Graham and Buffett's 'Frozen Corporation'

Companies that invest to stand still are not worth buying

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Dec 13, 2021
  • Some companies struggle to earn a return on their investments.
  • Investors might want to avoid these companies.
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The best businesses are those companies that can continually reinvest capital at a high rate of return. An even better business is a company that can reinvest capital at high rates of return and return cash to investors.

At the other end of the scale, the worst businesses are those operations that need to invest a lot of cash just to stand still. This kind of business is what Benjamin Graham used to call a "frozen corporation."

Warren Buffett (Trades, Portfolio) laid out what Graham meant by this definition at the 1998 meeting of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholders: "Frozen Corporation was a company whose charter prohibited it from ever paying anything to its owners, or ever being liquidated, or ever being sold."

These companies are, unfortunately, the rule, not the exception. Most businesses invest a lot of cash just to stay still, and they are pretty poor investments. If one tries to figure out how much a company like this could be worth, "it forces you to think about the realities of what business is all about," Buffett said.

Business is all about generating cash and putting money in a company today to take more out in the future. No one who goes into business is saying they want to stand still with a company that continually consumes all the cash it generates. The overriding aim of going into business for most people is to turn a small amount of money into a significant recurring income stream.

Finding these companies and avoiding them is the challenge. However, some sectors have a reputation for consuming more cash than they generate. A classic example of this is the airline sector, and another is the steel industry. Both of these sectors are notorious for having high capital spending requirements, no competitive advantages and volatile input costs. They go through periods of high profitability and periods of significant losses. Cash generated during periods of high profitability is then consumed when the market turns.

These are the businesses where it is obvious to see if a company is consuming more cash than it is generating. Other operations are more difficult to understand. Amazon (

AMZN, Financial) is a great example. For years, this company generated losses and reported little to no cash flow.

However, now that Amazon has moved on from its growth phase, it is a cash machine. It would not have been clear to investors 10 years ago that Amazon would become the cash cow that it is today. Its potential was obscured by massive capital spending obligations and growing losses from its retail business as it tried to grab market share.

The question is then, how does one distinguish between a company like Amazon and a company like Uber (

UBER, Financial)? Both of these companies had to spend heavily in their first few years of operation in order to build out their business models and grab market share. Uber is still in its "growth" phase even though it is the largest ride-share company in the U.S., and it is unclear if the business will be able to switch to cash generation any time soon.

The answer to this question is the same as it is for many other problems in the world of investing. The only way to determine if a company will ultimately become a cash cow is to understand how the business operates. Research is required to understand where it makes money, how it makes money and how it generates cash.

Suppose one looks at the difference between Amazon and Uber. In that case, one can see that Amazon's major cash outflow has been on the capital spending account while Uber's major cash outflow has been on the operating income account.

To put it another way, Amazon was spending to grow during its growth phase, while Uber has been spending to survive.

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