Geoff Gannon June 13, 2015

How to Judge a Business’s Durability

My last post listed examples of threats to a company’s durability. This post will be about how we assess those threats. You can always imagine a threat. Is it a realistic threat? How do you judge that?

There are some industries where durability is pretty much perfect. The business doesn’t change much. Barriers to entry are high. The future development of substitutes is unlikely. Location advantages are big.

A good example is lime. Lime is reactive and has a short shelf life. You don’t store it speculatively. You don’t import it and export it. Customers need to get their lime from a deposit being worked somewhere within a few hundred miles of them. Over the last 100 or so years, the real price of lime hasn’t changed that much (real price volatility compared to other commodities is quite low). The price right now is perfectly in line with the real average price per ton since 1900. Lime consumption in the U.S. was no higher last year than it was in 1998. The industry is more consolidated and perhaps less competitive than it was in 1998. I don’t think capacity is being fully utilized now. And I do think inflation will always be passed on to customers (as it was over the last 100 years). So, if Quan and I were to research a company like United States Lime & Minerals (USLM), we could probably start by assuming that last year’s EBIT would – in real terms – represent that company’s durable earning power. That could be our starting point for a buy and hold analysis.

That’s usually not the case. Even when we find a company that has a long history of being the leader in its field – say Strattec in car locks and keys, H&R Block in assisted tax preparation, etc. – there is a risk of change. In these two cases, we know there will be change in the product. For example, more people will prepare and file their taxes online in the future than they do now. And more drivers will enter and start their cars with the use of electronics instead of physical locks and keys. What we don’t know is how that will affect the companies.

Take H&R Block. The company competes in assisted tax preparation. In the 1990s and 2000s, many people switched to using software and then online products to prepare their taxes. But who were these people?

Most were people who had always prepared their taxes themselves. I use TurboTax and know a lot of people who use TurboTax as well. But, I actually don’t know anyone who used H&R Block even once in their lifetime and now uses TurboTax. Everyone I know who uses TurboTax used to – decades ago – prepare their taxes themselves using a pen and paper and a calculator. They didn’t use a CPA. And they didn’t use H&R Block.

Now, this is anecdotal. But, if I hadn’t asked the question “who are these people” I might have assumed that if tens of millions of people are switching to online tax preparation they are coming from companies that include H&R Block. Maybe they are. But, maybe they are a different segment of the market. If you ask that question: “Who are these people?” you can then start an investigation into how customers are segmented.

But, this still presents two problems. One, even if the migration to TurboTax and its competitors was all from do-it-yourself tax filers – that doesn’t mean that is the only group that will switch.

The other problem is that I just mentioned I use TurboTax – I don’t use assisted tax preparation. Most people I know don’t either. This means I will have a poor understanding of H&R Block’s core customer. I will make the mistake of assuming that the tax preparation market is made up of customers like me and people I know – when that’s probably half the market or less.

So, I won’t understand why some people get assistance preparing their taxes. And I won’t understand why these people don’t just switch to something like TurboTax.

This is a very common problem. We run into it all the time.

I’ll give you an example of a stock Quan and I wanted to pick for Singular Diligence – but the price got away from us before we could. It’s a U.K. company called “Greggs”. I live in the U.S. Quan lives in Vietnam. The last time I was in the U.K. was more than 15 years ago. The fast food industry in the U.K. has changed since then. So, we started from a position of real difficulty in understanding the customer. Quan and I are foreigners as far as the analysis of Greggs is concerned. And we’re not even there on the ground to do scuttlebutt. So, this was a tough stock to analyze. Now, we benefited from being in contact – via email – with more than one person in the U.K. So, we could have people visit multiple Greggs locations in the U.K. and report back to us. This was helpful.

But, there was another problem. A cultural one. The folks who write about stocks in the U.K. are not – it turns out – the folks who go to Greggs. The people in the U.K. who write about stocks and who work in that industry skew heavily toward being higher income and London based. London is part of the U.K. But, most of the U.K. isn’t London. And quite a lot of Greggs isn’t London.

So, there is a serious danger here. It’s particularly serious because Quan and I don’t live in the U.K. So, if analysts at an investment bank or a New York Times reporter or someone like that says something about America’s Car-Mart I can say to Quan: “That’s irrelevant. People in New York City know no more about Arkansas than you do. And none of these people know anything about not being able to buy a 9-year old used car without credit and not having a credit card to charge it to.”

