We are big fans of this occasional series in the New York Times:
In the articles, the author takes a look at actual small, closely held businesses that are for sale. He assesses the pros and cons of each business from the perspective of a potential control buyer.
These articles serves as important reminders that our approach should be based on business appraisal not securities analysis or investment analysis. In these articles, the author and the commenters provide a very practical and refreshing approach to weighing an investment decision. They are not rooted in Wall Street or securities analysis at all.
Our favorite of the three articles is the one on the HVAC business. That being said, we disagree with the author’s contention that the value of this business is found in knowhow and processes. Instead, we think the success is based on customer captivity augmented by local economies of scale. The information is sketchy but the business seems to only provide repair/maintenance services to homeowners and rejects both new construction and commercial work. They also work in a tight geographic area , venturing no further than a 20 minute ride from the office. Assuming the numbers are correct, this allows them to earn outsized returns on capital. Its profits are 10 times more than the average HVAC company according to the article. They also have pricing power (“the company policy is to not reduce prices to meet competition”).
Our sense is that the company locks homeowners into annual service contracts – thereby achieving customer captivity. By having a high concentration of customers in a tight geographic area, they achieve local economies of scale in transportation and marketing among other possibilities. They probably also have brand loyalty.
The IT company is also enormously profitable. Its estimated 2013 sales are $30 million with just 14 employees and minimal fixed assets. Again, the details are sketchy but they too have carved out a powerful niche in the software industry. While extremely profitable, we think the total addressable market is too small for the big software companies to worry about. (As an aside, we wonder why they think EBITDA is useful here. We can’t imagine that they have much goodwill to amortize and we know depreciation is low. Do they have significant interest expense?)
You will also notice that they also use moat-type concepts. In the trucking article, for example, the author refers to the barriers to entry posed by onerous government regulations. This dynamic is very similar to what we encountered when investigating Moody’s moat here.
This is an important reminder that for real businessmen, reducing the threat of competition and counting the cash are the key concerns – not forecasting the price of gold, what the Fed might do or quarterly EBITDA updates.
In the book I am currently reading, Investing: The Last Liberal Art, the author Robert Hagstrom conjectures that one of the reasons for Buffett’s success is the hybrid nature of Berkshire. That is, by acquiring both wholly owned companies like those discussed above and noncontrolling interests in publically traded companies, Buffett has kept his investing process rooted in business. “I have always thought,” writes Hagstrom, “that much of Buffett’s success is a result of his hybrid investment vehicle, Berkshire Hathaway. Because Berkshire owns both common stocks and wholly owned businesses, Buffet has benefited greatly from this unique perspective.” p. 71
We try to keep these words from Benjamin Graham in mind at all times: “Investment is most intelligent when it is most businesslike.” The Intelligent Investor, Chapter 20, “Margin of Safety”: The Central Concept, p. 286. (Emphasis in original.) So much of what we read even in the value investing community pulls us away from a businesslike approach. Articles such as these help to keep us grounded.