Reducing Opportunity Costs by Minimizing Luck

This article was inspired by a few recent Twitter posts by John Huber at Base Hit Investing. John is one of my favorite writers and a fan of Warren Buffett's concentrated investing approach. As previously written, I've struggled over whether to adhere more closely to Ben Graham's diversified, quantitative approach or whether to stick mainly with Buffett's concentrated, buy and hold approach.

So John Huber first posted the following tweets:

  • John Huber @JohnHuber72 I am sensing a certain tone in the value investing community that I'll call "Buffett fatigue". Many are sick of hearing about Buffett's principles, "compounders", etc... I totally agree on the air time, and maybe I'm the proverbial bell at the top, but I have 2 points... (1/2)
  • John Huber @JohnHuber72 "Buffett fatigue" isn't new (In 1998, Michael Burry lamented how everyone was piling into Coke at 40 PE b/c "Buffett is in it"; 2) The fact that "true value investors" are sick of hearing about compounders and the principles of Buffett doesn't diminish the merits of that approach
  • John Huber @JohnHuber72 In reality, each business is worth the discounted total of what it will earn in the future. To me, it's no more or less conservative to make future earning power assumptions about a stable, no-growth company than it is for one that is currently growing.
  • John Huber @JohnHuber72 I think "value" and "growth" are not mutually exclusive. They are not separate style boxes. The value of any business is not what it earned last year, it's what it will earn in the future. Whether you look at stocks at 10 P/E or 30 P/E, you're making a judgment about that future.

I then replied as follows:

  • Bill Esbenshade @bill_esbenshade @JohnHuber72 Although what I love about Graham and early Buffett is that it’s algorithmic and idiot proof; low PE, low debt, etc., buy a spread of 20+ positions, and pick a simple sell rule; this approach produces excellent results based on extensive back testing (and personal experience)
  • Bill Esbenshade @bill_esbenshade @JohnHuber72 Buffett’s find a moat, concentrate, & buy & hold approach requires good judgment and strong emotional resilience; it’s emotionally tough and hard to stick with because my judgment could be wrong, resulting in opportunity costs I don’t want to incur over my limited lifespan

This Twitter exchange caused me to jot down some thoughts about luck, opportunity costs, and the goal of minimizing luck and opportunity costs:

  • Graham’s quant approach involves: (1) application of a screening formula; (2) selection of a diversified portfolio of 20+ stocks; and (3) adherence to a mechanical sales rule.
  • Buffett’s concentrated approach isn’t mechanical and depends on the investor’s subjective judgment of whether a company has predictable earnings and a sustainable competitive advantage. A Buffett-style investor may feel certain of his judgment, but he can still be wrong due to unanticipated future events — also known as bad luck. If a concentrated investor is wrong his investments will underperform.
  • Graham’s diversified, mechanical approach isn’t based on subjective assessments of whether a company has a sustainable competitive advantage — it works regardless of the investor's judgment and the possibility of misjudgments or unanticipated events. On a diversified, portfolio basis, Graham’s approach minimizes the impact of bad judgment or future bad luck.
  • All this raises the question: if I’m reasonably assured of good long term returns with Graham’s mechanical quant approach (based on extensive backtesting by multiple authors including Ben Graham, Tobias Carlisle, Joel Greenblatt, James Montier, etc.), then why would I jeopardize these reasonably assured good returns — and risk incurring unrecoverable opportunity costs over my limited lifespan -- by following a concentrated approach that depends on subjective, accurate assessments of sustainable competitive advantage?

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Opportunity Costs

I think a lot of investors fail to consider opportunity costs. When a person invests in a stock or bond, the opportunity cost of that decision is the forgone chance to invest the same money in something else that might provide a better return.

When an investor keeps money in stocks that are fairly valued or overvalued, he increases his opportunity cost because he forgoes the opportunity to invest in undervalued companies with better appreciation potential. Conversely, when an investor only keeps money in undervalued stocks, he minimizes opportunity costs by maximizing chances for appreciation. The goal is to keep opportunity costs as low as possible.