I know that we need to get in touch with people who know more about the places where America’s Car-Mart operates and the people who buy cars there. I know not to trust a New York based source’s opinion about an Arkansas based business. And I know not to trust a source with a six-figure income about the need for sub-prime borrowing.

That’s obvious to me when dealing with America’s Car-Mart because I live in the U.S. It’s a lot less obvious when dealing with a stock like Greggs.

This is the number one most important part of scuttlebutt: talking to the customer. To understand durability, we need to understand customer behavior.

Now, sometimes the customer lies or can’t articulate how exactly they make their choices. But, even then – I think they usually give away a lot. For example, when looking at why Weight Watchers members quit – a lot of customers will cite cost.

However, most customers will admit there are other reasons besides saving money. And they will often berate themselves in a way that makes it clear there is a gap between their words and their actions. Cutting out a monthly expense is a good excuse. But, really they want to quit because it is hard or they have already reached their weight goal or something like that. So, in the case of Weight Watchers some customers say they quit to save money – but we don’t believe them. Even though we don’t believe them, we still need to hear from them. Because we can still gain information both about why they claim to be quitting and why we think they are actually quitting from their own words.

For some businesses, Quan and I are able to get a very good explanation of customer behavior. For example, I think we have a pretty perfect 3 part model for how Americans choose which supermarket to go to:

  1. Convenience
  2. Selection
  3. Price

We’re pretty confident that you can explain the vast majority of customer defections in the supermarket industry in terms of a store’s failure of either convenience, selection, or price relative to another local option. In the case of U.S. supermarket shoppers, we can also say that “local” usually means about a 3 mile radius. This last claim has been tested in an academic paper. It is used by a major U.S. supermarket in its 10-K to explain the range in which they think competition occurs. And it is supported anecdotally.

These 4 assumptions were very important for us in deciding whether or not Village Supermarket was a durable business. Village Supermarket operates – mostly quite large – Shop-Rite supermarkets in Northern New Jersey, parts of Southern New Jersey, and now a couple stores in Maryland. New Jersey and Maryland are very densely populated places. New Jersey doesn’t grow much. Barriers to entry in the local markets where Village competes seem to be very high.

I’ll use an anecdote to illustrate. I grew up in a town that is within a Village store’s “circle of convenience”. I lived in that town for about 25 years. For most of those 25 years, you had 3 supermarkets to choose from. For part of those 25 years, you had 4 supermarkets to choose from. All the locations that were supermarkets when my parents moved to that town are still supermarkets today. Some are operated by different companies – but only because they bought the parent company. One location was added. The addition in capacity was much smaller than the increase in local population. The one new store was in a completely newly built shopping center that had previously been undeveloped land (which is quite rare in that part of the country). The existing stores in town invested in expanding square footage, parking, etc. to the extent this was possible.

So, this is an oligopoly where you don’t close the existing sites and you rarely add new capacity. You reinvest in the existing sites as much as possible. But, the number of suitable locations for a brand new supermarket of the ideal size is low. Village leases stores for 20-40 years. It owns some others. So, it’s not like suitable sites for a 60,000 square foot supermarket come up every day in Village’s region.

This information allowed us to ask questions about competition from Wal-Mart, online, etc. We could dismiss Wal-Mart right away. It’s harder to build a Wal-Mart than a traditional supermarket in Northern New Jersey. This market is tougher than the ones Wal-Mart normally competes in. And we knew that Wal-Mart draws from a much tighter “circle of convenience” for its grocery shopping than for its other product categories. Wal-Mart draws from exactly the same circle of convenience as traditional supermarkets. If a Wal-Mart opens 10 miles from a supermarket, it has no impact on the profitability of that supermarket. Remember, 10 miles is a 20 minute drive. You don’t actually average speeds better than 30 miles per hour in your local area. So, Wal-Mart is one threat to durability we did not take seriously.

The next is online groceries. Shop-Rites have competed with Peapod for like a decade now. If you compare the online groceries to in-store groceries in terms of convenience, price, and selection – online has no advantages. You need a scheduled time for delivery. So, it’s no more convenient. You need to tip. Given the size of the average grocery order and the tip people give, you are adding 10% or so to the price of your shopping trip. And, to date, online grocery selection has been narrower than in-store even for companies that use their stores as the distribution point for online.

