No Images? Click here May 2018 Investments – good business v bad business modelsThe world’s premier investor, Warren Buffett, doesn’t merely buy business on P/E ratios - a common fallacy concerning his investments. He looks for what he terms are strong franchises. We’d describe them as enterprises with a strong recurring business model which will have features including strong management, preferably with significant ownership skin in the company, enduring demand for its products and features which make it hard to replicate or successfully compete against it. One well known Buffett observation is that airlines are inherently weak businesses. They swallow up huge amounts of capital keeping their fleets of aeroplanes up to date and they suffer hugely if there are significant fuel price fluctuations, disputes over landing rights or global tension affecting aviation routes. They also have vast amounts of competition. By contrast, airports are natural monopolies and have lots of money making activities on site including parking and business rentals in the terminal buildings plus fees from airlines. Those with long memories will recall that various airline start-ups in Australia including Compass Mark I and Compass Mark II failed because they didn’t have proper access to terminals. Companies with characteristics of strong franchises An Australian company which has been described as being the sort of business Warren Buffett would buy is ARB Corporation Ltd which manufactures and distributes quality accessories for large four wheel drive SUV’s. With hoards of vehicles travelling outback trails, mining activity in Australia and tradies having heavily adopted four wheel drive utilities with add-ons, ARB has a good market. That market extends into Europe where camping bodies placed on 4WD vehicles creates a natural market for ARB products. It also has good markets in the United States and in the Middle East. A look back through ARB’s half yearly and yearly financials and periodic statements to the stockmarket over 20 years shows a company which sticks close to what it does best and which has constantly produced an increase in sales and profit year after year. ARB guards its brands and its quality jealously and you won’t find ARB products among the lesser brands marketed in places like Autobarn. You can only buy ARB products through authorised ARB fitment centres, and it has a significant emphasis on product development. A few years ago we were on holidays at Cable Beach Resort in Broome and I stood on the beach and watched the 4WD vehicles driving down the beach. Almost every vehicle had an ARB sticker. The people who go on the long trek around Australia’s outback fitout their vehicles with all the ARB extras because it’s recognised as being the quality brand; particularly its air locker differential which enables vehicles to navigate steep inclines with greater safety. I’ve been following the fortunes of ARB Corporation for 20 years and it’s been an ideal investment vehicle. CEO’s of most companies could only drool at ARB’s performance. It’s had a long term executive chairman with a significant shareholding and a long standing financial director cum company secretary also with a significant but not overly large shareholding in the company. It has expanded its product range, made tactical acquisitions and taken part of its manufacturing to Thailand because of the shortage of certain trade skills in Australia. Companies with similar strong franchises to ARB include CSL and Reece, and to a significant degree, Macquarie Group. Poor Business Models Enterprises which have poor if not inadequate business models include AMP, Myer, Medibank Private, NIB, airlines and listed veterinary companies. Each of these enterprises have significant weaknesses compared to the strength of ARB, CSL, Reece and Macquarie Group. Is AMP cheap? A question I have been asked by investors is should they buy AMP because its price has fallen so far? To quote Warren Buffett, if you put new management into a bad company, it’s usually the company which emerges with its reputation intact. In other words, it’s a bad business model and new management is unlikely to be able to work miracles with it. Yesterday style businesses Myer and David Jones have long been written up as yesterday style businesses. The reality is that their glory days as retailers were 50 or 60 years ago. Many of the products that they used to sell are now sold by specialised niche businesses or are sold online. Myer has been eaten away by specialist fashion stores, specialist furniture stores and online retailing to mention some of its woes. Health Insurance companies Medibank Private and NIB are health insurance companies faced with having to increase premiums at least two times the rate of inflation to keep up with galloping health costs. They’ve also been roundly criticised for selling junk policies and having so many policy options that they confuse the customer. Additionally they face growing resistance in respect of extras policies where they have traditionally been able to take up to 32% of premiums off the top but recently this has fallen to about 25%. It’s still far too much and understandably, health fund members may prioritise their hospital cover over their extras cover and cancel their extras cover in order to keep the former. There is no sign that these companies will be able to significantly expand their business in a market where policy surrenders are running ahead of new policies written. Roy Morgan research is reported in The Australian of 17th May as having data showing that 256,000 decided not to renew their health insurance in the year to March 2018! The veterinary companies Apiam Animal Health, Greencross and National Veterinary Care have all traded well below their 12 month high and it’s clear that markets spot weakness. The veterinary businesses are suffering because there is a structural problem with a vast number of full time veterinary vacancies being advertised which cannot be filled. The reason they cannot be filled is that female graduation from the veterinary schools are running at up to 85% of classes and over the last 30 years as the proportion of female graduates has increased the older mainly male vets have progressively sold practices and retired. There is now a growing proportion of veterinarians who are only available to work family friendly hours. As a result they leak patients to privately owned practices run by full time veterinary owners who are prepared to put in the hours and spend the time getting to know their clients with smiles and handshakes. This is creating growing staffing problems for the corporatised veterinary companies who find it difficult to fill the times when people who work in the community work full time are most likely to want to take their animal to the vet for treatment. The problem is a growing one and it’s likely to grow further as ambitious vets wishing to build up their own good practice establish practices in competition to practices run by corporates. Providing they have a couple of partner vets who are prepared to work full time they will increasingly win market share back off the corporates. In fact we have observed over several years that a substantial number of privately owned practices located near Greencross practices report a steadily growing clientele of ex Greencross clients wishing to come to a practice with full time veterinary practice owners. This is a structural weakness within the corporate practices which they are unlikely to overcome any time soon. Where do the listed dental companies sit? The answer on this is mixed. 1300 Smiles is probably the closest to a sound business franchise with Pacific Smiles next. Both of those companies were founded by dentists and both of them had multiple practices under their management being before listing on the stockmarket. Smiles Inclusive is unproven, not run by a dentist and listed prior to owning and operating a significant number of practices. Additionally, the average size of its practices are small and the fact that its initial 52 practices have 61 unused dental chairs indicates that many of the practices may be in a run down condition. Over the long term, I regard none of the dental practice companies as being of the quality business franchise standard of ARB Corporation or CSL. The reality is that all of their practices have to be conducted by employed dentists once their vendor dentists have completed their contractual obligations. Over time, practices run by employee dentists won’t function as well as the best privately owned and conducted practices because their lead dentists simply don’t have sufficient skin in the game. Best wishes to all Dentists Graham Middleton The Synstrat Group provide financial advice, accounting services and administration services in respect of client superannuation funds and investment portfolios. For further information on this subject, please call Graham Middleton, Roger Armitage or Cameron Darnley.
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