Once you start thinking about investments this way, certain investing ideas stop making sense. If you think in terms of opportunity costs, it seems illogical to adopt any investing rule unconnected to whether the position is undervalued and safe per traditional Graham/Buffett value metrics like PE, price to cash flow, debt to equity, current ratio, and DCF analysis.

In my case, I had certain investing rules that probably raised opportunity costs and reduced returns. One of these was an arbitrary limit on the number of stocks in my portfolio. When I was making concentrated investments in just a handful of companies, a la Warren Buffett, I set an upper portfolio limit of eight stocks. I needed this limit for practical, pragmatic reasons -- I couldn't learn everything possible about more than a handful of companies. I've since shifted away from concentration and back to a cigar butt portfolio, a la Ben Graham and Walter Schloss, largely because of the emotional challenges of Buffett's concentrated approach. I'm now making investment decisions based primarily on quantitative metrics. I don't need to know too much about each company, and my buy/sell criteria are based mainly on financial ratios.  

Given the simpler, mechanical nature of the Graham/Schloss approach, an arbitrary upper limit on the number of stocks in my portfolio seems unnecessary and probably raises my opportunity costs. An upper limit makes it more difficult for me to invest in undervalued micro caps. I originally planned to equal weight a portfolio of 20 to 30 cigar butt positions. I like equal weighting because it forces you to be contrarian and buy more of a declining position when the value metrics and financial ratios are still attractive. In Deep Value by Tobias Carlisle, Carlisle notes that equal weighting can significantly enhance long term returns.

Incorporating the idea of reduced opportunity costs, I now try to approximate equal weights across positions while still investing smaller amounts in undervalued micro caps, even if that means exceeding a 30 stock portfolio. I'm trying to reduce opportunity costs by bending or discarding rules that keep me from investing in the most undervalued companies. Unnecessary or inflexible investing rules -- whether it pertains to valuation, financial stability, or diversification -- increase opportunity costs and reduce chances for investment appreciation.

I'm reminded of Walter Schloss, who often held up to 100 positions, many of them very small. Schloss clearly tried to avoid inflexible, irrational rules about which undervalued opportunities he could take advantage of.  

Investors often seem to ignore opportunity costs when deferring taxes. When you hold on to a fairly valued or overvalued stock for tax reasons, you reduce tax costs but increase opportunity costs. That's because you give up the enhanced returns you could get -- on average -- by selling the overvalued stock and putting the money in a stock that’s undervalued and has better appreciation potential. John Huber at Base Hit Investors wrote the best article I've seen on this subject, titled "Portfolio Turnover -- A Vastly Misunderstood Concept." In my opinion all stock investors should read this article.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Marginal Benefits

I just wanted to write a quick post on technology, marginal benefits, and actual harm. 

Speaking personally, I think I’ve reached the point at which further improvements in my day-to-day tech devices, my iPhone, iPad, iMac, and Apple Watch, no longer confer meaningful additional benefits. Everything is truly good enough. Apple can continue improving its products, and at some point I’ll be forced to replace existing stuff, but I don’t suspect I’ll be too happy about it. 

I think Apple is trying to address this situation — and the good enough problem — by segmenting the market through a range of product price points and features. The problem is the iOS updates — if I own an older but good enough version of the iPhone, the latest update may not work too well and Apple will ultimately discontinue support for earlier versions of iOS. So it starts to feel like I’m being forced to replace a product I don’t want to replace. Feelings of delight shift to feelings of exploitation.

None of this is new insight, I know — people have been writing about this issue for a long time.  

