The 3 Killer Cs - Cyclical, Capital-intensive and Commoditised

"The 3 Killer Cs"

Not one but three 'killer Cs' lurk around the darkest corners of the business world. 

If any one of them grips a business, it makes life hell for the managers and profits elusive for the owners. What are they? 

The first is 'cyclical'. 

• When a business is cyclical, it sees large and unpredictable swings in its revenues, margins, and profits. Everything that matters is all over the place. 

The second is 'capital-intensive'. 

• Businesses afflicted by high capital-intensity require a lot to produce little. They s u  c k investors dry as they need large amounts of capital to make profits. 

The third is 'commoditised'. 

• Companies here can do very little to prove to customers that their product or service is better than their competitor's. 

The presence of even one of these killer Cs is bad news for a business. 

The best type of business to own

Businesses with Good Fundamentals - the best type of business to own


The best type of business to own is "one that over an extended period can employ large amounts of incremental capital at very high rates of return."  (Buffett)

In practice, most high-return businesses need relatively little capital.  (Buffett)

While the highest return attainable as a criterion is understandable, how capital intensive is a business is a very important consideration.

Buffett opines that between two "wonderful" busineesss one should choose the least capital intensive.  He admits that it took Charlie Munger and him 25 years to figure this out.  (Buffett).

Two important things in the capital structure of the business

Capital Structure

When looking at capital structure, try to determine two things:

1. Is the business a consumer or producer of capital? Does it constantly require capital infusions to build growth or replace assets? Warren Buffett - and many other value investors - shun businesses that cannot generate sufficient capital on their own. In fact, one of the guiding principles behind Berkshire Hathaway is the generation of excess capital by subsidiary businesses that can be deployed elsewhere.

2. Is the business properly leveraged? Overleveraged businesses are at risk and additionally burden earnings with interest payments. Under-leveraged businesses, while better than overleveraged, may not be maximizing potential returns to shareholders.

Capital-intensive and Capital-hungry companies

CAPITAL SUFFICIENCY

Capital-hungry companies are sometimes hard to detect, but there are a few obvious signs.

Companies in capital-intensive industries, such as manufacturing, transportation, or telecommunications, are likely suspects.

Here are a few indicators.

1. Share buybacks

The number of shares outstanding can be a real simple indicator of a capital hungry company. A company using cash to retire shares - if acting sensibly - is telling you that it generates more capital than it needs. On the other hand, if you look at a company like IBM, ROE has grown substantially, and massive share buybacks are a major reason.

Warning! : When evaluating share buybacks, make sure to look at actual shares outstanding. Relying on company news releases alone can be misleading. Companies also buy back shares to support employee incentive programs or to accumulate shares for an acquisition. Such repurchases may be okay but aren't the kind of repurchases that increase return on equity for remaining owners. (Comment: to take a look at HaiO share buyback.)

2. Cash flow ratio

Is cash flow from operations enough to meet investing requirements (capital assets being the main form of investment) and financing requirements (in this case, the repayment of debt)?

If not, it's back to the capital markets. This figure is pretty elusive unless you have - and study - statements of cash flow.

3. Lengthening asset cycles

If accounts receivable collection periods and inventory holding periods are lengthening (number of days' sales in accounts receivable and inventory), that forewarns the need for more capital.

4. Working capital

A company requiring steady increases in workng capital to support sales requires, naturally, capital. Working capital is capital.