How To Decide Where To Invest

“Invert, always invert.” – Carl Gustav Jacobi. German mathematician.

Jacobi is famous for his work in differential equations, number theory, determinants, and elliptic functions. You don’t learn much about those in high school. The invert idea however is available in may fields. Among those investing.

Why invert?

Sometimes problems are hard to understand looking at them from just one direction. For example if you want to study memory, your ideal move is to study forgetting instead. Using data, sometimes it is easier to study the did not happen part easier. Like the probability of there being a match of birthdays in a crowd is difficult to calculate directly, but easy enough to find the probability of no match. The likelihood of a match then is, 1- the probability of no match.

Applying inversion to investing.

It is difficult to find what you should invest in, but not so hard to find what you should not invest in. The idea being if you don’t make any big mistakes, you should do okay among the rest.

An area of search for the do not invest in

In business there is a concept called “operational leverage.” The leverage idea you are familiar with is financial leverage. In financial leverage. If you borrow at one price and invest at another higher price the margin enhances the return on your capital. If you don’t recover the cost, it wipes out your capital very quickly.

Operational leverage is similar. Instead of interest you establish a business with high fixed costs, ones that happen regardless of volume, and low variable costs, the ones you incur to add another unit to your sales.

Operationally leveraged business like newspapers, television stations, airlines, hotels, mines, oil producers, and chip manufacturers have huge fixed costs relating to the cost of creating the ability to do business at all. After they exist, the cost to deliver another unit of revenue is tiny comapred to revenue. The first processor chip from a fabricator costs upwards of $5 billion. The second and every one after about $5.00. If they sell for $500 each The first 10 million or so recover the costs and every one thereafter is nearly pure profit. Clearly the key variable in establishing the business is the ability to sell enough pieces. How much of capacity must you use to breakeven and how quickly does the product become obsolete?

I have no idea what the numbers are today, but at one time you needed to use a printing plant at a newspaper somewhere around 85% to breakeven. Today few can recover their fixed costs.

Growing is risky. In all cases, you add capacity in steps. Like going up stairs. You must be sure about the volume before you add more capacity. You cannot easily add half a server farm or half a mine.

Why not invest in companies with high fixed costs today?

It’s simple really. The decision to invest in capacity was made at least a few years ago. The Corona virus has disabled their ability to use the capacity fully and there is a serious concern about how long it will take to return to the necessary sales volumes.

As an example – airlines

  1. By the summer or fall of 2020W, will airlines return to the ticket price and volume levels they enjoyed in 2019 ? Probably not.
  2. Can they dispense with their fixed costs? Mostly airplane financing and hub operations. Unlikely. Maybe by bankruptcy but then you don’t want to be a shareholder.
  3. How close can they come?
  4. Can they count on old pricing models? Not likely. Everyone cuts price to gain cash flow even if not fully recovering the fixed costs. All of their competitors have low variable cost operations too. Suppose it costs $80,000 worth of fuel, airport taxes, and staff to fly a plane with capacity of 500 passengers to Los Angeles. At the old price of $800 you don’t need 500 people on board to make cash flow. Somewhere someone would do it for $500 per ticket and 200 people on board. Or maybe even with 300 people at $400 each. The one  in the most trouble with fixed costs will offer a lower price to get volume because the postive cash margin is better than nothing even though it does not recover all the fixed costs.

Think about the price, capacity utilization, variable cost margin  equation

When looking for a security to buy today

The prime field will be with companies who can recover the volume they need quickly or ones that have low fixed costs. Something like a food supplier. Maybe Starbucks or something like it. Maybe a retailer. You will need to think about how readily people will begin to use the product or service and how the pricing structure of the supplier works.

Some like airlines, will be very hard to rationalize. Others like mines might have the odd possibility but only if they have a commodity likely to be in demand and already shrunken fixed costs. Union contracts, pensions and such related ot the old volume/cost realtionship can hurt.

The situation is a good one for people who estimate that the financially and structurally agile will flourish while those with high fixed cost committments and/or high debt will suffer.

You have some time just now so sit in a chair and think about which products and services you will begin to use again at something close to the level you used before. Will others do it too? Of the providers, which is most agile? You will likely need at look at some financial statements for that.

Mid-202 may well be a buying opportunity but only for the ones who do their thinking first. Avoid the likely losers first off and then look among the other choices.

I help people understand and manage risk and other financial issues. To help them achieve and exceed their goals, I use tax efficiencies and design advantages. The result: more security, more efficient income, larger and more liquid estates. Please be in touch if I can help you. 705-927-4770

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