Monday, August 12, 2013

Strategic Planning Analogy #510: Overcoming the Spread

Awhile back I was trying to help my mother liquidate some of her assets. One of the things she had was a collection of old coins. I went to a dealer in coins to find out what they were worth.

I was shocked by the spread between the wholesale price (the price the dealer pays to acquire my mother’s coins) and the retail price (the price the dealer charges when he resells the coins). I felt like I was being cheated.

It looked to me like collectable hobbies were a big rip-off. You are stuck buying at retail (high) and reselling at wholesale (low). Even if your collection appreciates in value, you may never see any of that gain because it gets lost in the spread between buying high (retail) and selling low (wholesale).

If you advocated dealing in the stock market in that same way (buy high, sell low), you’d be seen as crazy. But collectable hobbyists do it all the time. I guess that’s why it’s called a hobby instead of a business.

In the business world, there are essentially three ways to make money. One is to be like a collectable hobbyist. You trade in assets (like coins) which you hope will appreciate in value, so that you can resell them at a profit. We’ll call that the “Appreciation” strategy. The appreciation strategy includes a lot of the business approaches used by those who do a lot of M&A activity, private equity funds, and stock traders.

The second way to make money is by being like that coin dealer. You make money by helping people using the Appreciation strategy make their transactions. Your profits come from the spread between retail and wholesale. We’ll call this the “Mediator” strategy. It is the approach used by brokers, agents, investment bankers and retailers, among others.

The third way is to make money by adding a new element of value that wasn’t there before. We’ll call this the “Creator” strategy. The value can be created by taking raw materials to make a new product (i.e., manufacturing) or by taking raw ideas and processes to make a new service (which is like a form of intangible manufacturing).

Just as I saw collectable hobbies as a rip-off, I see similar flaws in strategies primarily focused on the Appreciation or Mediator approaches. As we will see in this blog, the Creator strategy approach has inherent advantages over the other two approaches, because it tends to avoid the problems I saw in collectable hobbies.

The principle here is that the approach you take for gaining profits makes a difference, and the creator approach tends to have the most solid foundation for success.

1) Problems With the Appreciation Strategy
As we saw with the coin collecting, there is a big spread that needs to be overcome in order to profit from any appreciation. This same problem applies to all who operate under more of an appreciation approach. If you are a private equity fund acquiring assets or a business doing a lot of M&A, you are familiar with this problem, although you may call it something else.

There is something called an “acquisition premium” when you buy companies or businesses. It is the price you pay over the current ongoing value of the business as is. This is most easy to see when a publicly traded company is acquired. The acquirer always pays a lot more than what the company had been previously trading for. Supposedly, the public trading price on the stock market is a fair assessment of the value of that business pre-acquisition. So the premium means that you are paying a lot more than the market thinks it was worth.

The fact that one has to pay a premium over the trading price is like the spread at the coin dealer. You acquired the company high, sometimes as much as 30% or more over the pre-acquisition valuation. And often, the company is resold via an IPO, where the price is intentionally set relatively low, to appeal to the initial buyers of the IPO stock, who want to achieve a quick appreciation on their investment.

As a result, a whole lot of appreciation has to occur in order to cover that spread and make money. That can be hard to come by in this slow-growing economic environment. This is compounded by the fact that those attempting to acquire are finding more savvy sellers who are demanding a larger premium (just ask Michael Dell in his attempt to take Dell private). So the gap may be getting larger while the opportunities and tricks available to get an appreciation over the gap are getting more difficult. This is why many private equity funds are having difficulty finding ways to effectively invest all that money.

A second problem for those using the Appreciation strategy approach is that they tend to have less control over their strategy than those using the other approaches. Commodity prices can fluctuate rapidly. As we saw in the great recession, prices on mortgage devices can plummet quite quickly. And the strategy only works if you can find another set of buyers to pay you more than when you first bought the asset, which is not guaranteed. With less under one’s direct control, the harder it is to make sure the Appreciation strategy succeeds.

2) The Problems With the Mediator Strategy
Mediators, like my coin dealer, also have problems. The largest problem has to do with market disruptions and disintermediation. In the past, agents, brokers and the like held special power because they were about the only way to connect buyers and sellers (the power of mediation). Now, thanks to disruptive digital business models, buyers and sellers can approach each other directly. Instead of going to the coin dealer, I could have sold those coins directly to consumers on Ebay and kept some of the spread for myself.

Travel sites have eliminated most of the need for travel agents. Why use an expensive stock broker when you can trade directly online? And in the retail space, there are so many digital ways for consumers to beat the spread, that retail stores are at risk of being showrooms for digital competitors. The ability to go direct makes many Mediators superfluous.

And even those Mediators who are keeping their positions are finding out that the spread between wholesale and retail is shrinking. The digital explosion is making knowledge available to everyone. This eliminates friction, makes markets flat, and reduces the power of the Mediator (who used to thrive by having special information other did not). As a result, the Mediator adds less value to transactions, thereby cutting the commission they can demand.

3) The Benefits of the Creator Strategy
The Creator approach avoids many of these problems. First, instead of getting caught in the trap of buying high and selling low, Creators are more likely to buy low and sell high. Why? Creators buy raw materials and sell finished products. Raw materials tend to cost a lot less than finished products. And buying the services of an engineer can be a whole lot cheaper than selling the cool stuff dreamed up by that engineer.

The Creator strategy, by its very nature, is converting lower cost inputs into higher value outputs. This conversion creates real economic value. You are not trying to take a relatively similar object and artificially create a spread between two transactions for that same object as is done in the other strategies. No, you have two different sets of objects—raw inputs and finished outputs—and the difference between the two causes a natural bump in value.

This Creator bump is easier to protect and is more in your control than the type of spread attempted when working as an Appreciator or Mediator. This gives the Creator strategy approach many advantages.

The Warren Buffett Way
These are not necessarily new ideas. This is essentially the philosophy behind Warren Buffett and his approach at Berkshire Hathaway. Warren Buffett has tried to steer clear of the problems in typical Appreciator of Mediator approaches. For example, instead of doing a lot of rapid buy and sell, Buffett holds for the long term. That way, he has fewer spreads to cover (less buy high, sell low). Instead, he tries to get the value out of the long-term output of what the company creates.

Second, Warren Buffett prefers to invest primarily in businesses where clear and simple creation is going on. Businesses based on fancy financial trade maneuvering or businesses where the path to value creation are more vague (like social media) tend to be shunned.

This approach has worked quite well for him. So maybe a more creator-based strategy is better for you.

The implication is that the more real value you can create through asset conversion, the better off you tend to be. Even if you are doing acquisitions or acting as an intermediary, there is room to become more of a creator and less reliant on merely trying to beat a spread. As an intermediary, you can be the disrupter of your industry and create the leading substitute for the status quo. As an acquirer, you can become more like Berkshire Hathaway.

And, as a manufacturer or service provider, you can best break out of the commodity mode by creatively adding more and more value into your conversion from input to output. That differential advantage through superior conversion (in speed, cost, quality or innovation) provides more room to find a profit.

Businesses attempt to make their profit in one of three ways: by Asset Appreciation, Transaction Mediating, or Value Creation through Asset Conversion. The first two approaches tend to be more problematic, because they tend to rely on more of a buy high, sell low methodology. The third approach is more solid, because it creates more value in a more controlled manner.

We covered a lot of economic territory in a very small blog. There are lots of nuances here that we did not address. But the basic idea of trying to create natural value bumps by converting cheaper inputs into more valuable outputs is a key place to focus one’s strategic energy.

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