Someone who reads my blog emailed me this question:
“Would you invest in a deeply quantitatively undervalued company but whose qualitative nature you may have some trouble fully understanding?”
Not intentionally. I’ve bought into stocks where it turned out I didn’t understand some things about customer behavior, societal trends, etc. You said “whose qualitative nature you may have some trouble fully understanding.” There are a few ways to think about that. When I say I understand a business, I mean I understand the economics of the business. We are talking about things like customer behavior. I would invest in a business where I don’t understand some technical aspects of what they do. Let me give some examples.
Babcock & Wilcox
I wrote about Babcock & Wilcox (BW, Financial) for the newsletter. I bought it for myself, and then I owned it through the spinoff. It spun off into BWX Technologies (BWXT, Financial). BWX Technologies is focused on things like nuclear reactors for U.S. Navy submarines and aircraft carriers. B&W Enterprises is focused on things like boilers for coal-fired power plants in the U.S. and similar equipment for things like waste-to-energy plants in the rest of the world. I’m simplifying. Each of the two separated businesses does other things, too.
To summarize the key markets they control: B&W Enterprises probably has an installed base of between 30% and 40% of boilers at coal plants in the U.S. The aftermarket is profitable. It makes a lot of money doing maintenance on coal power plants it helped build in the first place. BWX Technologies is involved with the U.S. military’s use of nuclear technology. Mainly, it provides almost all the important parts needed to have nuclear reactors on ships. The U.S. Navy – unlike almost all other naval forces in the world – has a lot aircraft carriers (all huge) and submarines. U.S. aircraft carriers and submarines are always nuclear powered. Because of their strategic uses, this is kind of necessary. It’s not strictly speaking necessary for the attack subs. But some U.S. subs are ballistic missile subs. They carry nuclear weapons, and they are the last line of defense in the case of a second strike. Basically, no country in the world could ever carry out a nuclear attack – no matter how large and how well-planned in advance – that could destroy all of the U.S.’s ability to respond with enough nuclear weapons to devastate the attacker in return.
Foreign governments know where some U.S. nuclear weapons are. It’s not hard to guess. But they don’t know where the ballistic missile subs are. This is an important part of not just the U.S. Navy’s strategy but the U.S. global strategy as well. And, honestly, it’s an important part of the defense of U.S. allies – like NATO members. Very few U.S. allies have much of an ability to deter a nuclear attack on themselves. A couple do. If we put aside countries like Israel, France and the U.K. – most allies of the U.S. are counting on the U.S. having ballistic missile subs and carrier groups even though they don’t.
I’m not especially knowledgeable about military matters, U.S. domestic politics, geopolitics, etc. My guess as to whether the U.S. will ever phase out attack subs, ballistic missile subs or carrier groups is not better than yours. It might be worse. You could say that I don’t understand the politics of how the U.S. Navy makes decisions. I understand it well enough to know that there’s an oligopoly of countries who are members of the nuclear club – and that number is unlikely to decrease. As long as that’s the case, I don’t expect the U.S. to build fewer numbers of each of the classes of ships that Babcock’s reactors go into than the current long-term plan projects. The U.S. Navy puts out a long-term plan for assets like carriers and subs. We have some guidance going out a couple of decades. I thought there was a lot of earnings visibility. I think the U.S. Navy feels it needs these ships and feels it can’t get the reactors from anyone but Babcock. I felt I understood the business.
But think about this technically for a moment. Do I really know the technical issues involved in what BWX Technologies does? The work it does is things like building nuclear reactors for the Navy, co-managing (as part of various consortiums) nuclear sites that are important to national security, doing uranium down blending. These are technical activities that I don’t know anything about. I have no science background. Honestly, I’ve never taken even a high school level course in basic physics. I never took a single science course in college.
I did read a few books while researching Babcock. I read some books on atomic energy generally and a book on just above every major accident in the history of nuclear power was useful. Babcock isn’t involved in civilian nuclear power anymore. Not long after Three Mile Island, it sold its civilian reactor business in the U.S. If I had to understand things like whether the U.S. would ever build nuclear plants again for civilian power generation, it would have been too hard. It would have been too technical. Likewise, if I had to – as you would when analyzing a defense contractor – compare competing designs for a fighter jet, submarine, etc., that would have been too technical, too.
We wrote about Breeze-Eastern (no longer a public company) for the newsletter. Breeze is the leading duopolist in the search-and-rescue helicopter rescue hoist industry. At the time we picked the stock, Breeze had been – for years – working on new projects like cargo-loading equipment. One of the projects involved the Airbus A400M Atlas. The market potential for that project could be big. But my newsletter co-writer and I couldn’t judge how big it could be. There had recently been a deadly accident involving an A400M. That wasn’t the issue for us. Those accidents happen with new planes. For all we knew, it could’ve been human error, a software error, something that was easy to fix, etc.
We didn’t think the project was going to be killed by that, but we can’t tell the difference between a new plane, helicopter, etc., that might eventually hit 100 or 200 deliveries and a new plane, helicopter, etc., that might one day eventually hit 1,000 or 2,000 deliveries around the world. If Airbus (AIR, Financial) has one design and Boeing (BA, Financial) has another design, we don’t know which one will be adopted.