There seems to be an assumption among tech writers that all technology and all technological improvement is good. I’m really starting to question this. Is my Apple Watch or my iPhone a good thing? Is social media a good thing? Do these technologies make it harder to focus on in-the-moment conversations, and make it harder to develop deeper relationships with people you care about and want to spend more time with? Do these technologies distract you and cause unnecessary stress? Do social media and smartphones redirect time and attention away from what’s important and toward things that are trivial or superficial?

Flip-phones are sounding better and better to me.

Success = Different, Hard to Copy, and a Valued Service/Product

Most long term business successes seem to have three things in common:

  1. The product or service is different from what most competitors are offering.
  2. The product or service is hard to copy because it depends on activities most competitors are unwilling to invest in or commit to.
  3. Customers value the product or service, as reflected by gross margins, bottom line profits, and returns on invested capital (ROIC). I define ROIC as operating income divided by the sum of working capital plus net fixed assets plus short term debt.

Right now I think this analysis is most relevant to retail companies, some of which are failing and some of which may survive.  

Costco is a great example of a company that seems to meet these three criteria. Costco does high volume, very low margin retail sales through brick and mortar stores, which is different from almost all other retailers (Sam's Club is the only domestic competitor that comes to mind). This service is hard to copy because other retailers lack, among other things, the infrastructure and the bulk purchasing power (part of Costco's activities) to profitably operate at such low margins. And customers value the service enough for Costco to generate an attractive profit and ROIC. Costco has a trailing, 12 month ROIC of 29%. 

Best Buy is another interesting retailer to examine. The company has survived despite other electronics retailers going out of business (Circuit City, Radio Shack, etc.). Best Buy has a trailing, 12 month ROIC of 56%. In a recent interview with the New York Times, Hubert Joly, the CEO of Best Buy, explained the company’s survival and success by noting the following efforts:

  1. Avoiding “showrooming” products that customers will price-check and purchase on Amazon by making sure store prices match Amazon’s (through a price match guarantee). This approach cuts into profits but keeps customers in the store and away from competitors.
  2. Differentiating from online retailers like Amazon by offering customers technical expertise/service. The company started an adviser program that offers customers free in-home consultations on what products to buy and how they can be installed.  
  3. Improving shipping times — and making immediate gratification possible — by using stores as delivery centers.
  4. Cutting costs by letting leases for unprofitable stores expire, consolidating overseas divisions, reducing the number of middle managers, and reassigning employees. 

Best Buy’s dual focus on differentiating where possible while also cutting costs and achieving price parity with Amazon is something Michael Porter talks about. Porter says a low cost producer must exploit all sources of cost advantage while simultaneously achieving parity or proximity in the bases of differentiation relative to its competititors. Competitive Advantage, by Michael Porter (The Free Press, 1985). Similarly, Porter says a company with a differentiation strategy should aim for cost parity or proximity relative to its competitors by reducing costs in all areas that do not affect differentiation. Id. Applying these ideas, Best Buy is spending more on technical expertise/service -- its source of differentiation -- while pursuing low cost parity/proximity in non-differentiated activities like middle management and divisional structure (by cutting middle management and consolidating overseas divisions). These efforts all facilitate Best Buy's price-matching efforts.

Improving ROIC

A key question for any retailer -- or any struggling business -- is how can it improve a low ROIC? If the ROIC is persistently low (say in the single digits, like 9% or less), it raises the question of whether the business should be merged, acquired, or liquidated, with any resulting monies going to shareholders. 

Any time you reduce net fixed assets you get a two-fold benefit in ROIC:

  1. Depreciation expense declines because of the reduced assets, which then improves operating income. 
  2. When net fixed assets decline the denominator in the ROIC ratio declines.

Reductions in excess cash and inventory reduce working capital, which also improves ROIC. So retailers must find a way to operate with less fixed assets, less inventory, and less cash, while also selling something different and profitable through a hard to copy set of activities.

