- Even if the industry has wonderful growth numbers, profitability might remain out of reach.
- We’ll define and describe the industries long term investors should avoid.
Most of you are familiar with Warren Buffet’s comment on the airline industry in his 2007 letter to shareholders:
“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”
Now, most connect the above statement only to the airline industry. However, in a deflationary environment where our youngsters expect lots of things for free—think WhatsApp—and extremely low interest rates, there will be more industries where shareholder wealth creation will be difficult to achieve.
In today’s article, we’ll define and analyze some of these industries.
Gruesome Industry Characteristics
Buffett has described three kinds of businesses: the great, the good, and the gruesome.
A great business must have an enduring “moat” which protects excellent returns on invested capital. Think of a big mine with an extremely long life of mine, high grades, and low mining costs, or of a business that can consistently reinvent itself and stay ahead of the competition while keeping margins high with the high margins allowing for the cash to be deployed elsewhere through investments or dividends.
A good business is one that requires a significant reinvestment of earnings if it is to grow. A clear example of such businesses are regulated utilities which make money but also require large continuous capital investments.
A gruesome business is one that has constant demand for capital and is seldom profitable due to unconstrained competition. It’s important to analyze such environments in order not to get caught in one with your long-term portfolio. In the short term and for trading, such industries are great as they give leverage on the booms and busts in the economic cycle and investors’ sentiment.
Examples Of Industries To Avoid For Long Term Investors
We’ll start with the steel industry.
Cumulative earnings for global steel producers have been negative over the last 5 years. However, what is keeping many alive is the hope of a steel price boom like the one experienced in 2007.
Figure 1: Steel price. Source: Trading Economics.
The problem is that even if the price rebounds, additional capacity will quickly emerge and create another decade of miserable returns.
Another example is the shipping industry.
You can’t have a competitive advantage in shipping. Anybody can buy a ship and offer shipping services. As soon as shipping fees rise above profitability, new supply is built which creates a state of oversupply.
The sector was surprised by the high demand before the financial crisis so there weren’t enough ships for a while, but this has quickly changed over the last few years.
Figure 2: Baltic dry index. Source: Quandl.
Increased supply quickly lowered shipping fees which has kept shipping companies on the verge of profitability in the last few years and you shouldn’t expect a sustainable rebound because as soon as shipping fees increase, there will be another ship building boom.
The aviation industry is also an unprofitable industry however some carriers defy the odds and have been profitable for longer periods. Companies like Southwest Airlines Co (NYSE: LUV), or the European Ryanair (NASDAQ: RYAAY) which has been extremely profitable and has grown in the last 10 years. State owned and related carriers have been, and continue to be, gruesome businesses. If you must invest in airlines, choose the lean, low cost ones as they seem to have some long-term advantages.
The above are the usual suspects but there are other industries that still have difficulties in finding their place under the long-term investment sun: biotech, internet, and technology.
Biotech is a sector where companies burn through hundreds of millions of dollars and often with nothing to show for it. Biotech companies focus on the research and development of new drugs, and have extremely long product development times with uncertain outcomes.
An analysis of 211 public biotech companies in the period from 2003 to 2009 shows how extremely low the drug approval rate is. Only 8.9% of NCEs (new chemical entities) and 14.7% of biologicals reach the market. When the drugs are approved, the issues aren’t solved. If the drug is too expensive or the competition produced something cheaper, shareholders might not see profits at all.
Figure 3: NCEs and biologicals approval rate. Source: Avance.
Investments in biotech remain attractive due to the possibility of hitting the jackpot with an amazing new drug. However, the profitability remains questionable, but as people continue to play the lottery even if the odds are against them, so too will people continue to invest in biotech.
Similarly to biotech, the internet offers some winner stories like Microsoft and Google, but also many stories like Webvan, Bebo, or Myspace which went from a $12 billion valuation to $35 million. Current internet and social media giants still struggle to be profitable and we are still far away from seeing the first dividends. As new competitors arrive, millennials get bored and switch to new apps, compromising long term profitability. A great example of a company still struggling with profitability even though our President Elect uses it daily, is Twitter (NYSE: TWTR).
It’s easy to plot amazing growth numbers, potential breakthroughs, increased global trade, and travel trends into financial statements based on positive assumptions. What is often omitted is that hundreds of companies go after the same market making it almost impossible to be profitable.
Before you invest for the long term, be sure to understand long term market dynamics and risks.