What are "Business Economics?"

In the way Buffett uses it

This post is part of my weekly newsletter and is for educational purposes.

You'll notice that I frequently use the term "business economics" in my writing. The purpose of this post is to define business economics as it is used by Buffett and provide an example of superior business economics.

Share this post with a friend or colleague who might find it helpful.

What are “business economics?”

Berkshire Hathaway was a "cigar butt" investment Buffett made early in his investment career. Buffett owned significant stock in Berkshire Hathaway. The management and Buffett agreed on a price to buy Buffett out. On offer day, the management undercut Buffett and offered him a little bit less than what they had agreed upon. Buffett acquired the entire company and fired the management that backstabbed him. Buffett considers this purchase to be a mistake. Berkshire Hathaway was in the textile business, which was a capital-intensive business in an extremely competitive industry with declining margins. When commenting on the ending of Berkshire Hathaway’s textile business, in Warren Buffett’s 1985 annual letter to shareholders, he wrote:

“When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact."

To paraphrase, when a business has superior management and poor business economics, it’s usually the poor business economics that remain. Buffett would rather have decent management and superior business economics. In a Berkshire Hathaway annual meeting, Buffett described how the CEO of one of its firms had dementia and managed the company for a number of years before passing away. This goes to show how predictive the underlying business economics are in determining a company’s success.

*“Cigar-butt" investments are investments that are on their last legs. They may have a few years of cash flow left in them because the business is in decline. Even cigar butts have value. Hence, "cigar butt" investments are investments where you pay a discount to the remainder cashflows of the company.

To give a poker analogy to any poker fans. Superior management and poor business economics are similar to forcing Phil Ivey or Tom Dwan to play bad hands (the bottom 50% of their range). Good management and superior business economics are similar to a small- or mid-stakes pro who is being dealt strong hands (the top 20% of their range).

Business Economics is a general term that encapsulates many aspects of a business:

-The business model

-Competitive Moat or Competitive Advantage

-Hidden Competitive Moats

-Long term sustainability of its competitive moat or advantage

-Synergies (In the real sense of the word)

In order to properly assess business economics:

-the business must be in your circle of competence or the business must be understandable

-you understand the psychology and behaviour of consumers and how they interact with the business’s product or service

I will use Shinoken Group (ticker: 8909, delisted), a real estate sales, general contractor/real estate development, property management, energy, and senior care company in Japan, as an example. Shinoken was acquired in 2022 and is no longer publicly traded.

Shinoken Group showcased superior management and superior business economics at an extremely attractive price. The opportunity to purchase a stock with all three of these characteristics is extremely rare. When an opportunity is identified, one should place a high conviction and concentrated bet. I put 1/7 of my net worth into this investment when I found it.

Shinoken Business Model:

Shinoken Group started off as a real estate sales and development company that developed rental properties for working professionals in Japan. Soon, they expanded into property management. This is an obvious vertical; once the property is sold, not every owner wants to manage the property themselves. Next, they expanded into energy by offering gas and electricity to clients. This is another vertical, as any tenant needs gas and electricity to live in the unit. And lastly, once the tenant or the landlord retires, they can request a senior caretaker to come to their home or move into the company’s senior homes. The company has also converted entire apartment buildings into senior homes.

Once a customer is acquired for their real estate development and sales segment, they have the opportunity to become customers for their property management, energy, and senior care offerings. In other words, marketing expenses used for the purposes of real estate development and sales trickle down to every vertical segment of the business.

Shinoken Competitive Advantage:

Shinoken purposefully develops real estate within 10 minutes of the nearest train station. In major cities, people primarily walk and take the train. Anecdotally, having travelled to Japan and booked hotels and Airbnbs there, I can say that there is significantly more demand for accommodations that are a 10-minute walk away compared to those that are a 20-minute walk away. While I was in Japan, I averaged 16 to 20 thousand steps a day. 20 minutes is an awkward distance where one doesn’t want to call a taxi but is far enough that your legs start to feel tired.

By only developing within a 10-minute walk of any train station, the company created a competitive edge over its competitors. First off, demand will always be high for properties with a proximity advantage to train stations. Second, vacancy rates will be low, resulting in lower turnover for their property management company. Even in a recession, the last thing people do is relocate. What happened during COVID was that the company experienced all-time lows in vacancies because of the advent of working from home.

Hidden Competitive Moat:

In investing, all knowledge is cumulative. Everything you experience—the activities you enjoy, the places you go, and the products and services you buy—all adds up to your cumulative investment knowledge. I am kind of a Japan fanatic. I enjoy Japanese food, craftsmanship, products, and, shamelessly, anime. Having watched quite a few Japanese TV shows with English subtitles, I knew that work-life imbalance is systematic in Japanese society. Working professionals constantly work overtime. Employees wait until their boss finishes their work before leaving as a sign of respect, even if they have nothing to do. It is frowned upon to use all your vacation days. When the train passes and creates a lot of noise, salarymen scream at the top of their lungs to reduce stress. Shall I continue further? Now what are the chances that the same salarymen want to conduct an open house on their day off? The majority of salarymen who invest in these real estate investment assets use external property management firms. As a result, once they employ a property management company, they do so almost indefinitely. The company's property management business generates exceptionally reliable and predictable cash flow. The property management segment's cash flows were practically bond-like in their consistency and security.