Finally, there is The Fresh Market. This is a real threat to Village’s durability. The Fresh Market has the best business model for entry into the New Jersey grocery market. Its stores are smaller. The up-front capital costs are lower. The payback period is quicker. And it can siphon off high gross profit sales even if a customer uses The Fresh Market for perishables and Village for non-perishables. Margins are good in perishables. So, The Fresh Market is a big threat. The barrier to entry is lower for The Fresh Market than it is for Wal-Mart, Village, etc. You can put a Fresh Market where you would be unable to put a Village or a Wal-Mart. Generally speaking, a Fresh Market can be as small as half the size of a Village store while a Village store could be half the size of a Wal-Mart.

The Fresh Market has no advantages in price. And it has narrow selection in non-perishables. But, it can be quite convenient and have strong selection for the perishables shopping for a household. A lot of grocery shoppers make more than one trip a week of unequal size. It’s a real danger that a household will split its shopping between a traditional supermarket like Village and a perishables focused format like The Fresh Market.

So, we highlighted The Fresh Market as the biggest risk to Village in our Singular Diligence issue on the stock. And that’s really from thinking about customer behavior and barriers to entry. We disagreed with the arguments in favor of online groceries and Wal-Mart because those options don’t perform especially well in terms of convenience, selection, and price. And because it’s hard to put a Wal-Mart close enough to one of Village’s Shop-Rites to make a difference.

It’s also worth mentioning that opening a Wal-Mart in a local market wouldn’t necessarily have the long-term impact you might expect. If there are 3 supermarkets and you add a Wal-Mart, it’s entirely possible that the now 4th place store will eventually close. In most cases, Village wouldn’t be the operator of the marginal store. We just didn’t feel that the ratio of households to supermarkets in a local area was likely to change except if you added a Fresh Market. That was very likely to increase competition permanently in the town. Because we could easily see how The Fresh Market could enter a town and yet no one else would exit that town. And that would leave the incumbents worse off.

You can also see here that one reason why it’s easier for us to analyze Wal-Mart and online groceries is because they aren’t asymmetric with Village. Village can sell online groceries too. Wal-Mart doesn’t have an easier time adding a location in Village’s markets than Village itself does. And we know Village has a hard time adding locations.

Situations like Greggs and Weight Watchers are different. The competition people were suggesting would be a problem for those companies was positioned quite differently. With Greggs, we would get comments that people wouldn’t want cheap and unhealthy good. They would be willing to pay up for food that is healthier, fresher, etc. And I’m sure some people will. There was just a danger that we were hearing more from that segment of the total customer pool than from the segment that appreciated cheap and filling food.

So, we make a special effort to talk not only with customers of the industry – but some core customers of the company itself.

Western Union is another case where there was tough. Most information out there about Western Union – in the media, on blogs, among analysts, etc. – is written by people who are really, really far from Western Union’s core customers. They don’t have any use for the service. They don’t know people who do have a use for the service. And so they can have a lot of misconceptions.

Now, this one was easier for us because Quan lives in Vietnam and spent several years in the United States. A lot of people from Vietnam take up residence in the U.S. and elsewhere around the world and send money back to Vietnam. So, Quan knew lots of people who use Western Union and competing services.

We were able to talk to these customers. And they were able to explain their behavior. Sometimes, we wouldn’t have correctly imagined customer decision making without talking to them. For example, we would have underestimated the importance of the receiver in deciding which service to use. We knew this was important. But, until we spoke to customers – I don’t think we realized that for most senders they go with the service that the person receiving the money asks them to use. So, if you are sending money back to your mom – you use Western Union because she says there is a location she likes right around the corner. Also, until talking to customers – I underestimated the importance of convenience like the exact hours of the location and whether they will deliver the money to your door and things like that.

I think talking to customers is always the most important part of assessing durability. I also think it’s the most important part of scuttlebutt. People ask all the time if we talk to management. The answer is that we do when we can – but we’ve never found it that useful. I might be overstating that. But, right now, I can’t think of a single time where something a CFO – for example – said was more useful to us than information we got from somewhere else. We’ve quoted CFOs in Singular Diligence a couple times before – but really only because it was a nice, clean, concise quote to use. I can’t think of a time when they gave us information we found particularly useful.

