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Value Investing – Concepts of Economics and Business Models (Lesson 19) - ValueInvestingNow.com
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Value Investing – Concepts of Economics and Business Models (Lesson 19)

Concepts of Economics and Business

“No nation was ever ruined by trade.” – Benjamin Franklin
There is no single statement or overriding concept that equates to defining economics. There are about a half dozen or so concepts that the average person would state as a definition of economics. The most commonly accepted definition of economics is the balance of supply and demand. In effect, it refers to determining the relationship between needs/wants against limited resources. With value investing, understanding the concepts of economics allows for a more comprehensive elevation of thought related to financial analysis. There are literally hundreds if not thousands of forces at work at any given moment impacting the market price and of course a value investor’s intrinsic, buy and sell value points.
The study of economics is done at two levels. The macro level refers to the study of economics as a whole. It focuses on how different characteristics impact the overall ability to efficiently produce and delivery goods to consumers. Think of the impact the federal government has related to laws that in turn affect production and consumption of goods and services. For value investors, there are many different macro level decisions that affect financial analysis. These include decisions made by the Federal Reserve, specifically related to interest rates. Others include unemployment, tax rates, and governmental expenditures especially for capital improvements.
The second level is called micro economics. This brings in all those macro level changes and their respective impact on individual businesses and industries. As an example, a simple increase in the interest rate by the Federal Reserve affects the interest rate related to long-term leases. In the immediate short time period, there is very little change as leases have cycle time frames before they the lease’s interest rate changes. But, in due time, it will affect the interest rate which in turn impacts certain industries. A single railway leases thousands if not tens of thousands of railcars. An interest rate increase will in turn up how much cash outflows for leasing purposes. Ultimately, the railroad will raise their revenue per mile of tonnage which increases sales to offset the outlay of money for a lease.
The overall idea is that every macro decision is like a rock getting tossed into a pond, the ripple effect kicks in and ultimately it reaches the shore line (consumers). The larger the rock, the more likely the ripple will cause some shoreline erosion. In most cases, the shoreline can easily absorb the impact of the ripple. Large rocks or boulders are world level events like war, sudden resource shortages (OPEC reducing their output) or significant government decisions (Britain’s decision to leave the European Union). Smaller rocks such as natural disasters, increases in tax rates, tariffs etc. affect certain industries and certain companies more than others.

Value Investing – Market Forces

As for value investing, there is one economic concept that dominates an investor’s thinking. It is called the ‘Market’. It is a place where owners of securities come to sell and buyers of securities are there to scoop up good deals. A value investor is involved in both roles. The goal is straight forward, buy low and sell high, remember the primary tenet of business. A value investor’s job is to understand this market related to a particular business, i.e. one of many investments in a portfolio.
While in the market whether buying or selling, those other economic forces impact the market’s thinking as a whole. A good example is an interest rate change. In general, anytime the interest rate increases, it reduces the overall economic production. The cost of capital increases, the economy slows down. However, it is beneficial to certain industries, especially banks. For banks, their primary source of revenue is the difference between the interest earned and the interest paid for the money they lend out; read the banking model in Calculating Intrinsic Value of Banks for a more comprehensive understanding of this principle. Increases in interest rates generally improves their net interest revenue. It can cause long-term issues because as interest rates go up, there are less loans made. But in the immediate time period, interest rate increases are a boon to banks.
It is essential for value investors to understand all these forces and their impact on the market for particular investments a value investor evaluates. This is done via financial analysis.
A simple illustration is warranted here. Using hotels as the model, Hilton Worldwide has $11.4 Billion in long-term debt and operating leases. See this snippet of Hilton’s liabilities section from its balance sheet 2020 annual report:
Concepts of Economics and Business
They currently pay an average interest rate of around 3.99% annually. Thus, total interest to service this debt is about $430 Million. Since much of the long-term debt exists in tranches (chunks) of notes with different maturity dates, any current increase in the interest rate will not have an instantaneous impact on the interest paid each year. However, when a note does expire and Hilton needs to refinance that note, it will be at a higher interest rate. Thus, over time, the aggregated interest paid will increase. Thus, assume the Federal Reserve increases interest rates a half of a percent. It is conceivable that in about seven years, much of the outstanding balance of debt and leases will have matured and need to be replaced with higher interest bearing substitution notes/leases. At .5%, this will add another $60 Million in interest paid to service this replacement debt. Thus, a simple macro level force does indeed impact a single company over the long run. This is how value investors think related to these macro level forces.
As a side note, Hilton paid out $429 Million in interest in 2020. A $60 Million increase in interest payments would decrease the earnings per share around 20 cents. This may not seem like a big number, but a simple multiplier of 14 means it will cause the market price to decrease around $2.50 per share just related to this interest rate increase. Hilton is a member of the S&P 500; thus, when the interest rate does increase, one of the members of the S&P 500 will have a negative impact on the S&P 500 index.
There are about eight different widely accepted concepts of economics:
  1. Choice – Every buyer and seller is given the choice to exchange their resources for a product or service. With value investing, choices are focused on the buy and sell points for investments. 
  2. Opportunity Cost – When a transaction is completed, each party has lost at an opportunity to sell it higher or buy it lower. It also refers to an alternative buy or sell which may have better risk or reward. 
  3. Supply and Demand – Defined as the willingness to buy or sell a product/service.
  4. Market – Centers where suppliers and buyers meet to negotiate the equilibrium of value.
  5. Equilibrium – The final net exchange price between a willing buyer and seller.
  6. Price – The exchange rate between two parties.
  7. Competition – Many sellers and buyers vying for resources.
  8. Macro/Micro – See above.