Every retailer is different but all struggling retailers should ask themselves the following questions:

  1. Is the company doing something different from most of its competitors?
  2. Are the activities that make up the offering hard for competitors to invest in or commit to, and therefore hard to copy? Note how a niche, small market, or low cost approach can be hard for large competitors to copy because larger players may consider smaller, low end markets too insignificant or unattractive.
  3. Do customers value the offering enough to generate attractive margins, bottom line profits, and ROIC?
  4. Can the company improve ROIC by increasing sales volumes, reducing cost of goods sold, reducing expenses, reducing net fixed assets, or reducing excess cash or inventory? Could the company lease some of the net fixed assets it currently owns?

Concentration, Diversification, and Dumb Trades

As a value investor I've always struggled with how diversified or concentrated my portfolio should be. I've followed both approaches -- imperfectly -- over the past 12 years. Much of the problem stems from the fact that I'm a big fan of both Warren Buffett (who favors concentration) and Benjamin Graham (who generally favored diversification).

Excellent books I've read over the past year have simultaneously clarified and exacerbated this confusion: Warren Buffett's Ground Rules by Jeremy Miller, Deep Value by Tobias Carlisle, and Concentrated Investing by Allen Benello, Michael Van Biema, and Tobias Carlisle. I also recently discovered a superb blog site, Base Hit Investing (BHI) by John Huber and Matt Brice, that has added greatly to my knowledge of return on invested capital, return on incremental capital, and the impact of portfolio turnover on overall returns. BHI has been pulling me toward the concentrated approach.

In an effort to capture the best of Graham's mechanical cigar butt approach and Buffett's more subjective concentrated approach, I've decided -- for the time being -- to go with a quantitative approach that tries to identify undervalued, unleveraged companies with high returns on incremental capital and/or invested capital. I'm using these return on capital metrics to try and avoid cigar butts (similar to Joel Greenblatt's approach). Below are the notes I made to justify this decision -- I often do this to steel myself from my own emotional and return-damaging whims:

  1. The problem with concentrating in select positions is that you get too emotional and you end up making dumb trades that hurt returns (motivated by fear, greed, etc.). Concentrated positions often lead to second guessing (due to the exposure that comes with a large bet) and overly aggressive, unnecessary buying and selling. It’s better just to equal-weight your positions and hold enough positions that you don’t mind taking a bath every once in a while. Good diversification and a clear sales trigger reduce dumb, unnecessary trading.
  2. Based on experience and the literature, you can reliably make good money with a diversified approach (occasionally great money). On an averaged, portfolio basis you'll always own a group of undervalued, unleveraged, well-run companies earning attractive returns on incremental capital and/or invested capital. Some picks won’t work out, but on average things should work out well. This is the big advantage of a diversified portfolio strategy: with a diversified strategy it’s not as important to be right about each pick (like you have to be with a concentrated approach) — you just have to be right on average. 
  3. A diversified, group approach allows you to buy smaller, more volatile companies and accept more stock-specific uncertainty, which can then drive higher returns. It also relieves the pressure to predict the future or know every single thing about a company/industry. By staying diversified you can use an easy, quantitative approach, make a few mistakes, and still get good results. And the companies you choose don’t have to be cigar butts with declining businesses — you can use return on incremental capital and return on invested capital to identify well-managed companies that are growing in a smart way. Smart companies don't just grow earnings — they grow earnings at a rate that’s attractive relative to the incremental capital required to support this growth.

So that's my investing approach, at least for now. I've also noticed a side benefit of diversification -- fewer stomach issues.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Simple Businesses

I've always been a value investor, picking both "cigar butt" Benjamin Graham stocks and selectively concentrating a la Warren Buffett. What I haven't always done -- that Buffett often talks about -- is invest in simple, understandable businesses. When I look over my time as a value investor, which started in 2005, it seems like most of my big mistakes/losses have involved companies where I didn't fully understand the product or how the company generated revenues. For this reason I'm now applying the following checklist to any concentrated investments:

  1. The business is simple and understandable;
  2. the business is quantitatively cheap, based primarily on financial ratios like price to earnings, price to free cash flow, enterprise value to operating earnings, price to tangible book, and/or price to net current asset value;
  3. The business is unleveraged and has plenty of working capital;
  4. The business is not heavily regulated or heavily supported by government funding/subsidies/programs;
  5. The business is not experiencing technological disruption; and
  6. The business is not experiencing business model disruption (a la Clayton Christensen).

