“The greatest victory is that which requires no battle.”
Source: Sun Tzu, The Art of War
Over the years, Capital Flywheels has repeatedly emphasized the importance of strong business models as well as strong balance sheets. While most investors pay lip-service to both, Capital Flywheels believes that these two factors are the primary sources of sustainable long-term capital and value creation.
A company with neither a strong business model nor a strong balance sheet is no different from a dice-roll. For mathematical prodigies, it is still possible to make money in these situations as long as the price of risk is lower than the calculated odd of the risk, but Capital Flywheels is most definitely not a prodigy in math. For investors like Capital Flywheels, value creation through strong business models and fortress balance sheets will likely prove superior (and more repeatable) over the long run.
In the last few years, many investors and thought leaders have increasingly accepted / embraced the importance of business models, but strong balance sheets are often still regarded as just a defensive measure…something that you look for in order to reduce blow-up risk.
Although strong balance sheets certainly reduce blow-up risk, Capital Flywheels believes the offensive value of a strong balance sheet is significantly underestimated. In fact, many investors (both professional and retail) often believe strong balance sheets are a waste of resources and would prefer companies to take on leverage in order to amplify returns on equity. While this may be the correct decision for some companies, it likely materially reduces financial flexibility when capital / value creation potential is high.
When is capital / value creation potential high? When all of your competitors are on the verge of going out of business.
Capital Flywheel finds it very surprising that many companies are operated with a pro-cyclical bent. Companies often want to grow when their peers are growing. Companies often feel like they need to grow when their peers are growing.
But in the history of every single industry, big companies usually did not get big by just grinding it out against competitors. Big companies get big when their peers collapse and leave the market. Big companies did not get big by just being 1% better than their competitor. Big companies got big when their competitors became 10-100% worse.
For example, the US is down to 4 mega banks – JP Morgan, Bank of America, Citi, and Wells Fargo. These four banks are the result of decades of consolidation in the banking industry. Every few years, a recession comes along and thins out the herd. These four banks with mega balance sheets have survived every single one of them (though some of them did need some help in 2008). And the power of a strong balance sheet not only allows them to survive, but to go on the offensive when their peers are weak. These four banks have been major consolidators in past periods of economic weakness, which allows them to buy good assets cheaply (2008 is, unfortunately, again, an outlier since these banks were, in some instances, forced to buy some not-so-good assets for the greater good, but that is a different story).
In life, kicking someone while they’re down is frowned upon, but in business, is there a better strategy?
Another example: Retail. For decades, Walmart was the most feared company in retail. It gradually took over every city in the United States. While Walmart certainly grew because it was better than peers (and a lot better than mom and pop stores), the big jumps in business always came after weaker peers exited.
The same dynamics are happening now with Amazon. Sure, Amazon is already gaining share consistently from peers, day-in and day-out. But the real jumps in business will be when Macy’s and JC Penney and Nordstrom go out of business.
This is not just because customers have fewer options. The offensive power of a strong balance sheet is tangible even if peers are only weakened.
A strong balance sheet allows a strong business to scoop up talent when they are being laid off elsewhere. A strong balance sheet allows a strong business to expand when others pull back (for example, scooping up prime commercial real estate locations while peers leave). A strong balance sheet allows a strong business to continue to invest in future-critical R&D while peers are forced to pull back.
All of these things allow a strong business to not just be 1% better but a lot better simply because peers do not have the capacity to keep up. A strong balance sheet allows a company to continue to get 1% better at the same time that peers become 20-30% worse at conducting business.
What’s interesting is that everyone’s favorite investor already advocates and carries out such a strategy: Warren Buffett / Berkshire Hathaway has consistently advocated against leverage with a preference for investing / buying out great companies during periods of stress. It surprises Capital Flywheels that many investors, especially value investors, do not appreciate the same things (strong balance sheet and strong business models) in companies that are not named Berkshire Hathaway.
Whether society likes it or not, this current crisis will likely be another major period of consolidation. Companies with strong business models and strong balance sheets will not only see peers never come back, but these strong balance sheets will allow them to accelerate expansion in ways that will likely be very hard for struggling peers (that do survive) to catch up when things normalize.
Many (all?) of the companies in Capital Flywheels’ Paper Portfolio share these qualities (strong business models and strong balance sheets). The next 6 to 12 months are uncertain, but the long future has, likely, never been brighter.