Sometimes, the best business decision is to change businesses
A version of this post first appeared on TKer.co
When you use fundamental analysis to estimate the value of a stock, you have to make a lot of projections.
How quickly will the sales grow? Will profit margins expand or contract? What will the company’s capital structure look like, and where will interest rates go? Where will tax rates be in the future?
If the projections you put into your valuation model are off, then the value you calculate will be off. Analysts call this phenomenon "garbage in, garbage out."
To demonstrate how difficult this exercise is, let’s try projecting the sales for A1 Widgets Corporation, a hypothetical company that’s the worldwide leader in selling indestructible widgets. Based on A1’s order book, sales for widgets will grow for exactly five years. In the fifth year, everyone in the world who will ever need a widget will have one. From there, there will be no more demand for widgets, and the widget factories will close.
What will A1’s sales look like after the fifth year?
If you said $0, then you’d be wrong.
Because A1’s owners and management had the foresight to quietly gain a foothold in the emerging cloud infrastructure and AI technology businesses. As a result, the company will soon see more sales and growth than ever before. Earnings will eclipse what they made selling widgets. And the stock price will explode.
No, this was not a trick question.
There are countless examples of companies expanding into or outright pivoting to businesses that no one could’ve foreseen.
Having a great product to sell isn’t enough to have a business that’ll generate a great return for shareholders for many years to come.
You also must have stellar management with a killer instinct for allocating capital.
Not only does management have to figure out how to sell the company’s core product for growth and profitability, but they also have to be able to read the tea leaves and recognize when the tides of business are turning. Maybe the market for the product is saturated. Maybe the product is becoming obsolete. Maybe customer preferences are shifting with technological developments. Maybe there are other significant opportunities to pursue, and the company has both the finances and expertise to capitalize on them.
Most companies continually make subtle adjustments that often go largely unnoticed. Some completely overhaul their business.
Take Berkshire Hathaway, which was a textile company when Warren Buffett took over it in 1965. Not long after, Berkshire became an insurance company that also sold candy. Today, it’s a diversified conglomerate selling everything from energy to airplane parts to underwear. And it has a massive stock portfolio generating market-beating returns. (I discussed Berkshire’s culture of change in a recent appearance on Yahoo Finance.)
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