I'm either avoiding or investing smaller amounts in companies that don't meet all these criteria. 

One of the reasons I like simple, understandable businesses is that you’re less likely to be blind-sided by technological or business model disruption, or by unanticipated regulatory changes or lost government funding. It's generally easier to see potential disruption risks with a simple business -- the risk is usually more obvious. Investing in simple, cheap businesses, and diversifying appropriately, may be the two best ways to guard against "falling knives" and surprise stock losses due to disruption or regulatory changes.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. This article should not be construed as investment advice.

Overstating Disruptive Threats

Some entrants present existential, disruptive threats to incumbents, but many do not. Entrants often fail to generate meaningful profits and move upmarket, allowing incumbents to wait them out -- albeit with a temporary sales loss. The incumbent eventually regains the sales -- it just takes time for entrants with unprofitable business models to start exiting the market. 

A strong balance sheet makes it easier for incumbents to wait out competition from unprofitable entrants. If the entrant has a disruptive model that's profitable, and is therefore a true long term threat, an incumbent with a strong balance sheet can either: (1) alter its business model to compete with the entrant (often difficult to do, for reasons explained by Christensen), or (2) shed assets and serve a smaller share of the total market. A leveraged incumbent may find downsizing difficult or impossible, since it must generate revenues/profits sufficient to service debt.

A lot of investors assume every entrant poses an existential, disruptive threat to incumbents without considering whether the entrant's model is profitable/sustainable or whether the incumbent can survive through business model changes or downsizing.

Some Thoughts on Investing

I've been picking stocks and managing my own portfolio since 2005, buying undervalued positions based on the strategies of Benjamin Graham and Warren Buffett. See Concepts page for discussion of Graham and Buffett. For about half this time I was highly concentrated in a handful of good companies a la Warren Buffett. I held these companies as long as they were undervalued or fairly valued based on a conservative analysis of discounted cash flow (with low, medium, and high estimates of value). This usually led to holding periods ranging from three to five years.  

For the remaining time from 2005 to 2016 I managed a portfolio of 12 to 30 "cigar butt" stocks. These companies were chosen based on Graham-style quantitative analysis. This second approach was focused on limiting downside risk. Stocks were selected and held only if they appeared undervalued based on ratios like price to earnings, price to "owner earnings" (similar to free cash flow), enterprise value to operating earnings, and price to tangible book. This often resulted in more turnover, especially if positions were rising. Tax avoidance did not enter the decision making process.

With both these approaches I tried to stay in companies that were fairly unleveraged and had reasonable levels of working capital, consistent with Graham's writings. A highly leveraged company with low liquidity can be forced into bankruptcy through a single period of poor profitability and tight credit conditions — even if historical profits have been good. As Buffett notes, "any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero." From a psychological standpoint it’s also harder to buy additional shares of a highly leveraged company getting beaten up in a broad economic downtown — it’s harder to be contrarian. That’s because the market may be correctly assessing the leveraged company’s ability to survive a more difficult economic environment.

