The father of value investing, Ben Graham said the stock market is a voting machine in the short term, but a weighing machine in the long term. In early Amazon letters, Jeff Bezos would quote this concept and follow by saying something about having their heads down, working on making the company heavier in the long term.
When I evaluate the heft of a company, one of my first thought exercises revolves around understanding the capital intensity. Unfortunately, the term “capital intensity” has become financial gobbledygook. I succumb to this, too. Why? Because the concept divides fixed assets by whatever variable you want. Divide by total assets, revenue, net income, operating cash flow or labor costs. Is it a lot or not? But what about the finer details? Sure automobile and steel manufacturing are capital intensive, but what about everything else? Where is the line exactly? Why?
I was recently reading some old shareholder letters of a public company and he spoke of the importance of the quality of the tangible assets in an evaluation of a capital intensity business. He adamantly pointed out that higher earnings on low tangible assets might appear attractive, but if it is achieved with old equipment that is junk –and must soon be replaced by a much more expensive machine– the quality of those earnings, and the equity value, might in fact be quite tenuous. An old junker White tractor from the farm appeared in my mind. I then saw the pristine cab of a new John Deere tractor 8x the price… this thought was followed sharply by the debates I would have with my father. Both machines pulled an implement across the field, and the one was far cheaper to acquire. Why not use the cheaper one? However, my father knew the value of the business itself was greatly effected by the quality of the tangible asset beneath. Even so, he bought the tractor and encouraged me to be the one to drive it. I proudly set out to prove my higher ROA theory. I was green, in a White tractor. My father inherently knew the importance of being able to extract more value than you put in, and sometimes that means preserving your equity by buying something that endures longer. He wanted the more reliable resale of the John Deere and higher return of equity. Ultimately, it’s a strategic judgement call that only the owner can make… and I think his hunch was more right for his business.
I then thought about mistakes I’ve made within Little Engine Ventures. I have, at times been know to overpay for tangible assets. Sucker? Perhaps. Let me show you why I made these mistakes. But first, let me invite you to join Mikel in holding me accountable to this rule I recently wrote for myself:
If the return on tangible assets is less than 50% ask yourself if you’re getting a 30% or greater discount on the price of the tangible asset. If not, walk away.
The above rule is simple to write, and hard to execute. It takes discipline. And that discipline is especially hard to follow when almost no investments make >50% ROE in sum. We don’t make that in sum at LEV because we buy goodwill value. However, it is possible. There is no law that says you cannot. (as you can tell, I like to ask why don’t trees grow to the sky first.) Anyways, I think there are a lot of high finance and a great number of amateur investors that forget the basic principles of business in this area. Entrepreneurs and owners rarely forget this truth: property, plant and equipment are only useful if they increase the effectiveness of the people using them. Unit production per labor hour must go up. This is why we buy machines. And, why we have machines inside of buildings, is to make sure the machines last longer.
The value of property, plant and equipment almost always deteriorates. Thus, the remaining useful life, and future utility, must be estimated. How many more hours of work are available in this tractor before it’s dead? What about this factory? What about this bottling line within our production facility? The closer to dead you put your equity, the more risk you place upon your equity. Avoid risk of permanent impairment. The simple way to reduce risk is to avoid over-paying; and thus my above rule.
After leaving the farm (that’s not hyperbole), I immediately sought high return on tangible asset businesses. I hated machinery; and it wasn’t just because I couldn’t fix it myself, but largely because it rusted and deteriorated. I wanted my equity in assets that had a better than 50% chance of appreciation, ideally the odds were far higher than that. I also was not particularly good at buying at a steep discount. So, over the next decade I grew to love high gross margins and low fixed assets, and even lower fixed tangible assets. Buying another laptop or office desk was miniscule. It didn’t matter. I could generate far more than 100% return on tangible assets, so why sweat the purchase price? But I did. I sweat it hard. I bought used furniture, and thought deeply about utility of computers two years after use by the first user. I did this largely because it directly influenced my team. Cost management matters here. How will we move computers from engineering to shipping? Do we really need office furniture, or will this desk from my house serve? This simple passion to squeeze out and squeeze down tangible asset cost was an obsession. People saw it. We took care of our stuff well enough, but more importantly, we kept the volume of our stuff in check. We did this so we could make more money for ourselves, both as owners and as employees. It was an aspect of pride. (and it allowed me to encourage people to “put up with” old stuff, while I was spending money elsewhere!)
When I look at entire companies, be they private or public, I always start with understanding tangible assets. What does this company require to generate value for customers? Where is their edge? How expensive would it be to recreate? Can I buy a similar machine and hire someone to operate it?
All of our companies would be hard (if not impossible) to recreate for less than we paid. However, there are aspects within each business that draw my attention. A few have unique machines and processes. Most have reputations that lead to repeat customers. All but one of our companies are light on tangible assets –several exceed 300-500% ROTA; and have gross margins around 50%. I want to grow, grow, grow these! Why? Growth of operating cash flow is non-dilutive compounding of goodwill, even without a lot of dividends. Unfortunately, (as I’ve discovered), its way easier said than done. It’s not impossible. It’s hard. And, when the edge is in the reputation rather than unique processes, the growth is often slower. Reputations grow slowly. They deteriorate much more quickly.
So where is the heft? How does this shape capital allocation within operations? How do we make our businesses “heavier” while remaining asset-light?
I believe it comes down to people and processes. Really great people are worth more than their compensation. And, we can retain them for less than their value if we bring something unique to them. We enter into a partnership of sorts. And, as owners, this is often in some form of a pledge and an operational insight. We have a method that works for us, and we’d like to offer you a job, using this method. Are you willing? Able? For our businesses, this is often about delivering a product or service of superior quality or timeliness. Occasionally, the job is about efficiency or geographic expansion. Our promise to teammates is to compensate the employees and try to make the work enjoyable, be it directly fun, or more indirect, pride in one’s work.
As we begin to evaluate capital replacement decisions, expansion decisions and even shrinking revenue in certain areas, my job as capital allocator is to compare internal changes with external trades. It’s getting more nuanced because I have more options. And, frankly, I love it.
But, from one owner to another, it is our job to think deeply about how we assemble our people, machinery and equipment and the activities they do for the benefit of our customers and the relationships with our distribution partners? Should we not be always able to improve just a little bit more? And, occasionally, shouldn’t we be able to surge forward greatly?
A new mentor recently said, “Americans are known to rip open their shirts and do some superman stuff.” What is Superman but a man that requires no machines?
And, while I like that American dream pretty well, I also know it’s not real. What is real however, is the wisdom of Batman. It’s a mix of light-weight, high tech, with a simple throat punch, cloaked in humility, that inspires a city to care for the weak.