This Fool turned failure into success.
In a recent article, I looked at how investors might find the best businesses to invest in.
However, in the mid-nineties I found myself owning and managing a business with poor economics and undesirable characteristics. It was clear that something had to change.
It had to be turned around, and with the help of Warren Buffett, investor extraordinaire, it was. This is what happened when I set about transforming that business into a better one.
A bad business
My contracting and maintenance business had all the characteristics of a low profit margin business selling something that many other businesses sold in a competitive market place, where the lowest bidder usually prevailed. In short, it was a commodity-type business with precious little to distinguish it from its competitors.
On top of that, it was labour intensive, cash flow timing negative, and had a big seasonal aspect to its operations. To be frank, its very survival balanced precariously on a knife-edge.
When you are scouring the market for businesses to invest in, it's a good idea to watch out for, and avoid, undesirable characteristics like my old business had:
- Erratic profits
- Low profit margins
- Low returns on equity
- Low brand loyalty
- High competition
- Over capacity in the industry
When faced with a dud set of attributes like that, management has to change things fundamentally to deliver a meaningful return to investors.
I wanted to turn my poor performing business into a consumer monopoly-type business; in other words, I wanted it to have predictable, robust and excellent business economics that would enable it to produce lots of cash.
It was a challenge, to be sure, but with Mr Buffett's guidance, it was achieved.
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Moats and bridges
The concept of a consumer monopoly business is based on the business developing some kind of monopoly for its products or services in the market place. In other words, its customers favour the businesses offering, over others, because of things like its brand, or its geographical dominance, or its technological edge, amongst other things. This is often described as its economic moat.
One realisation of a consumer monopoly is seen in the analogy of a toll bridge operation. Here, the operator has monopoly over customers crossing the river, for example, and in the absence of competition, can set tariffs at a level that ensures a profitable enterprise. It's a useful concept to apply to business operations and featured heavily in the rehabilitation of my company's business model.
Specifically, I wanted to:
- Achieve predictable revenue
- Add value to the product
- Increase profit margins
- Reduce the labour intensity of operations
- Create brand loyalty
- Generate revenue from less competitive areas
In a nutshell, rebuilding the business model consisted of several fundamental actions. The first involved narrowing the scope of the operations with a view to occupying a definable niche in the market.
Secondly, the business was switched from being contract led with a maintenance back-up service, to being maintenance led with a contract back up service. In other words, repair and replacement contracts flowed from routine maintenance; a crucial change, because customers were less inclined to shop around when at the point of equipment failure, and margins were then higher.
Thirdly, greater effort was put into the pursuit of service excellence, better brand building and marketing. As customer loyalty developed, this was leveraged by switching customers to maintenance contracts. These contracts added value, making the service less labour intensive; increased profit margins; achieved all year round predictable monthly revenue and ensured customer loyalty.
It was now a classic 'toll bridge' operation, a geographically focussed, niche dominant consumer monopoly business, and the affect of this model on its economics was transformational.
A powerful combination
In effect, the presence of a consumer monopoly generated lots of positively timed cash flow at higher profit margins, which powered other desirable characteristics of what had become a good business. There was now a high return on invested equity and earnings had become robust, consistent and predictable.
Happily, the business was then sold at a premium based on its now slick metrics, thus realising its intrinsic value, and successfully concluding my first Buffett-style investment.
What to look for
So, rather than creating your own consumer monopoly business as I did, why not pick one that is ready made by looking for businesses that either have, or appear to be developing, some kind of moat, when searching for investments on the stock market. Such companies may:
- Be dominant in a particular market niche
- Have a consumable or repetitively purchased product or service
- Have a customer base loyal to the brand
- Experience freedom to price with minimal constraint from competition
When you find them, remember that the price you pay determines the level of your future compounding returns from the investment. If they are too expensive, why not put them on watch and wait for a good offer price to come to you?
More from Kevin Godbold:
Further reading: Mary Buffett and David Clark, Buffettology | Alice Schroeder, The Snowball