All eight of these will come into play as a value investor. Throughout these lessons, anytime one of these affects the principle or particular situation, it will be noted and identified to the member. The key is that it is so important to be on the alert for these economic concepts and their respective impact on a business financial model.

In addition to the impact economics plays on a financial model, there is another equally impactful aspect of value investing. This is the business model.

Value Investing – Business Model

In business there are four distinct business models. Just about any business can be identified with one of the four. The following are the four types of business models:

  1. Low-Volume, Hi-Margin
  2. Hi-Volume, Hi-Margin
  3. Low-Volume, Low-Margin
  4. Hi-Volume, Low-Margin 

No single model is the best nor the worse. Each works within their respective industries. In general, the models exist by default and it is highly improbable that the model can move into another one of the types without changing the particular business sector/industry. An illustration is appropriate. 

Wal-Mart is by far the most significant retail player in the world-wide market. They control about more than 11% of all retail. They definitely follow the Hi-Volume, Low-Margin model mostly out of default. All of their competition uses the same model. It is impossible for Wal-Mart to shift their model to Hi-Volume, Hi-Margin format. Their customer retention would fall dramatically if they raised their prices. But, this model works well with the retail industry.

At the other corner sits Boeing. Here, it is low-volume with a hi-margin. Nobody is going to mass produce huge airplanes; it literally takes several years from start to finish constructing an airplane. Quality control is a cornerstone of their business and even a little error can cause huge repercussions. They could go to the low-volume low-margin section but the overhead costs would cause the company to lose money. If this happens, they would go out of business. Out of necessity, this type of industry exists using this model.

Some businesses lean more towards one of the four but may have elements of two of the business models within its structure. It isn’t as if every business has to fall distinctively within one of these four types. But some bleeding over exists between two of the types is rare not the rule.

The following sections below explain the four types of business models and provide examples of businesses that use this model. In addition, this article elaborates as why the model is successful in the respective industries and that no single model is absolutely the best. 

Low-Volume, High-Margin Business Activity 

An extreme example of this type of business is a shipyard. Imagine how long it takes to build an aircraft carrier. In reality, it takes a little over 8 years from start to finish. Prior to laying the keel, there are several years of engineering and material requisition requirements to build the carrier in an efficient manner. Then there is the construction period and the testing period before final delivery is made to the Navy. In effect, one product taking 8 years employing several thousand workers has to cover its share of the overhead and profit for the company. To do this, the final product may have hard costs of materials and labor that is half of the final price charged to the Navy. The bulk of the sales price has to cover all the equipment used, facility costs, general overhead, licensing (the government just doesn’t let anyone handle nuclear material), taxes, and a host of other costs to run a shipyard.

The following are more examples of low-volume, hi-margin businesses:

Large Companies

  • Aircraft manufacturing – Boeing
  • Heavy Equipment manufacturing – Caterpillar, Komatsu, Hitachi & Volvo
  • Military Equipment manufacturing
  • Large Industrial/Commercial Contractors – Bechtel, Fluor & Kiewit

Small Business

There are certain business attributes that force the industry to exercise this model. They are:

  • Significant initial capitalization (financial, perseverance, and knowledge);
  • Almost all work is project based and requires extended time periods to complete;
  • Highly complex interactions and resource management;
  • Little competition 

Notice that in this model, although it is a low volume company, the term reflects the physical quantity, not the dollar value. Go back to the shipyard, an aircraft carrier is ONE item (low volume) but the sales price is nearly $8,000,000,000. That’s billions of dollars. 

In small business, it is really the same concept. For construction, it is ONE house, but it is an expensive item. It is the only way that a company can cover the indirect and overhead costs associated with running a construction company. 

Now on the flip side of this are industries that have high volume and high margins.  

