Friday, April 3, 2009

Cost Structure Is Key

The number one rule of value investing is: Don't Lose Money.

While nobody can predict the future with any level of certainty, a primary concern for every value investment is the downside risk of the business under consideration. With that in mind, it is of the utmost importance that investors consider the cost structure of every business under consideration.

To see how important cost structures are, consider the following chart depicting the share by industry of the US advertising market:

A naive glance at the chart above would seem to suggest that even if newspaper advertising revenue were to decrease for the next several years, newspapers themselves should manage to throw off tons of cash flow in the meantime. But a look at newspapers around the country reveal a very different reality.

Newspapers are burdened with fixed costs (e.g. printing, delivery, content), none of which can be cut without significant reductions in the quality of service. Contrast this with a law firm or consulting firm that can easily reduce headcount to better match costs with revenues.

Another important element that impacts costs is a company's debt level from cash advances and other loans. Debt payments are fairly fixed, and so a company with a large debt load has a rigid cost structure and high downside risk. This is one of the main reasons value investors prefer low debt to equity levels. For example, even if newspapers could reduce their costs and profitably serve only a few areas, their debt loads would not shrink along with them, creating a large burden.

When evaluating a company's downside risk, be sure to give strong consideration to its cost structure.

Data Source: IAB Internet Ad Revenue Report; PricewaterhouseCoopers Global Entertainment and Media Outlook


Anonymous said...

Thanks a lot for providing this valuable nugget of value investing advice. Your posts are short, sweet, and interesting.

Anonymous said...

Good information.

In the present economic situation if you are looking to get your message across to people and advertising your business without spending loads of money, then you can opt for traditional outlets like print advertising agencies. These agencies can offer you classified ad space at special discounts. This is also a great opportunity especially if you are setting up a new business or are tight on your advertising budget.

When you use a professional ad agency, you tend to receive an early notice of the special offers and prices and also a considerable reduction in the advertising rate for national press. So help your business grow by promoting it in the low priced publications. Use print media to cut your costs and boost your advertising efforts in this growing economic recession.

Saj Karsan said...

Thanks for the kind words, Anon!

ishhu said...