That is not true of customers and the people at the company we’re researching who deal directly with those customers. We got really good information from store managers at America’s Car-Mart. We got good information from customers of Breeze-Eastern and their competitor UTC in helicopter rescue hoists. We get good information from dealers. Actually, independent dealers are probably the best source of information because they deal directly with both the company we’re interested in and with the end users and yet they aren’t employees of the company. Tandy was a very interesting case because Tandy’s biggest customers and biggest competitors are the same people. So, when they told you they bought something from Tandy they were also really telling you why Tandy could sell that particular thing economically and they couldn’t.

Until Majestic Wine made its change in direction by firing its CEO and acquiring an online wine seller – we were definitely going to write about that stock. And that’s another U.K. company. So, despite the difficulties of researching a foreign stock, it’s something we’re still willing to do. I should say researching a company with customers in another country. Because it’s not like we have any difficulty analyzing Ekornes – a Norwegian company – when it comes to sales in the U.S. And Western Union is a U.S. company. But, the receive side is almost always not in the U.S. So, at least half of every transaction is decided by a customer in another country. And the person making decisions in this country was often born in another country – so, Western Union can also be considered a case of difficulty understanding “foreign” customer behavior.

Now, I am going to contradict everything I’ve been saying up to this point. So far, I’ve said the most important part of judging durability for us has been talking to customers. I said we like to get information from the two sides of a deal. If we can find the person inside the company who makes the actual sale – we’d be happy to talk to them. And if we can find the person on the buyer’s side who sits across the table from them – that’s our best source of information on durability.

But, there are two cases that prove we sometimes ignore this source of information. One, is Q-Logic. We got information from folks who operate storage area networks. The information was very good as far as proving Q-Logic’s durability. But, there was a problem. The information was good in explaining why companies who are direct customers of Q-Logic and companies that are the end users would want to stick with their existing solution. The information was not so good in explaining the durability of storage area networks themselves. See, the people we were talking to made their living off storage area networks. They obviously believed they were indispensable. We’ve yet to have a source tell us “This thing I spend every day working on is a total buggy whip. It’ll be gone in 10 years and my job along with it.” No one’s ever said that to us. They might think other parts of their company are doing dumb things. They might think their competitors will soon be extinct. They might even think their suppliers will soon be extinct. But, they never think their own job will ever be in jeopardy. So, that’s a problem. And I just wasn’t sure that we were getting good information on the wider durability issues at Q-Logic. However, the information we did get suggested a lot of “stickiness” in terms of people in IT being reluctant to change their behaviors.

So, that’s an example of where the scuttlebutt on durability was all excellent and yet I wasn’t so sure.

Now, let’s take a look at an example where we had zero scuttlebutt supporting the durability of the business – and yet I was completely sold on the idea the company would last.

We’re talking about Babcock & Wilcox. I’m going to simplify here. I’m breaking down the company into 2 parts instead of the 6 or so it really had. And I’m pretending the only power plants it served burned coal – when really some burned other stuff. So, when we analyzed this business it had two key parts. It made boilers and related equipment for coal power plants in the U.S. and elsewhere in the world. And it made nuclear (fusion) components for use onboard U.S. Navy ships.

The U.S. Navy only uses nuclear power on 3 types of ships: 1) Aircraft carriers 2) Ballistic missile submarines 3) Attack submarines. So, you have to be sure of the durability of aircraft carriers and submarines. You also have to be sure they’ll be nuclear powered. There are huge advantages to using nuclear power on ships you want roaming the globe without the need to refuel. So, let’s put that aside as a given. We’re still left with the a military and political question: “Will the U.S. Navy keep wanting aircraft carriers, ballistic missile subs, and attack subs?” And how can I possibly know they will? I don’t know more about global military strategy than the average person reading this blog post. I don’t know more about the politics of the U.S. Navy’s budget. So, how can I be sure these programs are durable?

And this is where we have to admit it’s all speculative. I read what the programs are and what they are used for. I thought they had some of the greatest strategic importance of any defense programs I could think of. And I asked: “Would you cut these programs or some other programs instead?” And my feeling was that if the U.S. Navy had these 3 programs and little else – it’d still have a lot of weight in the world.

I also thought that the Navy doesn’t have much incentive to reduce its budget. It has less than a for profit buyer.

Can we say Babcock & Wilcox is perfectly durable – either in regard to boilers or nuclear power on ships?

No. But, I think we can compare it to all the other stocks we might buy and compared to almost all of our other choices say it’s more durable. The preferences of the U.S. Navy should change less over the next 30 years than the preferences of most customers in most industries.

