What is a bad business?
- Collective, weighted under performance: Most companies in the sector should be earning returns on their invested capital that are less than the cost of capital, not just a few, and the aggregate return on capital earned by a sector has to lag the cost of capital.
- Consistent under performance: These excess returns (return on capital minus cost of capital) should be negative over many time periods.
- No delayed payoff: There are some infrastructure businesses that require extended periods of large investment and negative excess returns, before they pay off in profitability.
If you look at the return on capital across time for the auto industry, you see the same phenomenon play out.
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|Raw data from Capital IQ with my estimates of costs of capital by year|
|Operating Income and Invested Capital, adjusted for leases treated as debt|
The list looks almost identical to the unadjusted excess return rankings, though the excess returns for restaurants, retailers and other larger lessees became much smaller with the adjustment and airlines make the worst business list, once you consider leases as debt.
How do businesses go bad?
So, why do businesses go bad? There are a number of reasons that can be pointed to, some rooted in sector aging, some in competition, some in business disruption and some in delusions about growth and profitability.
- The Life Cycle: I have used the corporate life cycle repeatedly in my posts as an anchor in trying to explains shifts in capital structure, dividend policy and valuation challenges. It is a useful device for explaining why some sectors fail to deliver returns that meet their costs of capital. In particular, as sectors age, their returns seem to drift down and if the sector goes into decline, with revenues stagnant or falling, companies are hard pressed to generate their costs of capital. At the other end of the life cycle, young sectors that require large infrastructure investments often deliver extended periods of negative excess returns.
- Competitive Changes: A business can be changed fundamentally if the competitive landscape changes. This can happen in many ways. A legal barrier to competition (patents, exclusive licenses) can be removed, opening up existing companies to price competition and lower margins. Globalization has played a role as well, as companies that used to generate excess returns with little effort in protected domestic markets find themselves at a disadvantage, relative to foreign competitors.
- Disruption: Disruption is the catchword in strategy and in Silicon Valley, and while it is often hyped and over used, technology has disrupted established businesses. Uber and its counterparts are laying to waste the taxi business in many cities and Amazon has changed the retail business beyond recognition, driving many of its brick and mortar competitors out of business.
- Macro Delusion: While all of the above can be used to explain why an old business can become a bad one, there are new businesses that sometimes never make it off the ground, even though they are launched in markets with significant growth potential. One reason is what I have termed the macro delusion, where the sum of the dreams and forecasts of individual companies
Why do companies stay in bad businesses?
Why do investors invest in these companies?
- Industry averages excess returns, by year: 2005-2014
- Industry average costs of capital: US
- Industry average cost of capital: Global