Operational and Valuation RISKS in Stock Companies
When we’re talking about long term investment, we’re talking about a timeframe where the underlying quality of the business is going to make a difference as to whether or not our investment into the stock appreciates.
There are at least two routes through which risks pops up for the business investor: Operational and Valuation.
The first, Operational, is also called business risk. The operating risk of a business is that they stop earning profits. Maybe their inputs, the raw materials they use to manufacture, increase and they can’t pass those costs onto their customers. Or perhaps the executive management doesn’t do a good job maintaining or growing the business and the earnings atrophy. There is a possibility that a new technology enters the market and makes our business’s product obsolete. All of these factors are operational risks and this section will see us cover several more possible risks of this nature. Investors need to know how to pick out the reality of what sort of operational risks are present in a business, because they can kill returns.
Secondly, is valuation. Valuation and Operational risk go hand-in-hand. Before we get into the relationship of Operations and Valuation we’ll focus on the latter.
Valuation stands alone as a base-line factor for every investment opportunity. The question is, is the investment being offered at an attractive price relative to the underlying business and its track record of capability to return capital to shareholders (through earnings)?
An essentially important fact, too, is that if the investor enters into a business at a price that is excessive, they may simply never be able to earn a return. If someone pays $50 for every $1 of earnings a business makes, are they not a fool? 1 of 50 is 2%. Anyone can get a 0-2% return in a bank account. Not one reader of this book is going to be able to make good use of a 2% annual return. So if an investor is willing to buy a business at $50 to $1 earnings, they might as well just deposit their capital at the bank. If you buy a business at $50 to $1 earnings, you’re just hoping some greater fool will buy it off of you for $60 to $1 earnings.
When valuation is excessive the prudent investor simply moves on to the next opportunity.
Let’s return to operational risks and discuss a few common pitfalls for investors.
Operational risks we’ll discuss include:
• The business profits shrinking and even turning unprofitable
• The business growth tapering out and reversing
• The business making a lot, or most, or all, of its sales in a foreign currency
Beginning from the top, let’s look at how a business’ profits may shrink or altogether disappear. The two most common ways this takes place are:
When competitors enter their business and compete on price and/or the business product goes out of fashion
When management can’t or doesn’t control escalating costs
Let’s get an example for the first scenario. Weight Watchers was a super star business for several years. Their customer count was growing, most of their sales came from selling a service they provided at storefronts located in strip malls, and they didn’t need a lot of financing (read: debt to service) in order to expand their number of locations and therefore their business. The stock roared. Eventually competitors entered the market.
The competition was able to duplicate Weight Watchers service, and charge a lower price, and these upstarts ate up not only every part of the market that Weight Watcher’s hadn’t entered into yet, they also drove down the price of the service. Eventually, everywhere you had a Weight Watchers location customers had a Jenny Craig location to shop against. Jenny Craig and other competitors eroded Weight Watchers’ profit margin in that price war along with eating their market share. Earnings growth stalled out and then reversed.
Weight Watchers’ stock crashed 90% from 2011 to 2015. As of writing in 2021, the stock trades for one half of what it exchanged hands for in 2001.
During the mid-2010’s we had Blue Apron, a meal preparation and delivery service. Their story mirror that of Weight Watchers’: No barrier to entry means competition cropped up everywhere. Blue Apron’s product and service were duplicated. It is impossible to operate at scale in for large profit margins in a business so easily duplicated.
Here are a few more examples of large businesses destroyed by competition:
• Xerox (low-cost foreign competition)
• J.C. Penny’s (other department stores and internet retailer competition)
• Circuit City (more effective competitor in Best Buy)
Let’s now turn to the second operational risk listed: When management can’t or doesn’t control escalating costs. This one we’ll be brief. Basically, if the business can’t pass increased costs onto the customer in a timely manner, the company’s profit margin gets obliterated and earnings are destroyed.
That's all for now. Let's see what you've got.