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Recent articles:
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The Speculator
Small business or big, the rules are the
same
Sooner or later, most of us will own or work for a small
business. But tread carefully before you take the plunge -- and the
risk -- of buying. Also: some interesting dividend plays with
REITs.
By Victor
Niederhoffer and Laurel Kenner
The birth, death and sale of small businesses in
the United States is a key feature of the American way of life and
investing, providing an important source of wealth for those
involved in the transactions, as well as valuable lessons for all
investors. It is no exaggeration to say that the prevalence of small
business is the key characteristic of market-based economies.
Some
15 million of America's 21 million businesses are sole
proprietorships, and 4.8 million have fewer than 100 employees. Add
to these figures a reasonable estimate of those who have been or
will be owners, and the number could easily double. At some point in
our lives, most of us will own or work for a small
business.
We were therefore very pleased when, in response to
last week's article about real estate, we received the following
query from a reader:
Do you feel that purchasing a
convenience store for $300,000 plus $40,000 in inventory would be a
smart idea at this time?
The store nets about $50,000 a year
in profit and is in a community neighborhood of about 1,000 people,
plus a large manufacturing company whose employees go there for
lunch. The lunch could be expanded to make more profit.
Is
there anything we should be aware of in the purchase of a
convenience store? I sell residential real estate, and know very
little about commercial real estate and what the rate of return
should be. Thank you for your help.
--Jane Smith
(One
of the first things to know about buying a business is that news of
its availability for sale can have a very detrimental effect on
morale among employees, suppliers and customers. We therefore
changed the reader's name and slightly adjusted the figures to
maintain confidentiality.)
Our first reaction on receiving
the letter was, thank goodness this is a subject about which we have
some real knowledge. Vic founded the merger firm of Niederhoffer,
Cross & Zeckhauser in 1966. The firm and its successors have
sold well over 1,000 small businesses over the past 35 years, for an
average price of about $5 million. Vic and his current partner Lee
Henkel, who runs Niederhoffer, Henkel & Co., have personally
visited the offices and factories of many thousands of such
companies.
Moreover, Vic has started many small firms of his
own and bought and supervised more than a dozen with another
partner, Dan Grossman, in such businesses as air-conditioning
equipment, almond paste, auto-parts distribution, bottle-cap
equipment, communications devices, computer equipment distribution,
computer networking, incentive marketing, language programs,
mail-order hardware, mail-order seeds, pets and
solder.
Illuminating statistics on small business are
available from the U.S. Census Bureau:
| Small business stats |
| Size of company |
# companies |
Employment |
Annual payroll |
| At least 1 employee |
5.6 million |
110.7 million |
$3.55 trillion |
| 1-4 |
2.68 million |
5.6 million |
$143 billion |
| 5-9 |
1.01 million |
6.6 million |
$165 billion |
| 10-19 |
606,000 |
8.1 million |
$217 billion |
| 20-99 |
501,848 |
19.7 million |
$475 billion |
| 100-999 |
90,000 |
21.3 million |
$655
billion | |
The
average amount earned by each employee of the companies with 100 or
fewer workers is pretty close to $25,000 a year, rising to $31,000
for those working at companies with 100 to 999 employees. The hope
of selling out at a profit is one of the key factors in forming a
small business, and the forces that determine how much these
businesses are worth affect all aspects of economic life.
In
looking through the Internet search engines for articles on how to
sell a business, we found 4.6 million items on Google alone.
Evidently the subject is of great interest. While many of the
articles contain lists of tips on buying and selling, most of the
advice we reviewed was along the lines of, "Try not to buy one
that's about to go under."
A notable exception was "Seven
Secrets of Buying a Business" by Clifford Lazar, a forensic business
consultant. We particularly liked his Rule No.3: "Sever financial
relations with the previous owner." Lazar adds: "If you don't pay
cash for the business, try not to have the previous owner hold the
paper. He will have an incentive to have you fail so he can
repossess the business and pocket your down payment."
It's all in the numbers
We told Smith
that a key factor to consider in buying a business is how many years
the company would have to earn money at the going rate to cover the
excess you're paying above the business's net worth. For example, if
you pay $1.3 million for a company with $1 million in net assets
that is earning $100,000 a year, you'll need three years to cover
the excess. Vic has found that a good rule of thumb is to limit the
excess you pay to one year's earnings. Smith would need five years
to cover the excess price of the variety store. Unless some
exceptional growth is involved, that would appear to be high.
Considering that the community has only 1,000 people, we are
guessing that the growth of the town has been zero or negative
during recent years.
Another negative might be the store's
dependence on the nearby factory. If the plant were to move or
downsize, it might take many more than five years to recoup the
investment. From extensive experiences in buying and selling
businesses, Vic has found that no matter how long an establishment
has been in the area, no matter how lengthy the exclusive relation
that the business has with its chief supplier or customer, the odds
of a change for the worse are better than 50-50.
While we do
not believe in book value or the net assets at cost of a business as
the be-all and end-all in valuing a publicly held company, we find
they provide useful rudders. Eventually, all businesses reach a
point where they have average prospects. At that time, potential
competitors will be able to decide to buy the business, improve upon
it or replace the business structure by building from scratch.
Unless growth is very much assured for many years -- and remember
that business prospects tend to be very fickle indeed -- it would
seem prudent to assume that the ultimate value of the business would
be its net worth when it reaches that average point.
All too
many companies with below-average prospects for the future sell at
well below book value today. Value Line, for example, publishes a
weekly list of 100 companies with the "widest discounts from book
value." The top five discounts are all 80% or more. They include,
with discounts noted: NTL Inc. (NTLI,
news,
msgs),
97.5%; Polymer Group (PGI,
news,
msgs)
82%; CMGI Inc. (CMGI,
news,
msgs),
88%; Fairchild Corp. (FA,
news,
msgs),
81% and UAL Corp. (UAL,
news,
msgs),
80%. It's enough to get our antennae waving again, but this time on
the buy side.
