My son in-law, the hedge fund manager, specializes in financial companies – banks and insurers. Whenever he proposes a new investment, he has to have an “investment thesis” – a reason why his proposal will be profitable and why the returns will outweigh the risks. Right now he is looking at distressed publicly traded banks that have government (TARP) money. Much of this is either preferred stock or debt, often (to my great surprise) without common stock convertibility. His investment thesis is that the government thus bears the brunt of the downside risk while common stockholders, although at risk themselves, get huge upside potential. I think (and I sure hope) he is spot on!
Most small private companies have simple investment theses tied to the Justification of Purchase Test. This says that an equity investment in such a business is justified if:
The owner-manager can earn reasonable (fair market) compensation.
All debt (interest and principal) can be adequately serviced.
The equity investment earns an appropriate rate of return.
Buy-a-job businesses satisfy only the first two criteria and do not offer return on equity. Their investment thesis is just what it says – earn a fair salary and eventually get your money out when you sell (not with a return) and pay back debt, if any.
Better businesses meet all three criteria. Some – like distributorships – offer return on equity in the form of dividends, while others – like startups – offer return in the form of appreciation.
To me, some of the most interesting businesses can be set up either way. Commercial real estate (like apartment buildings that are fully occupied) offers steady long-term income, but little in the way of appreciation (in current market conditions). On the other hand, some such investors use a great deal of debt to attempt to increase their appreciation potential. Others are happy with lower-risk steady returns and shun debt. Scrap metal dealers are another case that can be played both ways. Some dealers keep inventory to a minimum, and expect steady (averaged over the business cycle) dividends. Others try to stockpile inventory when scrap metal prices are down, and sell it profitably when they peak.
I always ask my clients “How do you make money in this business?” In other words, what is your investment thesis?