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Investment is part art and part science. As suggested by legendary investor, Peter Lynch in his book One up the Wall Street: How to Use what You Already Know to Make Money in the Market, investment requires a combination of character, applied knowledge, gut feeling and the ability to make decisions. As investors we look to allocate capital in enterprises or assets that will yield the highest rate of return in the future. Therefore, we tend to define a good investment based on its capacity to generate income during its remaining lifetime. As a result, most of our good investments will naturally be good businesses: strong balance sheets with a healthy cash conversion cycle and low debt-to-equity ratio, encouraging income statements with stable growth in operating earnings and an increase in profit margins and above-average free cash flows. However, is it possible to identify a good business that is not a good investment? In other words, can a good business be a bad investment?
What is a good investment?
The answer to this question is wide and subjective. However, in the eyes of Warren Buffet, a good investment is based on allocating capital in businesses with a large ‘moat’ (competitive advantage). Throughout the years, in his letters to shareholders, Mr. Buffett suggested that a business with a strong competitive advantage is a customer franchise-it has brand power for various reasons and this brand power allows it to increase its prices and market share without the increase of capital expenditures. However, these are qualitative measures of what a good investment is. When it comes to valuation, Joel Greenblatt in his book The little book that still beats the market suggested the two valuation metrics that investors should pay extra attention besides the cohort of ratios available on any financial website: Return on Working Capital (RWC) and the Earnings Yield (EY). The first, RWC, tells investors how effective the management is in using the assets of the business in producing income and the second, EY, gives an estimation of how much you earn (as a business owner). Obviously, the higher the two metrics the better. However, these metrics ought to be used in concert with other valuation tools such as the F and Z scores which look at the financial health of the company and you might even want to use the Discounted Cash Flow model if you have a business that produces steady cash flow streams (such a subscription based company).
No matter how you look at a business a good investment naturally equates higher return. You allocate capital and then you expect it to grow – at what rate will depend on the business and the external factors that impact it. Consequently, a company that loses money and does not return a lot of cash back to shareholders is to be ‘labelled’ as a bad investment. It follows that a good investment requires a good company, at least from a fundamental analysis point of view. However, are there exceptions? In other words can a good company be a bad investment?
Good company, but bad investment
We have already established that a good business, from a mathematical perspective. Therefore, if you are to apply the metrics of fundamental valuation to Tesla Motors, you are unlikely to invest anything in the stock: the company has been haemorrhaging cash since its IPO in 2010. It never reported a positive bottom line and it is in a continuous need for investment to expand. Therefore, from a [simplistic] investment point of view Tesla would be a bad investment. However, what about what the company does? Is it a good business? The answer cannot be other than ‘Yes’.
Tesla Motors is a company that will revolutionize the automobile industry. Its electric cars use cutting edge technology that allows drivers to totally emerge with their cars. For example, the sensors scan the environment and as soon as you approach it, the car opens the doors to you. Moreover, Elson Musk is the driving force behind the company – his ability to sell and create new products cannot be broken down in numbers. However, it is hard to deny that Tesla has a high chance to impact the business world of the automobile industry. Also, the company fulfils an economic need: environmental friendly transport that is will become increasingly cheap with the expansion of Tesla’s power stations. Therefore, the case of this company shows that even if a company is a bad investment on paper it does not follow that it is necessary a bad business.
However, a final point needs to be made: does the fact that a bad investment can have as underlying basis a good company mean that a bad company can be a bad investment? Yes. Corporations, rarely, manage to turn around or get out of troubled situations: high debt, ‘dying’ industry, fierce competition, unfriendly regulatory environment and bad diversification can lead to a business to be severely damaged but it does not necessarily mean that it will be gone forever- if you want to look into a very interesting case, I recommend the situation of American Express in the 1980s-1990s.
