Value Investing

As some of the regular readers of this blog may know, I believe in value investing. I despise speculation - i.e. investing in companies lacking strong fundamentals out of hope that they may grow in the future.

In today's article, we will look at an imaginary company, and see if it's worth investing in.

Assume you have a company whose revenue is $10 Billion. This is not a particularly large company, but certainly not a small one either.

Suppose this company operates three divisions: the first produces raw materials - iron etc. The company sells some of these materials to its customers, but also uses them as input for its second division, which produces machinery. The third division of the company provides services to the company's customers.

The company's goods are more or less durable, hence the majority of the company's revenue is derived from its services division. In particular, the company's first division accounts for about 4% of total revenue, the second division for about 18% of revenue, and the third for the rest.

Now, would it be worth investing in this company? To answer this question, we ought to look at several factors:
- Its past performance
- Its financial condition
- Its competitors
- Future prospects
- several other factors

Let's begin with past performance: as I mentioned earlier, the company's revenue this year was about 10 Billion. Last year, it stood at 9.5 Billion, and the year before that at 9.3 Billion. In other words, revenues have decreased by 7% in 2 years.

The quality of the products of the first two divisions has not changed much, but service is not always great. In particular, some of the company's employees are not always very welcoming to customers who want to inspect the company's facilities etc.

Regarding its financial condition, the company has unfortunately amassed large amounts of debt. Being a relatively large company, it has managed to convince lenders that its customers and partner companies will not let it fail. Regardless, debt stands at more than 1.3 times its revenue. Though the company is still servicing its debt, it now has to borrow at higher rates, and in fact needs to issue more debt to service its existing one.

As for competitors, the company has many. Some of its products are protected by trademarks, but these account for only a small percentage of revenue. The quality for some of its services is very high, but not irreplaceable.

The future does not look great either. Some analysts believe that given that more than 70% of the company's revenue comes from services, the general recession that affects its other two divisions will not have such a big impact on the company as a whole. However, they fail to realise that the services revenue depends on the other two divisions: if no-one buys the company's products, no-one will need servicing. Furthermore, if income from the other two divisions declines, the company will find it hard to finance its services department.

The company is also not very flexible when it comes to cost-cutting: strong workers unions do not allow the company to stop producing unprofitable products, to divest some of its lines of business or indeed fire any employees.

Finally, the company's support functions are not at their best: the management structure does not allow fast decisions to be made, and ossified procedures mean that any innovative thinking is suppressed by bureaucracy.

In a nutshell: we have a firm with rapidly declining revenues, where its most profitable division depends on the division hurt by the economic crisis. It has a huge amount of debt, which surpasses its revenue (clearly much more than its income). It cannot really increase its revenues or decrease its costs. The situation is getting worse - its most skillful managers and future leaders are seeking employment elsewhere. Few are brave enough to stay and try and improve the situation, but they are not well liked by unionists.

Would you invest in this company? Probably not. In fact, definitely not. You'd have to be an idiot to invest.

The most perceptive readers will have understood that this company is Greece. Other than the 10 Billion figure, everything else in this article is accurate. So can there be anyone out there who thinks Greece will manage to avoid default?