value investing

The best of the many value investors I’ve worked with in my career used to explain what he did by saying, “There are no bad businesses.  There are only bad managements.”  He defined “business” as any endeavor that produces revenue.

In other words, the tools needed to make money–plants with machinery in them, sales forces, distribution centers, brand names, consumer goodwill…–are all there inside a company for management to set in motion.  Whether on not the firm makes a profit depends on how skillfully management uses this toolkit.

the value opportunity

Take two companies in the same industry and with identical assets.  Both have $100 million in annual revenue.  Company A makes $10 million in profit; Company B makes $3 million.

Value investors buy company B.  They either wait for or instigate change that will toss out incompetent management and put in new guys who will use the toolkit better.  (By the way, I wrote a lot about growth vs. value a few years ago.  Try my style test.)

what has to work

Two basic assumptions value investors make are that:

–change is possible.  Not a problem in the US.  Japan, where Western black ships are now toothpicks along the shore, is the obvious counterexample.

–the assets endure and can prosper in better hands.  Therefore metrics like price/book value or price/cash flow are reliable measures of a company’s worth.

the pace of change…

Look at the computer industry.  The mainframes of the 1960s gave way to the minicomputers of the 1970s.  The latter, in turn, lost out to the PC, whose dominance is now being undercut by mobile devices.  That’s 60+ years of history in two sentences   …that’s plenty of time for a nimble value investor to operate successfully.  But it’s also pre-Internet.

…is accelerating

Take Ouya.  It’s a $100, Android-based videogame console.   The idea is to play casual games on your TV, at a fraction of the price of a Nintendo, Sony or Microsoft console.

You can also play prior-generation games of all sorts on Ouya.  You can use old XBox 360 controllers, too.  Try games for free before buying.  (Developer tools come in the Ouya box, too,just  in case.  Revenues get split 70/30 in developers’ favor.)  There’s also the possibility of apps like Netflix, Hulu…

Maybe Ouya will be successful, maybe not.

What I think is more important is that Ouya has overcome the barriers to entry that supposedly ensure the permanence of the “toolkits” of incumbent firms:

–Financing:   Ouya set out to raise $950,000 through Kickstarter to get going.  It took in $8.6 million.

–Advertising:  social media  (In the UK, Ouya sold out in seconds;  in the US, it sold out on Amazon in eight hours.)

–Factories:  outsourced

–Game content:  all third-party.

Ouya’s biggest problem, as I see it?  It’s not XBox One, PS4 or Wii U.  Ouya’s low cost is likely to put downward price pressure on the price of all these traditional machines.  Ouya’s biggest worry is that its greatest competitive edge is its first mover advantage.  Low-cost competitors Gamestick, Game Pop and Project MOJO are are speeding down the same Internet-enabled trail Ouya has blazed.

What’s a value investor to do in this new world?