Cyclical businesses have been shunned by many investors as volatile, capital-intensive, and often commodity-based, while franchise businesses have been embraced as stable, high-return, growing companies. Rahul Saraogi, managing director of Atyant Capital, makes an eloquent case for cyclical businesses, not because he believes them to be superior in quality to franchise businesses, but because some cyclicals possess attractive but overlooked business model features. Saraogi makes the case by focusing on companies in emerging markets, especially in India, but the argument applies more broadly.
Generally, many cyclical commodity businesses may be less cyclical and less commoditized than assumed by the investment community. Meanwhile, many franchise businesses may be of lower business quality than believed by investors. This dissonance between market perception and economic reality may create opportunities to buy into reasonably strong cyclical businesses at valuations that do not reflect those strengths. Conversely, investors may want to avoid highly regarded franchise businesses whose valuations reflect too rosy a perception of business quality.
Why Cyclical Businesses Can Enjoy a Competitive Moat
In The Manual of Ideas interview below, Rahul Saraogi shares the somewhat surprising insight that cyclical businesses can possess sustainable competitive advantage. He describes several sources of competitive advantage, including the following:
- Cost leadership and efficiency: Commodity producers with a sustainable cost advantage may generate strong cash flow through the cycle and achieve respectable returns on equity.
- Processes that allow a company to scale: Some cyclical businesses excel at designing processes that support profitable growth. Scalable processes are particularly important in growing markets.
- Management depth: Companies that succeed in building out strong layers of management have an opportunity to gain market share. This may be especially true in emerging markets, where middle-management talent tends to be under-developed.
- Distribution and reach: Far-reaching networks may be hard to replicate, especially in emerging markets. Efficient distribution outside major metropolitan areas is difficult to achieve, making existing distribution networks more valuable.
- Entrenched relationships: Cyclical businesses may gain advantage by developing strong long-term relationships with partners and suppliers. For example, a sugar company may have strong relationships with local farmers, making it difficult for a competitor to gain a foothold.
The Importance of Valuation When Considering Cyclical BusinessesAccording to Rahul Saraogi, the issue of cyclical versus franchise businesses should be seen in the context of the stock market as a pari mutuel betting system. In such a system, the objective of investors is not to identify the highest-quality companies. Rather, success is driven by maximizing the gap between the perception and reality of a business. The market’s perception is measured by the market price. The lower the stock price, the lower the quality hurdle a business needs to clear in order to qualify as a viable investment candidate. The art of investing centers on the tradeoff between price and value.
Exclusive Interview on Franchise vs. Cyclical Businesses
The following conversation with Ragul Saraogi was recorded in 2012. Saraogi draws upon his experience in emerging markets in order to construct a thesis for investing in cyclical, commodity-based businesses.