If the company was selected as the property management company, what energy company do you think they would pitch to the landlord or tenant? Hence, the cash flows of the energy company are also bond-like.

The company that sells and develops real estate makes a one-time profit from the client. The customer is subsequently directed toward the energy and property management businesses, which produce long-term earnings at substantially greater margins. Also, potential future profit from senior care.

When I looked at the company, managed properties increased year over year. There was a similar trajectory in energy accounts. The company was actively diversifying away from its more volatile and market-dependent real estate development and sales business and into a stable and high-quality property management and energy business. The property management and energy segment performed like an "equity bond." A bond produces a cash flow that is stable and predictable, assuming no default. An "equity bond" showcases the same level of stability and predictability, with the exception that the cashflows will consistently increase over time. In addition, with the increase in cash flow over time, as an equity holder, you get the equity upside from the market price of the stock increasing. As a bond holder, you get no equity upside from the underlying business doing well.

There was a divergence in the way the market priced a Japanese corporate bond and the pricing of the property management segment of the business, which had over 99% occupancy, 0.1% of delayed payments, a growing base of properties under management owned by working professionals that are stressed out, and was within 10 minutes of the train station. Without looking at market comps, what multiple to EBIT would you assign to what I just described? Or, inversely, if you owned something like this, how much would you sell it for? 5x? 10x?  15x?  20x?  25x? 30x?  Personally, I wouldn’t even consider selling something as I just described unless I was offered at least 20x, but for the sake of the Japanese market, I assumed a 14x multiple would be a fair multiple. The icing on the cake was that the company was preparing to launch an income property REIT before they got acquired. If successful, the REIT would provide large real estate development contracts and ultimately add to the total number of units the company managed. In basic terms, the funnel from real estate development was about to get a lot larger. Shinoken would be guaranteed the property management contract for the properties developed for the REIT.

At 14x, just the property management segment alone, without the energy segment, was worth just slightly more than the entire market cap of the company (Net Cash was essentially 0 depending on the period due to a cash balance that covered debt). Shinoken Group was trading at 5x EV/EBIT and 7x P/E. The property management segment made up 1/3 of the company’s EBIT. The market price I purchased the stock at was between 1000–1200 yen. The intrinsic value of the company was 2700–3300 yen. Customers were funnelled from a more volatile and lower margin business segment into a more predictable and higher margin business segment. This demonstrated a shift in the quality of the company’s earnings. The market was pricing none of this in. Unfortunately, a Japanese company acquired Shinoken for 1600 yen, and no activist campaign was launched to rectify such a horrible deal. The lesson here is that not only do you have to identify undervalued stocks, you also have to be able to hold them long-term. I would much rather hold Shinoken for 10 years than have it bought out for a one-time 30–40% gain.

Conclusion:

Essentially, business economics are attributes of a business that dictate its quality of earnings over the long term. A business with superior business economics has attributes that provide it with high-quality earnings over the long term. There is no one-size-fits-all approach to the way superior business economics are developed, as each business is unique. I hope from the example above that it is clearer what I mean by poor, good, or superior business economics.

Brief note on Superior Management:

A separate post will be dedicated to superior management in the future. Here I’ll briefly explain why Shinoken had superior management. It's been a while since I revisited Shinoken, so I may be paraphrasing parts of the story. The CEO, Hideaki Shinohara (57 years old), founded the company when he was 25. He initially went through the trouble of building an income property from scratch for himself. Soon he realized that there wasn’t a service like this in existence. Having created the blueprint for his own rental property, he saw an opportunity to offer his blueprint to other working professionals. The company grew through in-house development and acquisitions. Certain verticals were acquired at very low valuations. The company acquired several companies at a sub-1 million USD valuation. One such company was a cleaning company. I had to recount the 000s when I looked at the acquisition press releases because I had never seen such small acquisitions in corporate America. Some of these companies were losing money or were marginally profitable because they did not have scale. Shinoken could solve the scale issue because it managed a lot of properties. Purchase negative net income businesses for a low valuation, incorporate them into your business as a vertical, and immediately make them profitable. The CEO was acquiring businesses as a financial buyer with no synergies attached to those acquisitions. In a little over 30 years, the CEO compounded his corporation from humble beginnings of simply wanting to create an income property for himself to creating an empire with multiple verticals. Reading through the investor presentations from the late 2000s was a masterclass in what superior management was capable of. The CEO showcased high levels of execution and a continuous growth mindset. Since he was only in his 50s, given the high life expectancy in Japan, he was a superior manager with a long career ahead of him.

Please feel free to ask any questions in the comment section below and I’ll be happy to respond!

Follow me on the following social media:

Instagram: https://www.instagram.com/compounders.ex/

YouTube: https://www.youtube.com/@continuouscompounding

Twitter: https://twitter.com/compoundersEX