Thursday, January 15, 2015

Commodity Isn't A Dirty Word

Warren Buffett popularized the metaphor of the economic moat to describe a firm's competitive advantage. As quoted in what I consider one of the best articles on the topic, Buffet explains, "What we refer to as a "moat" is what other people might call competitive advantage... It's something that differentiates the company from its nearest competitors - either in service or low cost or taste or some other perceived virtue that the product possesses in the mind of the consumer versus the next best alternative... There are various kinds of moats. All economic moats are either widening or narrowing - even though you can't see it."

Assessing companies' economic moats is generally considered sound practice for investors of all stripes. Value adherent Glenn Greenberg (of Brave Warrior Capital, and formerly of Chieftain Capital) urges the discriminating investor to "single out truly good businesses". In a similar vein, growth investor and writer John Train summarily lowers a scythe on a large class of investable equities, saying "I would avoid the large, cyclical industries even if they are supposed to be ripe for an upward swing." Instead, he exhorts us to invest in oligopolies and growth industries. Finally, noted entrepreneur and venture capitalist Peter Thiel states flatly, "You always to want to aim for monopoly and you always want to avoid competition... Competition is for losers."

I have no arguments with the importance of a company's economic moat to its ability to generate returns. However, I don't feel the need to invest only in truly magnificent businesses. This seems to shrink the universe of investable companies quite meaningfully. Furthermore, it introduces the risk of overpaying for an economic moat. Investors often tout the "high quality" of their portfolio companies, which is generally shorthand for high and predictable returns on invested capital. But this quality rarely comes cheap. You'll never lose your portfolio management job owning "quality" names, but returns may be disappointing. Finally, I'm hesitant to label a company "high quality" since it seems to imply that this quality is inherent and immutable. As Buffett correctly notes, one's moat is constantly widening or narrowing. Train similarly warns readers, "Beware of the company with a franchise that has turned into a commodity." 

Perhaps the solution is declare oneself a MARP investor - Moat At Reasonable Price. But I think it might be even easier to realize that the lines drawn between different investing styles are often quite arbitrary. I'm often reminded of this when I look through the countless products peddled by investment management firms. At the heart of it, all investors are presumably trying to buy stocks that are cheap relative to their future prospects. Why not, then, remain style and industry agnostic? The value of every asset is the sum of discounted cash flows, whether those cash flows are growing fast or slow, or whether they are steady or cyclical. Two caveats: (1) Value is admittedly better thought of as a range rather than a single number, and (2) Investors are well-advised to develop a deep understanding of several industries, and admit when a valuation project simply appears too difficult. But this doesn't negate the basic point that there are times when value-oriented investors would be wise to consider cyclical stocks fair game. In his interview for a book on global macro, Ospraie Management's Dwight Anderson demurred, "We are global micro, not global macro. What we do is pure Microeconomics 101: supply and demand, identifying which companies are low cost, which have cash, and so on. We are constantly striving to understand the changes in our industries: how the composition of demand is changing, how the cost curve is changing, what currencies are doing to change the cost curve, and who the competitive players are." (I have to concede that Ospraie had serious issues in 2008, but this should not be seen as an indictment of the whole strategy of investing in commodity-related firms. Perhaps they swung too far in ignoring global macro.) 

This seems particularly relevant given the collapse of commodity prices that has occurred over the past 18 months, and the concomitant decline in equity prices of firms in the sector. While the press seems obsessed with deciding when and at what price crude oil will bottom, this should be of less importance to a fundamental investor. It is far more important to ascertain a likely range of commodity prices in the medium term, and understand how this price scenario will affect a company's cash flows and balance sheet. There's little doubt that low-cost producers with strong balance sheets will be survivors despite the inevitable fluctuations of commodity prices. These turn out to be the moats needed to survive in cyclical and economically sensitive industries. Dwight Anderson is very clear on this point, cautioning, "You can't buy a high-cost asset cheap enough... When you have a high-cost asset, you have to get the price and the timing right... we will only invest in low-cost companies because we don't have to get the timing right." 

In describing the "Washout Phase" of a stock market cycle, Train notes that this is when "the really big money shows its hard...Mr. Getty buys a string of oil companies for two times cash flow." We don't appear to be there yet and Mr. Getty is no longer with us, but the revulsion against owning commodities suggests we're getting closer. In the meantime, patience is required, as is the occasional gentle reminder that "commodity" isn't a dirty word.

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