Lessons investors can take from the latest boom and bust cycle.
- Feb 11, 2005
- admin
- Investing
ANGRY RED HEADED STEPCHILD WITH FRECKLES.
Vertically challenged male at end of bar at 2 a.m.
Horizontally challenged female at end of bar at 2 a.m.
Call them what you want, but many consider these apt descriptions
for those lonely creatures still in the business of selling
long distance services.
You know which ones I’m talking about.
AT & T (SYM: T)…MCI (SYM: MCI)…
Yes, even Sprint (SYM: FON).
You’d be forgiven if you tried to forget the whole lot of them.
I know I tried.
Who wants to spend time thinking about companies whose revenues
and profits seem to be shrinking faster the Bernie Ebbers’
defense fund?
So I put them out of my mind.
Tuned out all things telecom.
Until the latest wave of telecom consolidation hit the news
recently.
The same wave that promises to complete a simian style evolution
as intense as any ever experienced in business history.
The same evolution that offers us, as investors, some of the most
profound lessons on the nature of business competition ever
recorded.
Lessons so important that if you take nothing more from this column
other than what I’m about to discuss, you’ll be a better
investor for it.
But instead of discussing why the AT & T merger makes sense or why
the MCI merger doesnt, I’m not going to talk about long distance
at all.
In fact, I’m going to talk about ice cream.
That’s right – ice cream.
Why?
Because to understand – from a competitive perspective – the boom
and bust that occured in the long distance industry in America,
we need look no further than our own neighborhoods.
And since we love ice cream so much, I figured….
Anyway, sit back and relax as we play a quick game of Tycoon Monopoly.
Are you ready?
Ok.
Now let’s assume that you lived in South Beach, Florida.
The weather is always hot and people are always thinking about
refreshments.
One day your friend Jason comes to you and asks you to invest
in a new ice cream parlor he wants to open.
After doing your research, you realize – quite suprisingly – that
there isn’t one single ice cream parlor on the entire beach.
You seize the opportunity and invest.
Within 3 months Jasons Ice Cream Parlor is officially open.
6 months later Jasons is doing more business than you
ever dreamed.
Good press.
Lines around the block.
Heck, even Madonna and Rocky sneak in occasionally.
But that’s not the best part.
The best part is that because you have the only ice cream
shop in town, you guys are able to charge everybody very
high prices for the ice cream.
So high in fact that you guys average $10 for each and every single
ice cream cone sold!
That means that for every $1,000 in capital invested into Jason’s
the business earns a $300 return.
30 percent return on capital – not bad at all!
But then one day – as you’re being driven around South Beach in
your brand new Rolls Royce – you realize that another ice cream
shop opened barely 1 mile away from yours.
Yes, Bob’s Ice Cream Shop just announced its grand opening.
At first you get concerned.
But you put your concerns aside when your lines are still
strong at Jasons.
Still plenty of business to go around, you think to yourself.
But it doesn’t stop there.
Suddenly realizing how much money there is in ice cream,
5 more shops open on the beach.
That’s one ice cream shop for each square mile!
Pretty soon, the competition becomes so fierce that prices
drop rapidly.
Now, instead of selling ice cream for $10 per cone, you’re
lucky to get $5 per cone.
That means that for every $1,000 in capital invested into Jason’s
now the business earns $200 back.
Its at this point that you learn several important lessons
about investing:
Lesson # 1. Strong businesses attract competition.
Lesson # 2. Competition lowers prices.
Lesson # 3. Lower prices mean lower returns on capital.
As you begin to digest these lessons, Jason comes to you with
what seems like a good idea.
The bank has offered him a $10 million line of credit to
expand the business.
You guys jump at the offer.
With that kind of money you could open more stores and wipe out
the competition.
But during the 90 days it takes to close the loan, 10 more
ice cream stores open on the beach.
Prices drop from $5 a cone to $1.50 per cone.
Why?
Because all these ice cream stores sell esentially the
same product.
And since they all need to pay for rents and salaries they
have to bring people into the stores.
And nothing brings people into stores better than discounts.
But now, the terrible price competition has eliminated your
profit entirely.
In other words, whatever pricing power you had is completely
gone.
You now have a commodity product – a product that
competes solely on price.
But thats only half the problem.
The other half is even worse – now a recession hits.
So here you are – an owner of a company that sells a commodity
product with way too much debt – entering a recession.
And now, for every cone you sell for $1.50, you lose .10 cents.
Why?
Because the interest expense on the debt is beginning to choke
you.
It’s at this point that you learn your 4th valuable lesson
about investing:
Lesson # 4. Never invest in company that has a lot of debt.
ESPECIALLY A COMPANY THAT COMPETES IN AN INDUSTRY WITHOUT
PRICING POWER.
Because at some point – and this is a guarantee – you will
enter a recession.
And while a recession can be a terrible thing for some
businesses, it can be great for other ones.
Let me explain.
The recession was so severe that 12 out of the 17 ice
cream shops on the beach quickly went out of business.
That’s the good news.
The bad news is that your ice cream shop was one of them.
The bank called your loan.
But our story doesn’t quite end there.
As you walk home from the auction that sold your
beloved property you realize something new:
Bob’s Ice Cream Shop – the second shop to open after
yours – didn’t take on any debt and kept his costs low.
And right now, he’s using all the money he has to buy
out the remainder of his struggling competitors.
That’s right.
He’s consolidating the industry to eliminate the competition.
He’s making sure that by the time the recession is
officially over, Bob’s Ice Cream Shop is the dominant
player on the beach.
Yup – 30 percent returns on capital will soon be Bob’s
for the taking.
And its Right then and there that you learn your next
lesson:
Lesson #5: Companies that run lean and debt free operations
during boom times, quickly become consolidators and gain
market share during bust times.
Airlines, automobiles, internet, software, hardware,
insurance, railroads…radio….
Its the nature of business and its happened since the
beginning of time.
And its exactly whats happening now in telecom.
So, as you sit on the corner and watch Bob drive by with
your ex-wife and old Rolls Royce, the last and final lesson
occurs to you:
Lesson #6: If you would have taken a 30 day free trial
to the Tycoon Report before you invested into this busines
you would have known all of these lessons and much, much more!
So what are you waiting for?
visit us here and try the Tycoon Report risk free for 30-days:
http://www.tycoonresearch.com/login_visitors.asp?email=submitted
Remember, you are what you read.
–Dylan Jovine