Thursday, December 30, 2010

Start/buy a private business or buy some stocks?

Investing in a stock and investing to start up a private business are more or less the same things, as they both are in essence businesses with the only difference being that when you invest in a stock you are buying a small portion of a business, and when you start your own business you own the whole thing (for simplicity’s sake, we’ll assume that there are no partners). As with any other choice between 2 investments, you should pick the option which you believe will generate the highest long-term risk-adjusted returns.

And while stocks and private businesses are in essence the same things, there are some differences that can have an impact on their risks and the returns that they produce. In this article, I will be talking about some of the advantages of owning a business outright, as well as some of the advantages of owning a small fraction of a business.   

Control over hiring and firing decisions

If you have your own company, you will have control over hiring and firing decisions. You will be able to take your time and really select to join your organization good, honest, hardworking people who are good culture fits and who are passionate about what your company is trying to do.You can also fire managers or employees that might be destroying shareholder (you) value.

Getting the right people on board and firing the people that hold a company back is a main ingredient in creating a great company that generates really excellent long-term profits.

If you owned shares of a public-listed company, however, it can be very difficult or almost impossible for you to remove a management team that is more interested in their perks and bonuses than in creating value for shareholders. Sure, you can vote against the re-election of board members and maybe voice your displeasure at the annual general meeting, but unless you are very rich and own a huge amount of shares in the company, or if you and a lot of other shareholders team up together, you probably won’t be able to change very much.

I don’t know the exact number, but I believe that quite a number of public-listed companies have damaged their competitive advantage and their long-term profitability by hiring people that are dishonest or people that might not necessarily fit in well in their organizations. How many times have you shopped at a retail outlet that had really lousy customer service and you vowed never to shop with that company again? What about management teams that took on excessive risks only to see shareholder value destroyed when their bets didn’t pay off?

While you might have control over firing and hiring decisions in your own business, some publicly traded companies have really great hiring processes, superb cultures, and effective training programs. These companies select the right people and help them grow in a way that is mutually beneficial for both the employees and their businesses. Because of their reputation of hiring only really good people and having in place really good training programs, these companies are also able to attract really talented people to apply for jobs with them. Unlike those companies that are experiencing deteriorating competitive advantages and profitability due to them having sub-standard employees working for them, the employees at these companies  drive profitability and keep their companies relevant and ahead of the competition.   

Your newly started company might also find it difficult to attract talented people, as it might not have a reputation as a good place to work at yet. It might also take a long time to develop a great culture and put in place excellent training programs (and many companies, both private and public-listed, fail to achieve these things); these things have to be in place for your employees to grow, remain relevant, and create great value for your company.   

Control over capital allocation decisions

Being the owner of a private business, you get decide exactly how to allocate your company’s capital. How you deploy your capital today will determine the kind of returns you get in the future. I can only imagine the number of sub-optimal decisions regarding the deployment of capital that have been made by management teams of public-listed companies. These sub-optimal decisions range from buying back shares when they are overvalued, not investing enough in their divisions that can generate good returns on investment, investing in divisions that generate poor returns on investment, holding on to too much cash for too long and letting inflation eat into shareholders’ wealth, and etc.

There will always be managers that are absolutely horrible at allocating capital, but there are also managers that are really excellent capital allocators, and their decisions on how capital should be deployed can very well make their shareholders very rich. It is also a fact that not all private business owners are good capital allocators themselves, and they can very well end up destroying a lot of value.    

Competitive advantage

There are some really great companies with really have great competitive advantages which you can buy shares in. These competitive advantages will help protect those companies from the threat of competition, put those companies in a better position during economic downturns, and allow those companies to grow at a healthy rate and reap greater profits than the average company in their industries. All this can translate to lower risks and higher long-term returns for you if you are a shareholder of those companies.  

When you start a new business or buy a private business, that business might not have a significant competitive advantage or even any competitive advantage at all. It can take many years to develop a durable competitive advantage, and I don’t think many companies succeed in doing that.

But if you believe that you have a great concept or can create a business that can serve a certain market segment better than other competitors in that market, then you can build on this concept and develop competitive advantages that can sustain and grow your company for the long-term.

While I believe that the best returns and lowest risks come from investing companies with very good competitive advantages or starting companies and developing durable competitive advantages for those businesses, the fact is that there are a lot of companies, both publicly traded and private, that don’t have a significant competitive advantage but are still profitable and still can grow (although the long-term growth and profits will never be as impressive as those companies with important competitive advantages).

So, it might be ok to invest in mediocre companies when they are trading at a very steep discount to intrinsic value (as long as you sell once they approach 2/3 of their intrinsic value, and probably even before that  depending on your tolerance for risk) and to start mediocre businesses that might not have much growth prospects but can generate a reasonable amount of cash to justify the investment to get them up and running.    

This applies more to buying stocks vs. buying a private business than buying stocks vs. starting a business, but investors can sometimes find stocks trading at such a steep discount that the companies behind those stocks have market caps that are only a fraction of the price that they would fetch if they were private companies being bought in a negotiated transaction. 

The lower the price paid, the lower the risks, and the higher the returns; if you buy a business for $20,000 that you estimated is worth $100,000, there’s a lot of room for a mistake to be made in your estimations or for the business’ profitability to be impaired before you start losing money on your investment (not paper losses but losses in the sense that intrinsic value falls below the price you paid for the stock). There might not be much of a margin of safety if you buy a private business at full price.

If you have any questions, or if there's anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care and have a very happy new year!