Industry Structure
Growth for hard asset based businesses inevitably requires large incremental outlays for fixed assets. After all, once an airline is flying full planes, the only way to get more passengers from point A to point B is to acquire an additional aircraft, which can cost US $35 million or more.
Because the incremental fixed investment occurs before asset deployment, companies in this sector generally finance their growth with external funding. Debt can be used to finance almost all of the asset's cost, so lenders generally require the asset to provide collateral against the loan. With this model, high leverage is not necessarily a bad thing, provided that the company can make enough money deploying the asset to cover the cost of debt financing and earn a reasonable return for shareholders.
Subsector: Airlines
(With this in mind, airlines are generally the least attractive investment of all the companies in this subsector. Airlines must bear enormous fixed costs to maintain their fleets and meet the demands of expensive labour contracts, yet they sell a commodity service that's difficult to differentiate. As a result, price competition is intense, profit margins are razor-thin - and often non-existent - and operating leverage is so high that the firms can swing from being wildly profitable to nearly bankrupt in a short time. If you don't think this sounds like a recipe for good long-term investments, you're right - airlines have lost a collective $11 billion (excluding the impact of recent government handouts) between deregulation in 1978 and 2002. Over the same time period, 125 airlines had filed for Chapter 11 bankruptcy protection and 12 of them filed for Chapter 7 liquidation.)
Hallmarks of Success for Hard-Asset-Based Businesses
Cost leadership: Because hard-asset based companies have large fixed costs, those that deliver their products most efficiently have a strong advantage and can achieve superior financial performance, such as Southwest in the airline industry. To get an idea about how efficiently a company operates, look at its fixed asset turnover, operating margins and ROIC - and compare its numbers to industry peers.
Prudent financing: Remember, having a load of debt is not itself a bad thing. Having a load of debt that cannot be easily financed by the cash flow of the business is a recipe for disaster. When analysing companies with high debt, always be sure that the debt can be serviced from free cash flow, even under a downside scenario.
Investor's Checklist: Hard-Asset-Based Businesses
- Understand the business model. Knowing a company leverages on hard assets will provide insight as to the kind of financial results the company may produce.
- Look for scale and operating leverage. These characteristics can provide significant barriers to entry and lead to impressive financial performance.
- Look for recurring revenue. Long-term customer contracts can guarantee certain levels of revenue for years into the future. This can provide a degree of stability in financial results.
- Focus on cash flow. Investors ultimately earn returns based on a company's cash-generating ability. Avoid investments that aren't expected to generate adequate cash flow.
- Size the market opportunity. Industries with big, untapped market opportunities provide an attractive environment for high growth. In addition, companies chasing markets perceived to be big enough to accommodate growth for all industry participants are less likely to compete on price alone.
- Examine growth expectations. Understand what kind of growth rates are incorporated into the share price. If the rates of growth are unrealistic, avoid the stock.
The Five Rules for Successful Stock Investing
by Pat Dorsey
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