Two categories of businesses investors should avoid

While many businesses benefit greatly from being listed, some do not. These are what I call ‘unlistable business models’ and fall into two broad categories:

1. Those with margins that need to be hidden; and
2. Those that are too complex for outsiders to understand.

The first category’s poster child is contract manufacturers.

The contract manufacturing business model is that you do not own the brand or the intellectual property, and probably do not take part in the distribution of the product. Instead, you manufacture for a third party.

You are basically a ‘hired gun’ in the manufacturing sector. The more commoditised the product, the simpler the manufacturing process, and the lower these margins.

And it is these margins that cause problems for listed contract manufacturers: they are forced to disclose (at least to some degree) how much money they make from their clients. Thus, the moment any listed contract manufacturer publishes a set of results that shows fantastic returns and margins, its customers will use this against it at the next contract negotiation to push their prices down.

Given that contract manufacturers carry the fixed overheads of factories, they typically want (need) to fill these assets with volumes and thus will take a lower margin just to ensure that these assets are filled with volumes.

Armed with this knowledge, customers have the pricing power here – not the listed contract manufacturers.

(Unlisted contract manufacturers will not face this same fatal flaw to the same degree.)

Hence, contract manufacturers just simply do not work well in the public markets.

For those with some JSE history, Beige Holdings was a good example of this, but more recently, Libstar (Libstar profit slumps) is proving this view true.

Interestingly, to fill its empty vaccine manufacturing facility, Aspen Pharmacare is increasingly turning to this, but the group may be somewhat sheltered from this pressure by stiff licensing and pharmaceutical regulation, murky margin disclosure in its results, and long lead time contracts.

Complexity

The next set of businesses that probably would do better unlisted (that is, wholly owned and operated by those who understand them) are those that are too complex. In my opinion, markets and investors pay a premium for simplicity while marking down things they do not feel they adequately understand.

A good example of the complexity that the market has slapped a discount on (though you may disagree here) is Transaction Capital (Bringing rationality to Transaction Capital). Perhaps another one is Blue Label Telecoms, particularly with its impossibly complex, intertwined investment into Cell C.

Read/listen: ‘It’s really sad to be leaving on a low – but that’s life’: David Hurwitz

While I am less certain of Blue Label Telecoms, and Transaction Capital is a special situation, more broadly, the market tends to slap (permanent) discounts on conglomerates. While popular a couple of decades ago, most conglomerates have been broken up and seen vast amounts of value unlocked across public markets.

But why were there these discounts in the first place?

It’s hard to say, other than that taking a bunch of very different businesses and sticking them together with duct tape for the sake of ‘diversification’ is not the job of a board of a listed company.

Investors should diversify their portfolios while boards should build the best single and coherent business they can in their space (realising returns to scale over time, which conglomerates tend not to realise as each of their separate businesses can often be sub-scale).

Take Barloworld. What does selling Caterpillar equipment and spares in the UK, Russia, Mongolia, and South Africa have to do with crushing corn in large mills to make starch and glucose additives for predominantly alcoholic beverages

Well, nothing.

This same business also used to own the Avis car rental company, but that was recently unbundled. My guess would be that despite a stated strategy of building a conglomerate, Barloworld will be involved in some corporate actions in a decade or so’s time to ‘unlock shareholder value’ that is slowly being ‘locked’ as it conglomeratises its group.

Read:
Discount problem continues to haunt holding companies
Does PSG’s delisting signal the end of investment holding companies?

I am not picking on Transaction Capital, Blue Label Telecoms or Barloworld – I am just highlighting that markets hate complexity. If you have or are running a fantastic business and want the best rating you can get in the stock market, make it simple to understand.

Simple breeds confidence, confidence leads to conviction, and conviction results in good ratings.

Given that most people reading this are not intending to list a business on a stock market, what is the relevance of this article? Simple: a good rule of thumb for investors is to avoid these two categories of unlistable business models as they tend to perform badly over time.

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Keith McLachlan is chief investment officer at Integral Asset Management.