Lesson 1: Don’t Buy Crappy Businesses

21 04 2010

When Mr. Buffett isn’t selling out stadiums, he offers us priceless investment advice. One of his most famous quotes:

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

While I can’t say I agree with that statement, I’ve discovered the truth of another: ‘It’s far better to buy a good company at a good price than a terrible company at an amazing price.’ In my last post, I detailed China 3C Company and indicated that it was grossly undervalued. While I still believe that to be true, I now realize that buying CHCG was a mistake.

When you invest in a crappy company, you’re introducing a speculative element. In the case of CHCG, the intrinsic value of the company is decreasing with the passage of time. Whether I make money on the investment is dependent upon whether the market price rises to the intrinsic value before the intrinsic value drops below my purchase price. And what controls this? Sheer luck. Contrast this with the purchase of a great business below its intrinsic value. As the intrinsic value rises, a rational investor shouldn’t care whether the market takes a week or 3 years to realize the value of the company.

And this is why I admit that investing in CHCG was not a good idea. I don’t want the success of my portfolio to be based on luck. Maybe Buffett could also teach us a thing or two about women.

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5 responses

10 05 2010
Walter

I don’t think that CHCG’s intrinsic value will necessarily decrease over time. Historically, it has a high ROE. Even if you assume it will have low ROE going forward, the return on market equity (the price you paid for the equity) can still be high. Not only that, but its free cash flow is high. It’s definitely not a stable business, but I wouldn’t automatically call it a “crappy business” either.

10 05 2010
Adam

Hey Walter,

Now that CHCG is changing its business model, it’s essentially a start up company. It’s been eating up cash, not producing it. Previous data doesn’t really apply in these circumstances as CHCG is going to be totally different now. That’s why its historical ROE isn’t valid. Investing in it was a mistake, but as long as a learn from it, I don’t mind.

-Adam

10 05 2010
Walter

Where do you see that they are eating up cash? According to their latest financials, they are free cash flow positive, and spend very little on cap ex. If I remember correctly, they are going to franchise stores in their new business model (along with opening their own stores), which means low cash outlay.

Also, they are going in a new direction with the business, but I don’t believe their are folding up their existing stores all at once, so their old business is still going to make up the majority of the company.

Anyways, my point is, I don’t think it’s fair to call them a crappy business. I’d say mediocre. Their stock is a penny stock, trading on the OTC, based in China, and with a short history. But I think that makes it a risky stock, not a crappy business. When I think of crappy businesses, I think: low ROE, low to negative FCF (and thus high cap ex), high financial and operating leverage, consistently low margins and inventory turnover, etc. Just looking at the fundamentals, I’ve seen much worse businesses.

10 05 2010
Adam

Ahhhp, I stand corrected about the cash flow. Rather, the losses are in net income.

I guess we could argue over our definitions of a crappy business, however I do agree that I’ve seen worse. lol.

Also, while they’re not packing up their existing stores all at once, the future of the business is going to be this new business model and we have little to no information about the company’s ability to make this model work.

The point of this post was not to declare that CHCG is fairly priced, but instead that I think it’s a much better idea to invest in great companies.

10 05 2010
Walter

I do agree with that. If you buy a good business at a good price, it’s pretty hard to lose money. I think many value investors try to calculate “intrinsic value” as a static number, then base their decisions on that. Like if stock X is trading at 0.5 of intrinsic value, and stock Y is trading at 0.7, buy stock X. But intrinsic value also changes over time. So we do have to be aware of this calculus. But… CHCG is so cheap!! Can’t resist 🙂 Anyways, good discussion!

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