“Value investing is all about finding what the business is worth, and paying lot less for it”
The above quote of Warren Buffett explains what value investing is.
Most books on value investing preach a lot about how to find undervalued companies. Some others give great insight on the discipline and psychology of value investing. Unfortunately, that is not all that is in value investing.
Finding undervalued stocks is just one part of the story, what you also need to focus on is the long term economics and growth potential of the business. Warren Buffett explains that in his another quote where he says:
“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
What Warren Buffett essentially means is that no matter how attractive a management is, if its economics do not support the business, it does not qualify as a good investment.
Based on these principles of value investing by Warren Buffett, here are types of business you should avoid investing.
Capital intensive businesses:
Capital intensive businesses are the ones that need huge cash to keep their business running.
Because of their “cash hungry” nature, capital remain stuck in the business for longer period of time, resulting in low Return on capital, making them poor long term investments.
Some sectors such as infrastructure development and mining are some examples of such businesses.
Companies that continuously need large doses of capital infusion in order to keep their operations running can get into trouble if their capital requirements are not met or if their cash flow is irregular.
In such cases, the business may not be able to pay its obligations and may have to sell its assets or even file for bankruptcy.
Investors must avoid investing in such capital intensive business as they always have a liquidity risk, and may not be able to generate profit if their liabilities exceeds their proceeds.
Commodity type business:
Commodity type of businesses are the ones where the products offered by different players of the sector are similar to each other with minimal or no difference.
When many players try to provide same product with no differentiation, price is the only differentiator that make consumer switch from one player to other.
For example, if there are three companies selling coffee of the same quality, the only reason why a consumer would prefer one seller over the other is the price at which he can buy the coffee.
When price, not the product becomes differentiator, companies start a price war, trying to gain market share by providing products at lowest price possible, shrinking their profit margins, leading to little or no profits.
Investors look for companies with stability in growth, because of lack of customer loyalty, businesses dealing in commodity types of products do not have sustainable growth, making them unpredictable and poor investment choice.
Business that needs continuous innovation:
There are many businesses that need to keep reinvesting to come up with innovative products in order to survive. Because of this, the management has to always be forward looking, doing their guesswork on the “next big thing”.
There are two basic disadvantages in this, first, in such cases management has to keep reinvesting a large portion of their profits(or even borrowed capital), in research and development to create a new products.
Second, as a company becomes more and more innovative, it becomes extremely difficult to repeat its previous success. One wrong move and business may lose huge market share against competitors.
For Example, Nokia, was once a market leader in the mobile phone segment failed to see the next big thing called smartphones. As a result, while Nokia kept itself focused on making smaller feature phones, its peers such as Apple and Samsung, took the market share from Nokia, leaving it far behind in innovation.
A business remains attractive investment, if there are fewer players. When too many players get into same sector offering their services, in order to gain largest share of the pie, they start competing each other focusing on gaining market share.
When gaining market share takes precedence over creating shareholder value, businesses struggle to make profit, work on wafer thin margins(even loss) and thus lose their place as an attractive investment.
For example, Recently too many player in the telecom sector made the sector highly competitive, making it difficult for service providers to stay [profitable. As a result some player, with not so deep pockets, were forced to pack their bags.
Investing in a sector where too many players exist makes it difficult for an investor to find which company will be able to survive. Few years back, Airtel was seen as the market leader in the telecom sector until Jio came in as a game changer, because of which almost all the companies lost the market share as well as revenue.
Another sector you should avoid investing are the ones that are highly sensitive to price or policy changes.
When businesses are sensitive to price changes, it makes businesses vulnerable to price volatility.
Any significant changes in the input cost or decline in demand can easily push companies in these sector into losses.
Companies like Iron and steel and oil marketing companies are highly price sensitive to the raw material prices.
Any rise in iron ore forces Iron and steel manufacturing companies to raise the prices of their products, if they don’t, they will suffer lower profit margins.
Similarly, the businesses that are influenced by Government policies are highly unpredictable. Any change in Government policies can turn the tides against the business, pushing them into losses.
Value investors love businesses with strong competitive advantage, high profit margins, low competition, and long term growth potential, and avoid companies that are sensitive to stimuli, such as changes in raw material price, competition, changes in Government policies etc.
If you are looking to invest for long term, these are the types of businesses you should avoid.
If you are want to know what makes a business great investment for long term, I would say invest the Warren Buffett way.
Here is a post that would answer all your questions.