Out of this experience the following seems worth noting (these are all personal observations/opinions and are not intended as investment advice -- anyone considering a stock market investment should consult a registered investment advisor):

  1. With Buffett's concentrated approach I was looking for good companies I could hold for a long time. To justify a long holding period -- and keeping money tied up in the investment -- I tried to predict future outcomes and understand everything about the company.
  2. I generated good returns with Buffett's approach, but I had difficulty keeping these returns because I sometimes held fairly valued positions too long. I invested so much time learning about each company that I "fell in love" with certain picks, making me less objective about buy/sell decisions. With big gains I was also reluctant to take the tax hit. These problems led to money sitting "fallow" and not generating a return.
  3. With Graham's cigar butt approach I did not fall in love with positions. I was always in undervalued stocks and had a firm selling rule, so emotions didn't really come into play. Because this approach was mostly quantitative, and because I had a diversified portfolio (rather than a highly concentrated portfolio), I felt less pressure to know everything possible about each company. I felt less need to predict future outcomes.
  4. Comparing Graham and Buffett, I think it's easier to take advantage of cigar butt volatility -- through a quantitative approach -- than it is to pick a handful of good companies that will grow over a long time period. That's because: (1) Buffett's approach presents emotional challenges, as already noted; and (2) stock volatility is a more common/reliable phenomenon than a single company's growth/survival. All stocks experience volatility and temporary mispricing, while few companies grow/survive over long periods. As Ben Graham observed, you cannot reliably depend on past trends to continue, growth or otherwise. You have to recognize what you don't know or can't reliably predict.
  5. I seem to do better -- and sleep better --  by trying to avoid losers rather than pick winners. In my experience, when you focus on downside risk you improve long term returns more than you do by trying to predict the future or find growth. Losses are hard to recoup -- if you lose 25% you have to make 33% on that money to get back to even. Graham's cigar butt approach seems better if your first priority is avoiding loss.
  6. I did worse when I became too concerned about avoiding taxes or holding on for maximum gains. I now focus on avoiding loss by making sure I stay in the cheapest low debt stocks I can find.
  7. One way to beat the tax issue is to "out-run" the tax hit through great returns, even if it means higher turnover from a quantitative, cigar butt approach.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. This article should not be construed as investment advice.

Retail Disruption

Brick-and-mortar retailers that only distribute and don't manufacture are being disrupted by convenient, low price online retailers with low cost structures. This is impacting a big swath of the retail industry.

Traditional retailers are protected -- to some extent -- when the distributed product is something consumers want to try on or touch before buying. Even then, however, sales of "try on" products are impacted by e-commerce: after a buyer makes the first purchase of a try on product at a physical store, he can make repeat purchases online.

Brick-and-mortar retailers trying to bolster sales through an online presence must compete with Amazon. And the difficulty here is that Amazon has the competitive advantages afforded by massive scale, a low cost structure, and a huge selection of products. By selling almost everything, Amazon provides one-stop convenience that other online retailers can't match. This convenience edge has been strengthened by Amazon Prime. So traditional retailers face daunting challenges when trying to compete online.

Retailers manufacturing unique products that they also sell -- like Apple -- are largely protected from Amazon. That's because these retailer-manufacturers can control distribution and/or distribute their products exclusively.

Looking beyond retail, other industries are experiencing widespread dislocation, often due to new technologies rather than Christensen-style low end or new market disruption. The oil industry is becoming less profitable due to EV's, abundant natural gas, and cheaper and cheaper solar/wind alternatives.

If a disruptive force doesn't swallow the entire industry market, then a disrupted company can try and adjust to reduced market share by downsizing. An unleveraged balance sheet makes downsizing easier and survival more likely. In the case of retail, many brick-and-mortar companies will survive -- particularly the companies that manufacture what they sell or sell products that people want to try on first -- but their sales may be lower. 

The Investor's Best Disruption Defense

It's hard to tell which companies are going to be disrupted. Newspapers once looked infallible but have since suffered low end disruption from free online news. Many traditional brick-and-mortar retailers have lost sales to online retailers who charge less and have lower cost structures. The traditional car industry, which has been fashioned around car ownership and performance attributes like gas mileage, handling, acceleration, and looks is probably going to be disrupted by (1) cheap, ultra-convenient transportation as a service (e.g., self-driving Uber cars) and by (2) electric, self-driving vehicles -- with tightly integrated hardware/software -- that function as mobile offices and living spaces.