But there’s an example of pure speculation. I have absolutely no scuttlebutt to go on when it comes to Babcock & Wilcox. I only have the same reports on coal power plants, the U.S. Navy’s plans, etc. that everyone else can read. We did that issue with no information gained through our own interviews.

Assessing durability is ultimately speculative. I was not sure enough about Q-Logic’s durability even though I had customer testimony in support of that product’s durability. And I was sure enough about Babcock’s durability even though I had no customer testimony in support of that product’s durability.

I still think getting testimony from customers and dealers is important. I think the two people on either side of the actual buyer-seller negotiation are who you want to talk to judge durability. But, I also think that assessing durability is maybe 50% testimony and 50% pure speculation.

In some cases, it’s 100% pure speculation. I speculated on Babcock’s durability with no quotes in support of it being durable. I just assumed based on what I – and everyone – knows about the buyer and the projects that they were durable.

Sometimes I’m not willing to make that speculation. Quan recently pointed me to a good short post on Strattec over at Value Investors Club. I don’t know if Strattec is durable or not. But, I don’t think I can speculate on its durability without customer testimony in support of that durability. So, I’m willing to speculate based only on widely available sources that Babcock is durable. But, I’m not willing to speculate that Strattec is durable.

What’s the lesson from that?

I don’t know. I don’t think Warren Buffett does much scuttlebutt anymore. But, I don’t think he’d be able to do as little scuttlebutt now unless he had done a lot decades ago. Still, he sometimes does. For example, he mentioned that before buying IBM stock he talked to the IT departments at some of Berkshire’s subsidiaries to see how sticky their relationship with IBM was. Quan did the same thing with Q-Logic. But, I wasn’t sure of Q-Logic’s durability.

Some of this may just be bias. Nuclear power is very old and really in a way abandoned tech. Most people have given up on it. Babcock gave up on civilian nuclear in the U.S. after Three Mile Island. If the tech hadn’t been abandoned that way – I don’t think I’d be as interested in Babcock. In both nuclear reactors and boilers, what they do is really engineering rather than technology. But, some people might say IBM is as much a client based professional service firm as it is a tech company. I don’t understand IBM well enough to say one way or the other. My fear is that a lot of people are interested in the ecosystems that IBM and Q-Logic and companies like that compete in. No one is really interested in doing what Babcock does unless they’ve been doing it forever. Nuclear and steam aren’t very sexy.

That’s an explanation Quan and I often fall back on. This industry is safe because no one ever seems to enter it and no one ever seems to want to enter it. It’s really just an appeal to history. If the history of the industry has been that competition is limited – then the future of the industry will be that competition is limited.

Is that a valid way of thinking?

Using history instead of just spitballing possible things that could put the company out of business makes sense. Spitballing doomsday scenarios may seem prudent. But, it’s really just an exercise in paranoia. Companies that don’t change a lot in industries that don’t change a lot are probably safer bets than companies that do change a lot in industries that do change a lot. I’m not sure how prescient you can be unless your prescience consists entirely of just saying “The future will look a lot like the past.” I definitely believe in that kind of prescience. Quan and I always try to come up with a reason or two for why the future won’t look like the past. But, that’s really speculative.

So, there are three approaches you can use to judge durability. One, you could gather testimony about customer behavior. Two, you can go by the history of the industry. Three, you can use a purely theoretical – that is, purely speculative – approach by trying to work out the adoption of future technologies and trends and how that can shift the economics of the industry. I did that for you with Village Supermarket. That discussion was mostly just speculation. It was like something out of a microeconomics textbook. I think that approach has an inherent appeal to most people reading this. It feels like it should be right. And it feels like the kind of work you should be doing. I obviously think it has a place – or I wouldn’t have analyzed Village that way.

But, I don’t think that you should give more weight to theory than you do to scuttlebutt and history. Industry history is a record of the economic interactions that really – not just theoretically – happened. And scuttlebutt can provide an insight into customer behavior which is really what product economics is all about. If you talk to customers, they will tell you about their willingness to pay. And they will especially tell you how “sticky” they are and why they stick with their current choice instead of going and searching for an alternative.

So my advice for how to judge durability is: talk to customers, study as much of the industry’s history going as far back as you can, and try to sketch out the economics of entering the market.

The biggest caveat is not to have too much faith in your calculations on industry economics. You can probably determine who has relatively high costs, who uses relatively high amounts of assets, etc. But don’t put too much faith in the quantities involved. The relationships between players are what matters – the numbers are less important.