When it comes to investing, we intentionally avoid certain areas that we think lack long-term predictability based on various factors, and hence, could be very speculative.
Take the energy sector as an example. Oil and gas producers provide products that are hard to differentiate and prone to macroeconomic uncertainties. It is difficult for us to justify the existence of a moat at most (if not all) energy businesses, which is echoed by the volatile returns on capital at those companies. In our view, those with the best sources usually win in this space as technology keeps improving and has become widely adopted. Also, the sector is crowded with tons of companies producing meaningful quantities of oil and gas all over the world.
For those genuinely enthusiastic about energy, we recommend taking a look at the service suppliers to the sector. Among companies like Exponent (EXPO, Financial), providing engineering consulting and failure analysis, as well as ANSYS (ANSS, Financial), providing simulation software, investors may have a higher chance of finding long-term value.
Similar to energy businesses, we consider drugmakers highly speculative as well. Pharma typically relies on patent protection to charge premium prices and fend off competition. As a result, these companies may achieve a decent return on capital consistently in the short run. But such dependence exposes the businesses to longer-term uncertainties as the patent expiration approaches. Shareholders can think of these patented drugs as bonds, but not annuity. To consistently generate future free cash flows, drugmakers have to keep developing and launching new products. This is where we see a significant risk in terms of the pharma business model, as the value of these research and development pipelines is not only unpredictable, but also probably extremely low. According to research by KMR Group, the success rate of a drug at the preclinical stage, making it all the way to obtain Food and Drug Administration approval, is merely one in 10,000.
While the pharma companies themselves might be a speculative bet, some of their service providers may offer long-term shareholder value with predictable cash flow for those who crave the lucrative and prospective health care market. One example is Waters (WAT, Financial), the world’s leading specialty measurement company whose mission is to improve human well-being, has 60% revenue exposure to the pharmaceutical industry. Global drugmakers like Bristol-Myers Squibb (BMY, Financial) and Pfizer (PFE, Financial) depend on the company’s analytical technologies throughout their research and development and manufacturing processes. No matter how successful the research turns out to be, Waters earns its money, a majority of which comes from recurring transactions (e.g., consumables and services).
Some other areas that we try to avoid include banking and fashion businesses. The former competes mainly on commoditized products with an increasingly complex business model, and the latter has to adapt to the unpredictable and rapidly changing trends of consumer taste frequently.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the financial market. We own shares of Waters.
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