"Rule #1: Don't lose money. Rule #2: Don't forget Rule #1." - Warren Buffett
Matt Duckworth from Deal Camp is back to discuss the top ways people lose money when they do an acquisition. This series is meant to address the concerns of those who want to make money but don’t want to lose it. In this third installment, Duckworth explains why buying a business in a bad industry is a surefire way to lose money.
What is a Bad Business?
Duckworth explains that a bad business is one where the cash flow is volatile and unpredictable. He uses an example of a business that had a cash flow of $100,000 one year, $50,000 the next, and then $200,000 the year after. This kind of volatility is a red flag for any investor.
When using leverage, the cash flow needs to be stable enough to cover the debt service payment. If the cash flow dips below the debt service payment, the investor will not only be stuck with the debt service payment, but also the operating loss.
One of the many genius revelations of Warren Buffett was that buying businesses with stable cash flow that were growing was like buying a bond or a rental property. This allowed him to use leverage in the form of insurance premiums to acquire businesses and still have the cash flow to cover the repayment of premiums (similar to paying back a bank loan).
What Kinds of Businesses are Bad?
Duckworth explains that businesses that don’t control their pricing, such as mining and commodities, are to be avoided. Construction companies are also generally very risky because of the economy and their small margins. Retail is hard because there are no intrinsic advantages in most retail shops. Restaurants are also risky because of fickle and unloyal customers. Any business that has any of these factors should be avoided.
Buying a business in a bad industry is a surefire way to lose money. Investors should be aware of the signs of a bad business, such as volatility in cash flow, lack of control over pricing, fickle customers, and low barriers to entry. By avoiding businesses in bad industries, investors can protect themselves from one of the leading causes of M&A loses.