High-Volume, High-Margin Business Activities 

Absolutely this is the preferred type of business model to have due to the contribution value both extremes bring to the company. But these types of companies are not as common and often have significant capital barriers to start operations. Mostly they are in the professional services industry such as law, accounting, engineering, and in some of the medical specialties. In general, the margins are in the 40 to 50% range. This is mostly attributable to variable costs as the primary cost driver. The following are some other examples of these types of businesses: 

  • Coffee Retail/Coffee Supply
  • Software Manufacturing
  • Entertainment (Music Albums, Movies, Videos, Games)
  • Hospitality Based Businesses (Hotels, Motels, Golf Courses etc.) 

An example of a large company with a high margin and a high volume is Apple. The I-Phones costs less than $450 to manufacture and get to market. Retail prices run in excess of $1,000 for the device. Apple sells nearly 100 million units per year. This is a rare business model that has driven the stock price off the charts. 

This type of business model is ideal. Typically in these types of business models, the overhead and capitalization costs are higher than other models. This is mostly attributable to the development of manufacturing facilities, distribution systems and reliance on technology. In addition, competition is keen as others seeking to enter this type of business model seek the same high margins this model provides. In effect, lucrative returns create competition. 

Another factor necessitating the high-margin requirements relates to higher than normal fixed costs. In many of these types of operations, fixed costs are recorded in the overhead section of the profit and loss report and therefore are not a function of cost of sales.

High-Volume, Low-Margin Business Activities 

This type of business model is traditionally seen in the retail and other consumer based product businesses. The following is a list of businesses that use this model:

  • Convenience Stores
  • Gas Stations
  • Grocery Stores
  • Fast Food Restaurants
  • Retail Outlets
  • Transportation (Bus Lines, Distribution, Taxis, etc.)
  • Service Based Operations in More Discretionary Income Dependent Areas of Business
    • Nail Salons
    • Hair Salons
    • Massage Parlors 

An interesting business attribute is the low capitalization threshold to enter the market. 

One last interesting fact about these types of businesses; this is most common form of business in our consumer based society. This reflects several business attributes:

  1. Easy entry for small business;
  2. Low capitalization barriers;
  3. Low knowledge thresholds;
  4. Many support systems;
  5. Limited government compliance requirements. 

In this type of model, the gross margin in absolute dollars is a direct reflection on volume. Competition is significantly keen. The best example of this are gas stations. In general, most gas retailers only have about an 18 cent contribution margin per gallon of gas sold. When the station down the street has his price 10 cents lower, he is really trying to garner market share that week. 

By the way, the number one company in the world using this business model. You guessed it: Wal-Mart. 

Based on this, you would think that it would really be tuff in your low-volume, low-margin business activity. Why would anyone get involved in that type of business model? Let’s find out. 

Low-Volume, Low-Margin Business Activities 

This one is the most interesting of all the business types. With low-volume low-margin operations the reader would wonder how on earth you would make a profit. Well, it turns out that there is another way to look at the equation. Less experienced business entrepreneurs always think in terms of margin as a percentage of sales. Experience and a little more sophistication teaches us that it is really about the absolute dollars. Which would you rather have? 

  1. Sales of 200 units in one day at 18% margin or
  2. One unit at 13%? 

Answer: It depends on the sales price. Assume that in A, the sales price is $7 per unit which means that we have sales of $1,400 and the dollar contribution margin is $252 (this is your high-volume, low-margin business model). OR in B, the sales price is $14,000 with a contribution margin of 13% which is $1,820. 

$1,820 is superior to $252. What industries fall into the type of model? Typically your household goods and high ticket items follow this model: 

  • Auto Retail
  • RV Dealerships
  • Marine Dealerships
  • Appliance Sales
  • Jewelry and Luxury Goods Retail 

These industries typically have higher overhead costs and compliance related costs. Since buyers of the product are rare, advertising becomes a significant portion of overhead costs. Just watch TV for half an hour and about a 1/3 of your commercials relate to the local auto dealerships trying to convince you they are the best. 

The negative attribute of this model is the higher than normal risk associated with acquiring customers. Any reduction in market share can wreak havoc with the financial profitability of the business. 

Summary – Types of Business Models

Some businesses will fall in the marginal areas of one or more of the models above. A good example is a furniture retailer. In general, furniture has a high margin with low volume. But many furniture outlets try to shift their model towards higher volume with lower margins; thus the constant bombardment of advertising from them with their endless sales.  

Overall, each of the models described above works for particular industries. The shear nature of the industry forces their hand into the respective model. When you think about your pool of investments, which model is utilized? Combining economic wide forces with the respective business model allows the value investor and opportunity to appreciate the particular pool’s business characteristics and it sets the stage for calculating intrinsic value and the corresponding buy/sell points. In the next lesson, it is essential that value investors understand the number one force affecting investments – the Federal Reserve. Act on Knowledge. 

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