The Right Way to Analyze High-Capital Intensity Companies
These types of companies have low variable costs and high fixed costs, which equals high operational risks. In good times, profits go up faster than sales. Unfortunately, in bad times, profits go down faster than sales too. This cyclical situation is further affected by financial leverage, which also tends to be high for high-capital-intensity companies because it is easy to borrow against property, plant and equipment.
Generally speaking, it is not so good to invest in them because of the downside risk they generate. High-capital intensity companies do not perform correctly in the long term because they face problems in restructuring themselves when it comes necessary. Let's take the case of an airline. Whenever demand falls, and airplanes are only half full, it is difficult for the company to reduce the number of pilots or planes. On the contrary, low-capital intensity companies can shorten the number of employees easily. That may be the case of a credit card company like American Express (NYSE:AXP).
Warren Buffett still owns several businesses that are in high-capital intensity industries.
What is paramount for these companies to be successful is to be correctly managed. Quality of their management is far more important than in low-capital-intensity companies. Why is this the case? Because during downturns, such as recessionary periods, if a high-capital-intensity company makes a serious mistake, it may find itself in financial straits and may even face bankruptcy.
The headwinds are more serious for this type of companies because it is easier for them to invest large amounts of money, borrow a lot from creditors, and compound their chances of getting into trouble during downturns or recessions. One solution to this problem is to hold a large stake in the company, as Berkshire often does.
Another thing to bear in mind apart from quality of management is temperament. Profitability of high-capital-intensity companies is highly changeable, so stock prices may periodically drop significantly. Pessimism in the marketplace may actually be a good time to buy if the long-term prospects are not affected.
To be able to decide whether to invest in them or not, an investor should consider if the company is undergoing a growth period. High-capital-intensity companies are even more profitable than other companies in their growth phase because the overheads are spread over a larger output. Their stock prices increase rather quickly.
For an average investor, it is best to avoid investing in stocks of high-capital intensity companies because the downside risk appears high.
This does not mean at all that an opportunity has to be missed, particularly,if there is a clear understanding of the company.
But it is worth remembering that for such companies, quality of management is even more important than for other companies.