Cheap transportation as a service is a form of low end disruption that appeals to people who don't derive additional benefits from car ownership. Electric, self-driving mobile offices/spaces are a new market disruption appealing to consumers who need transportation and a place to work/live -- a mobile work/living space gives these consumers an economical way to "kill two birds with one stone."

The flip side is that many traditional businesses survive disruptive threats. Some brick-and-mortar retailers are doing well, sales of printed books have stopped declining, and newspapers like the New York Times, the Washington Post, and the Wall Street Journal have made successful transitions to online content. It's hard to predict the future.

An investor trying to read the tea leaves can only really protect himself through adequate diversification. If you're a Benjamin Graham disciple, this means holding 10 to 30 stocks. If you're Seth Klarman, it means holding 10 to 15 stocks. If you're Warren Buffett, it means holding five or more stocks and knowing as much as possible about each one. Adequate diversification -- however you define it -- is probably the most reliable way for an investor to protect himself from the catastrophic effects that disruption can have on a single company/stock.

It's also worth noting that incumbent companies trying to address disruption through the creation of a low end or new market product often make their returns and balance sheets worse. Incumbents trying to self-disrupt often leverage up and/or pour money into projects with a poor return on capital employed (capital employed meaning working capital plus net fixed assets). Low end and new market disruptions that initially appear promising frequently fail because margins and/or sales volumes are too small to generate a meaningful return (that's why entrants generally pursue new and low end markets before incumbents do).

It's ironic: from an investor perspective capital expenditures to develop disruptive/promising new products should often be distributed as dividends instead, since new products usually fail and investors are well-positioned to invest dividend income in companies with higher/better returns on capital, while from a management perspective self-disruption through low end and new market offerings is critical to long term corporate survival, even if it means lower overall returns on capital employed.

Discounted Cash Flow Analysis

Every so often I read an article about how discounted cash flow ("DCF") analysis produces an unreliable stock value due to all the assumptions involved -- in terms of baseline/normalized earnings, discount rate, growth rates, termination values, etc. -- and how small changes in these assumptions can dramatically impact the present value of future cash flows. 

I think there's great danger in an investor trying to determine one stock value based on DCF analysis, and then making a purchase decision based on this one figure. An investor who computes one DCF value never discovers the impact of changes to his assumptions; these changes may make the investor's one estimate of stock value less helpful/realistic than it first appears.

DCF analysis becomes more valuable and realistic when it's used to compute a range of possible values based on worst, normal, and best case scenarios. When a stock is priced below a conservative worst case scenario, then DCF analysis is helpful in determining whether the stock is undervalued, especially when combined with an examination of financial ratios like price to earnings, price to free cash flow, and/or price to book.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock.

Recurring Revenues and New Products

A saturated market, increased competition, or longer replacement cycles (due to a "good enough" product) eventually cause product sales and profits to flatten or decline. 

To compensate for flat sales and profits a company may be able to create other successful products. Unfortunately it's impossible to determine: (1) whether and what future products will be created; and (2) whether any future products will generate meaningful sales and profits. Some things are too difficult to predict.

Because the success of hypothetical future products is too difficult to predict, an investor should believe a company is undervalued -- or at least fairly valued -- based on recurring sales of existing products, factoring in flattening sales and profits. An investor should be confident these recurring sales/profits will occur, hopefully because the company's offering is produced through a defensible, unique, trade-off based set of activities that's difficult for competitors to match. Recurring, defensible sales and profits provide the investor with a "floor" of downside protection.

In choosing between two companies that appear undervalued based on defensible recurring revenues, it makes sense to invest in the company with the best track record of creating successful new products. While it may be too speculative to determine whether a company is undervalued based on unknown future products, it makes sense to prefer companies that: (1) are undervalued based on defensible recurring revenues from existing products; and (2) have the demonstrated ability to create profitable new products. Some companies are better at creating and marketing new products than others, often due to internal capabilities -- what Christensen calls resources, processes, and values -- acquired over time.

