How Regulation can make one rich and famous!
Our periodic communication that reminds you to ask, “Should I react to those headlines?”
December 2024
Wooo Pig Sooie!
How Regulation can make one rich and famous!
“A farmer has to be an optimist, or he wouldn’t still be a farmer."
― Will Rogers
At Advisor.Investment, our ”favorite” investments have five characteristics:
- Easy to understand
- Strong competitive advantages
- Long runway to receive high returns on reinvested profits
- Shareholder-friendly management
- Stock price provides a margin of error to what we believe the underlying intrinsic value is
We also use themes to describe our investing biases, which include expanding global prosperity, a cyclical price pattern, and creative destruction.
As a real-world demonstration, let’s pretend we’re pig farmers. (Fair warning that I have no idea of the specifics of pig farm industry regulations, but “widget sooie” just doesn’t have the same ring!) We’ll also use nice, round numbers to keep things clear and easy to follow.
Pig SOOIE!
In our imaginary pig industry, our farmer has a big decision to make at her current 9-pig capacity: She can stay below 10 pigs, or pay 5 times the current value of her pig farm in regulation costs to get to 10-pig capacity. Therefore, most pig farmers decide to keep work easy, keep risk and stress low, and remain at that 9-pig capacity. A minority of farmers will say, “Let’s take the risk and pay the cost and try to get to 100 pigs.”
As you may have guessed, this risk situation occurs again near the 100-pig capacity, and 1,000-pig capacity, and 10,000-pig capacity, on and on and on. Until one day, there are just three farmers at the 80- to 99,000 pig capacity, and those three farmers control the industry.
But there’s another twist: Some of the lower-level farmers have developed a superior breeding strategy where their pigs are healthier, cheaper, or in some other way beneficial to consumers. The problem? They’re still subject to the same regulations. This is great news for our three largest farmers, as the “new-style farmers” have their dreams and passion and value to consumers destroyed. These farmers decide not to take the risk of expansion.
After 50 years or so of this three-farm dominant industry structure, one of those “new-style farmers” believes she has figured it out! “Aha,” she says, “I will take the risk to build a million-pig capacity to my new pig farm idea, instead of starting with a small 10-pig capacity. Oh, but I need a lot of capital (the money).”
As she shares her dream, an enterprising investor hears the story, has the capital to risk, and believes that she has all the skills necessary to implement her vision. The investor then provides the capital and goes whole-hog into the new million-pig farm venture.
In this shortened fairytale, the risk-taking pig farmer and investor live happily, becoming rich and famous as the venture works out extremely well and brings great value to society. Yes, this story sounds like the car industry, Elon Musk, Tesla and Ron Baron. There are other familiarities to the soft drink industry, Coke, and Warren Buffett. I think Coke even started a new cycle by investing in Monster Beverage! You can find other similar examples, such as Charlie Munger and Costco, Virgin Atlantic and Richard Branson, and so on.
As investors, we don’t have the skills to operate pig farms. Investors are the ones looking to hitch their wagons to the pig farm operator’s business. There are a few investment strategies that may work in this hypothetical pig farm industry:
- Join up with one of the Big Three pig farm industry leaders early on, acquired at a reasonable price.
- Join one of the smaller pig farms which are good enough to be acquired by one of the Big Three, if you can enter at a low price.
- Seek out the “new-style pig farmer” with the best new strategy, energy, skill, intelligence and investor-friendly approach.
- Create a diversified portfolio of several farms in the industry, purchased when all pig farm prices are low.
In this shortened fairytale, the risk-taking pig farmer and investor live happily, becoming rich and famous as the venture works out extremely well and brings great value to society. Yes, this story sounds like the car industry, Elon Musk, Tesla and Ron Baron. There are other familiarities to the soft drink industry, Coke, and Warren Buffett. I think Coke even started a new cycle by investing in Monster Beverage! You can find other similar examples, such as Charlie Munger and Costco, Virgin Atlantic and Richard Branson, and so on.
As a conservative investor, you would, first and foremost, seek to avoid your own capital destruction. For every strategic move you make, choosing when not to make a move is just as important. In our pig farm scenario, what would be some investment strategies to avoid?
- Investing in one of the Big Three Farms which has become bureaucratic, are poor allocators of its profits, and has a glamourous CEO who is overcompensated.
- Overpaying for a small pig farm with a short runway ahead.
- Investing in that “new-style pig farmer” with the vision and capability for only a 9-pig farm capacity.
- Investing in an industry as if it had the structure of this “pig farm industry” but it does not.
- Leveraging your “investment” so that you do not have staying power and are shaken out at a lower price or sell way too early. Turning the good investment strategy into a gamble.
Combining the four possible investment strategies and five strategies to avoid is how we think about what characteristics our “favorite investments” would have in hindsight. Our investment themes are based on the belief that most industry structures resemble this pig farm industry at some stage of development.
Market participants quickly realize that hypothetical “favorites and themes” used to explain investing, are not that easy to find in a competitive investment world, with real-world implications for the investment results. This realization along with the pain of waiting through long cycles, turns most market participants into gamblers and speculators, instead of investors.
The current investment climate is full of gamblers and speculators seeking to avoid the time, skill, and patience part of the equation. We believe one should avoid joining the ranks of speculators and gamblers, which is so very difficult to do at times such as these. Thanks for your attention. I hope this helps, and please be safe,
James
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