Likewise, I wouldn’t have been able to invest in Babcock in say 1946 to 1960. Right after World War II, it wasn’t clear whether all U.S. Navy carriers, subs, etc., would eventually be nuclear. More than that, it wasn’t clear what the design would be. There were engineering trade-offs that were still to be settled. For example, there was originally a great deal of concern that the world didn’t have enough uranium to fuel everything the U.S. wanted to do. This turned out to be totally false. But it might not have been obvious early on that rationing of uranium was not important.
Likewise, there was initial resistance to using steam on submarines. The original plans for nuclear powered subs were unlike what ended up being the dominant design. This was an unsettled market. When a market is unsettled, those technical aspects are important. If there’s a format war between two standards – two different models of airplanes, two different reactor designs, etc. – I can’t make any sort of judgment. I don’t have the technical know-how to tell you whether VHS will outlast Betamax or the reverse. I can’t tell you whether electricity will run on alternating current or direct current. I would need to wait until a dominant design was chosen, other companies were supporting that design, the company was in serial production of the design, etc. At that point, technical issues are no longer relevant. It’s possible to judge the economics without looking at the technical issues.
Waters
I’ll give you another example of a company I think I can understand economically – but I have no idea what it does technically. Waters (WAT, Financial) makes analytical instruments. I think the way it markets those products is an important part of the business. I’ve talked to some people who work at universities that have these instruments and allow different people at the university to use them. I have some idea of how important some of these instruments are to the work they do. But if I took you through the various things that these instruments do, I wouldn’t be able to describe what the instrument is doing without paraphrasing Wikipedia. That means I don’t understand what “high performance liquid chromatography” is. I don’t understand the technical aspects of the product Waters is selling. Does that matter?
It matters if some technical aspect a Waters product has and a competing product doesn’t have is a material advantage for Waters. It matters if a technical advantage drives earning power. I don’t think that’s the case at Waters. It’s not like it has one particular way of doing things and a competitor has a different way of doing it – and that difference is what drives its earnings. I don’t invest in businesses like that.
Warren Buffett (Trades, Portfolio) bought into IBM (IBM, Financial) stock. Now, obviously, Buffett doesn’t understand most of what IBM does. But he thinks he understand the economics of IBM. That means he understands the relationship the company has with its biggest clients. I felt the same way about a company like Omnicom (OMC, Financial) or Grainger (GWW, Financial). Omnicom is entangled with the marketing operations of its biggest clients in a way in which clients are unlikely to leave Omnicom. I expect Omnicom to increase its earnings at about the pace its biggest clients increase their marketing spending.
Likewise, I expect that once a big customer of Grainger – a national account-type business – starts using Grainger heavily, it’s going to become more and more dependent on Grainger and do less and less sourcing of MRO products elsewhere. What’s happening here is that Buffett – although he doesn’t understand the technical aspects of what IBM does – thinks he understand the relationship between IBM and its largest clients. Sometime, this relationship may be too technical in nature to understand. I’ll give you an example of a company that has some similarities to IBM but in which I don’t feel confident.
Teradata
Years ago, I might have been able to buy Teradata (TDC, Financial). I researched it a bit. I have an idea of what it does for its biggest clients and why that is important. I also see technical aspects of the business – other ways of doing much of what Teradata does – that could start allowing clients to mix Teradata with other solutions. Once they start doing that – experimenting in a small way with other possibilities –Â they may slip completely away over time. And what Teradata does is in an area in which some big tech companies may want to dedicate a lot of resources. I don’t like to own a business like that. One thing I liked about Breeze Eastern is that it had a 50% or better market share in a market that was too small for other aerospace companies to want to enter. It would be hard to displace Breeze – and it wouldn’t be remotely worth it.
This is also what I like about Atlantic International (ATNI, Financial). Most of the markets Atlantic International is in are small. So, they are often in a duopoly type position in a market that is too small to be worth the time of bigger telecom companies. Atlantic International’s markets aren’t prizes that other telecom companies want to win.
I avoid companies like Teradata. To be honest, I also avoid businesses like IBM. I understand why Buffett made that purchase. However, I’m too nervous that too many other companies want to spend time and money and focus on exactly what IBM does for its biggest clients. I don’t want to be invested in a stock where lots of other companies want to do what that company is already doing.
Something like Babcock is attractive because nuclear and coal are two areas in which no one wants to be involved. It has already peaked in terms of new build. There’s an installed base. It is not expected to take off as a technology like wind, solar, etc. I’d rather be invested in a company with a strong competitive position in coal and nuclear than in wind or solar.
The technical aspects of what a company does in coal or nuclear probably don’t matter. Not many people are thinking about new ways to compete in coal and nuclear. Lots of people are thinking up new ideas to implement in solar and wind.
I’d avoid emerging technologies and focus on settled markets where the technical aspects of a business are less likely to be important to the economics of the business.
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