business has to have:

 

1. Huge returns on capital - i.e. can grow at or above GDP while retaining little if any earnings

 

2. Pricing power

 

3. Growth opportunities available - I want See's Candy but I want it to expand out of California (what a waste of a wonderful business)

 

4. Preferably a royalty-based business with tremendous operating leverage in addition to characteristics 1-3

 

I can't find 5 of these, so I'll put my favorite business/company/stock in the world up as my only pick: McDonalds

 

1. Royalty-based business with phenomenal operating leverage

2. Wonderful platform of growth opportunities via remodeling, product inovation, emerging markets

3. Pricing power

4. Ability to grow the topline at 6%, EBIT at 8% while paying out 100% of earnings.

 

 

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I am a sucker for the network business models....

 

Amazon has been mentioned. No arguments.

 

UPS hasn't. German Post + DHL + Airborne Express + 8 years of burning money at high clips led DPW to retreat back across the Atlantic. If UPS stops to deliver 3 packages on your street but FDX does 3 packages in your neighborhood how does that advantage ever erode? ROIC 25%, Great Balance Sheet , low single digit units and pricing on the topline  in mature markets and HSD units but less pricing in less mature parcel markets(now also have a dominant position in Europe via TNT). In addition every package lowers your cost while capex to sales(5%) isn't what you get at PM(no disrespect to another great model) there isn't a ton of unit growth there and eventually people tire of pricing or the tax authorities get back involved.

 

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What do you think of the soon to be Mondelez Brand? 

 

I would base it on the cash return to me, as the owner.  In no particular order:

 

Exxon or Chevron or RDShell

Walmart

Tim Hortons

Hershey or Mars - private I know but it is a thought experiment

Cadbury - wo Kraft

Coke or Pepsi

Philip Morris - dont like the product

 

Basically, energy, candy, Coffee, and cheap goods. 

 

 

There is a reason these companies are never cheap.

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There was a great quote from Tom Secunda, co-founder of Bloomberg, regarding their development of the NEXT platform. By way of background, Bloomberg has absolutely been eating Thomson Reuters lunch of financial data and information. In the past several years, Bloomberg has jumped from 25 to 31% market share since 2005 while TRI has dropped from 37 to 31%.

 

The quote: "Our business model is that we keep our price fixed but we dramatically increase the value of our product."

 

I wish Bloomberg were publicly traded. There is lots of growth in financial services and it's growing aggressively into the media part of the business. The advantage provided by the near-addiction to its terminals is incredible. TRI has been killing itself trying to displace them with its Eikon toolset. Add to that a mindset where its willing to charge the same price to its customer while investing heavily to improve the products?  That's a fanatical approach to business. Hard to compete with that mindset.

 

It's so much more difficult for public companies to do this. Because it's hard to show the consistent profit growth Wall Street demands while investing hard in your offerings. 

 

So...big market to grow into + competitive advantage + profitable economics + delighting customers with product, service and stable price = FRANCHISE.

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I would jump into the high return on tangible asset businesses like the ratings agencies, Verisk, Fiserv, etc... Anything with big profits and a fat goodwill entry that grows at a slower rate than earnings. Financial tools and products will be relevant so long as the world economies grow.

 

I like these businesses too. The idea of low investment to continue growth. It reminds me of the reason Moodys was once one of the greatest businesses to invest in.  It could grow and grow without having to plowback much money to achieve that. It could pay everything out while expanding its operations and earnings.

 

But I have a hard time understanding the competitive advantages these low-investment businesses possess. It's obviously there. They're huge and profitable. I'm curious how you might describe their competitive advantage?

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The business has to have:

 

1. Huge returns on capital - i.e. can grow at or above GDP while retaining little if any earnings...

 

To really twist the knife on value investing and our focus on price...what about companies that show very low returns on capital because they're sinking all available cash into growth, leaning into investments in capital and expenses (marketing, personnel, R&D, etc.). It's hard to normalize their earnings to get a sense for how profitable they could be if they slowed down their growth. But when these unprofitable companies (and therefore low ROIC and negative P/E) have a competitive advantage that protects them from competitors while they grow, they can be some of the most exciting opportunities.

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The business has to have:

 

1. Huge returns on capital - i.e. can grow at or above GDP while retaining little if any earnings...

 

To really twist the knife on value investing and our focus on price...what about companies that show very low returns on capital because they're sinking all available cash into growth, leaning into investments in capital and expenses (marketing, personnel, R&D, etc.). It's hard to normalize their earnings to get a sense for how profitable they could be if they slowed down their growth. But when these unprofitable companies (and therefore low ROIC and negative P/E) have a competitive advantage that protects them from competitors while they grow, they can be some of the most exciting opportunities.

 

Enter stage left: Amazon

 

I wish I could normalize this company because I think the moat is huge - just cant quite get there....

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MasterCard/Visa - duopoly.  on a global basis, cash still accounts for 70% of transactions, therefore their is growth opportunities. Brand recognition/trust.  Inflation hedge - as dollars per transaction increases due to inflation, so does MA/V's profit as they take small portion of each of those transactions.

 

MA & V would be my picks as well. They're essentially a small tax on global consumer spending. As stated above, the transition from cash to plastic will provide growth for years. Both companies will also be able to leverage their brands and technology towards mobile payments. This all requires very little in terms of capital. MA has taken advantage of this by regularly buying back shares. Eventually both will be able to pay out sizeable dividends.

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To really twist the knife on value investing and our focus on price...what about companies that show very low returns on capital because they're sinking all available cash into growth, leaning into investments in capital and expenses (marketing, personnel, R&D, etc.). It's hard to normalize their earnings to get a sense for how profitable they could be if they slowed down their growth. But when these unprofitable companies (and therefore low ROIC and negative P/E) have a competitive advantage that protects them from competitors while they grow, they can be some of the most exciting opportunities.

 

I think the key with companies like this is to make sure their growth will actually pan out. There are some cases where this can be pretty dangerous, homebuilders are one and I'd argue some of the O&G E&Ps are as well. Basically you can end up where capex and growth is funded at the expense of underlying fundamentals, you can end up buying increasingly expensive assets while taking on debt/diluting shareholders and when a bubble pops you're pretty screwed. Level 3 is another example of this, where lots of capital was spend laying the fiber and only a tiny fraction of it has actually been utilized, supply drastically overshot demand.

 

Looking at companies that have had unusual spikes in capex isn't a bad idea though, for example, a company might have to spend a higher than normal percentage of revenues on capex to get some new factory going in order to satiate demand for whatever they're selling. As long as it isn't at the expense of the pricing of the product they're selling, it should be pretty good.

 

The other way to look at is is in industries where you have a ton of excess capacity relative to demand. You can see this a lot with cyclical companies. Supply overshoots demand, you take a bunch of charges by reducing your capacity (closing factories) which will make your numbers look bad for a few years, eventually the cycle of what you're selling emerges from the trough and you have demand exceeding supply. That's a good time for a company.

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