Marginal Improvements

As a product gets better, the additional, functional benefit of each product improvement tends to get smaller. Certain product functions become good enough. Continued improvement of these good enough functions: (1) isn't valued as highly by consumers, and may not be enough to convince consumers to upgrade to the latest product version; and (2) leads to over-complex, overserving, overpriced products that only appeal to the most demanding users, ultimately hurting a company's sales and profits.

It also seems like products hit a point at which they can't be meaningfully improved in their current form. When this happens a product's form/shape has to change to stimulate sales. PC's are good enough and hard to improve further, leading to stagnating PC sales, yet computing products have continued to grow through different forms like tablets and smartphones. 

Product functions that aren't good enough are the ones a company needs to focus on, because improvement in these areas motivates consumers to buy the improved product.

When functionality is generally good enough, it's time for a company to: (1) start improving product access and affordability, making it easier for consumers to acquire and use the product; and (2) start exploring new product forms where improvement will be valued.

Dead Simple

Mass market consumers generally want a product to be as simple as possible. That's why defaults are so important, and why "the best" isn't necessarily the most widely adopted. Simplicity is also an important performance attribute for companies to improve on -- improving a product by making it simpler and simpler to use, often by removing unnecessary, unused features. This is an area where companies with established products often seem to go wrong: they add unused features or functionality and never strip this cruft away despite poor user adoption. Overserving, over-complex features or functionality leave the door open for entrants to introduce a simpler, better-designed, less expensive product that's more useful.

Certain questions seem especially relevant in assessing an incumbent's ability to avoid low end disruption while also creating dead simple products that create new markets:

  • Are the incumbent's formerly simple products becoming more complex and weighed down with unused features?
  • Is the incumbent trying to improve the simplicity of its products by removing unused features, even as it tries to add valued functionality?
  • Is an entrant having success with a simpler, less expensive product that only focuses on the essential? Is the incumbent ignoring this success or trying to compete with its own simplified offering?
  • Does the incumbent appear committed to creating simple, well-designed products that either compete in the low end or create entirely new markets, even if it cannabilizes existing products that are more complex?

New (Sometimes Great) Products and Bad Businesses

You often see companies release a great, innovative product that's not profitable -- so the product eventually gets discontinued or the company goes out of business. Sometimes this is because the great new product incorporates technologies that are too expensive to sell in quantities sufficient to generate a bottom line profit. Or the product is sold in quantities sufficient to generate a profit but never goes beyond a niche market because of its high price -- incumbents aren't really threatened in this scenario.

Entrants with an approach that could be a low end disruption often face a similar problem: the company has a new, low cost way of addressing a job-to-be-done but never improves its product enough to accrue the pricing power needed to generate a profit. So the company hovers around breakeven profits and often goes out of business. 

Conversely, you see lots of low growth, "cigar butt" companies that persist with a mediocre but profitable product. These companies often survive -- and stay profitable -- despite pricier, technically superior new products or new, low cost approaches to the problem. In fact, the company with the superior, pricey product or the innovative low cost approach is often the one that goes out of business, while the cigar butt company continues operating. So a superior new product or low end approach doesn't necessarily translate into a "good business," sometimes because the new offering/approach is too expensive or overserving or can't generate the profits needed for product improvement.

You could define a good business as one where the product/service targets the job-to-be-done well enough -- in terms of product quality, convenience, price, etc. -- for the company to sell the product at an attractive profit. An attractive profit is one where the return on capital employed (capital employed meaning working capital plus net fixed assets) is high enough to justify continued capital expenditures/investment. Otherwise continued investment is a waste of time, money, and talent that could be productively invested elsewhere. Innovative products or approaches that can't generate an attractive profit -- an attractive return on capital employed -- within a reasonable period of time may not be as promising as they first appear.