Jun 23, 2010|
Will Warren Buffett invest here?
Warren Buffett is the world's most successful investor. He has an investment philosophy of his own. An investment/company fits Buffett's criteria only if:-
- It has strong sustainable RoEs
- Has consistent operating cash flow generating capability and
- Low to minimal leverage
Now, if one has followed Buffett's investment philosophy strictly then he/she might have overlooked the construction industry all together and never considered investing in it. The reason being - construction industry fails to meet Buffett's philosophy on all the three counts.
In this article we explain the reasons why the Buffett's investment philosophy should not be followed as strictly - especially for the construction industry.
Let us begin with the first criteria - sustainable RoEs. Numbers foretell the future. But it is important to understand that interpreting them right on the face of it can paint a different picture altogether. A higher RoE business is perceived to be better. But the construction industry is typically plagued with low double digit returns on capital and the reasons are obvious. Construction is a wafer thin margin business. The projects are created for social benefits - typically awarded by the government - and thus have a thin spread.
It should be noted that over the last few years, construction companies have typically made huge investments in subsidiaries. These subsidiaries undertake BOT projects on behalf of the company. Investment in subsidiaries will not be generating incremental returns to shareholders at least in the near term as BOT projects require huge upfront construction cost (with back loaded returns spread over the concession period) and have long gestation period. This depresses the initial RoEs. Thus, viewing construction industry RoEs (ranging between 12-15%) in isolation does not reveal the true picture. Adjusting for investments in subsidiaries, construction companies typically generate RoEs in the range of 18-20%! Now, this is certainly commendable in an industry which does not have a very strong competitive advantage.
Coming over to our second criterion on cash flow generating capability, construction is a working capital intensive industry and thus does not generate cash at the operating level. However, it should be noted that over the last few years, construction companies have advanced huge amount to subsidiaries in the form of loans & advances. This in effect exaggerated the working capital concerns. Adjusting for loans and advances the working capital cycle of the construction companies have improved - even if they have not managed to be operating cash positive. We do not expect the industry to be operating cash positive either but the point to be noted here is the exaggeration of concerns over cash flow due to capital mis-allocation.
The last criterion relates to leverage. Construction companies are highly leveraged. However, it should be noted that debt is typically used to fund working capital requirements and is short term in nature. This is in sharp contrast to other industries where debt is used to fund capex requirements. Thus, when a construction company faces liquidity crunch during a downturn, it can tweak its working capital cycle by stretching creditor days. This should reduce its reliance on debt when liquidity is hard to come by.
However, during similar crisis other companies in different industries are not as comfortably placed unless the capex they incurred via raising debt is generating profits immediately. If the capex was incurred in the initial stages and does not generate enough returns, the company might have to take more debt to fund its business operations. Thus, it might get trapped in the vicious debt cycle.
Thus, what we try to convey over here is - Buffett's criterions give you a broader sense on investing in particular businesses. But the investor must be wise enough to understand the industry dynamics and apply the philosophy accordingly. Agreed that the construction industry falls well short of Warren Buffett's investment principles. But it does merit an attention provided the valuations are right and the management is visionary in nature. Of course, it goes without saying that companies in the sector deserve lower valuation multiples that those imparted to companies with limited cash needs and strong competitive advantages.
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