4 things you have to
know
We are fortunate to have a very erudite group of
reader-philosophers who assist us with ideas about investment. These
correspondents help us tap into specialized and ever-changing niches
of knowledge that are essential for a chance of success in today's
rapidly changing investment firmament. One of them, Russell Sears, a
marathon runner (best time: 2:18:20 in 1996) and investment actuary
for Lafayette Life Insurance in Indiana, considered Smith's query
and focused on some root principles. He asked:
- Risk/reward. Does the cost spread her thin? Will she
have to mortgage her home to buy the store?
- Opportunity cost. What return could she receive with
the money she has available to invest? More important, what is the
value of the time she would have to invest in such a business?
Businesses don't just run themselves. Given limited time and
money, are there better opportunities?
- Business plan. Studies show that most mergers and
acquisitions fail because of wishful thinking. A key reason would
seem to be hubris. (To this we would add the ready availability of
"fuzzy accounting" methods for future earnings manipulation.)
Sears suggests that Smith dig deeper into what the cost of
expansion might be, and what regulations and legal issues are
involved.
- Liquidity. What's her game plan for getting out? Could
she give the store a new coat of paint and resell it? Or is this a
buy-and-hold? If so, the spread has to be great.
Sometimes
the greatest insights into important things come from considering
humdrum matters and generalizing them. The issues of liquidity,
opportunity cost, wishful thinking and resale involved in a simple
thing like paying more than six times earnings for a small retailer
in a dying town are all applicable to investment decisions for
public companies.
A word of warning: Be aware that despite a
company's apparent reluctance to be bought out, the board or owners
just might have knowledge of lightning ready to strike, or a patent
about to be challenged. Revenues from major customers, despite their
past continuity, often have a tendency to stop right after a
purchase. Once the key executive receives oodles of millions from
the sale, don't be surprised if he or she is not as single-mindedly
devoted to the business as you thought, especially when the salary
paid under the new situation is one-fifth the previous level. (These
are lessons we have seen played out in every field, and in every
state from Arkansas to Alaska.)
In next week's column, we'll
give further rules on techniques on buying and selling a business.
Send questions to gbuch@bloomberg.net. We answer
all our mail.
More on those pesky
REITs
The expert in real estate and the ignorant should be
friends. Many readers wrote in to indicate that while they might
agree with our conclusion that near-term prospects for real estate
don't look that great, they still find the dividends they receive
from REITs quite attractive. In many cases, these dividend yields
exceed 7%.
They asked us to list a few good REITs that have a
good chance of maintaining those yields in all weather. It turns out
that Barry Vinocur, editor-in-chief and publisher of Realty Stock
Review and Property magazine, whom readers may recall has been one
of our most strident critics, has long performed analytical and
practical work on this very subject. Here are some of his
thoughts:
"Though REITs may not be 'cheap' today, their
fat dividend yields still make them attractive in comparison with
non-REIT equities, as well as certificates of deposit and 10-year
Treasury notes. (REITs are required by statute to pay out 90% of
their taxable income as dividends to hang on to their tax-favored
status, but in practice, most of them distribute 100% of taxable
income. Many REITs treat some portion of their dividends as return
of capital, as a result of depreciation. That portion of a REIT's
dividend that is a return of capital goes to reduce the investor's
tax basis in the investment; it is not taxed as ordinary income.)
Just how secure are REIT dividends today?
"The good news is
that by any measure, non-lodging REIT dividends are well covered by
cash flow and, generally speaking, should be sustainable throughout
the current real estate downturn. (Lodging REIT dividends were
rocked by the recession and the sharp drop in travel after the
tragic events of Sept. 11.) Moreover, a number of REITs, such as
General Growth Properties (GGP,
news,
msgs)
and Vornado Realty Trust (VNO,
news,
msgs),
will have to raise their dividends roughly in line with their
earnings growth to maintain their REIT status.
"One reason
REIT dividends look so secure today is the single-mindedness with
which most companies have sought to lower payout ratios since late
November 1992, the dawn of the "modern REIT era." Payout ratios have
steadily and significantly declined over the past roughly 10 years.
The result is that most non-lodging REITs have dividends that are
all but bulletproof, today. Nothing short of an economic Armageddon
would produce across-the-board REIT dividend
cuts."
Vinocur recommends the following REITs as dividend
plays, with capital appreciation as a secondary objective: Home
Properties (HME,
news,
msgs);
Developers Diversified Realty (DDR,
news,
msgs);
Macerich (MAC,
news,
msgs);
Highwoods Properties (HIW,
news,
msgs)
and Colonial Properties (CLP,
news,
msgs).
He advises dividend-focused investors to consider housing their REIT
investments in a tax-deferred account, such as an IRA. The truly
dividend-obsessed may want to check out REIT preferreds.
We
will send Vinocur's complete thoughts on REIT dividends, along with
a full list of his top REIT picks, to readers who write us at gbuch@bloomberg.net. Vinocur's
Web site is http://www.realtystockreview.com/.
Last note
For many weeks, since the
market lows some 7% below current levels, the Speculators have
indicated they are throwing caution to the winds and maintaining a
150% fully invested policy, concentrated in biotech and a few big
names. As we write late Wednesday afternoon, the indicators we've
been watching closely on this play have turned highly bearish. We
are now moving to neutral to bearish in our own positions. If you
have based any investment decision on what we have done with our
money, you should be aware of our lightening and neutralizing.
At the time of publication, neither Victor
Niederhoffer nor Laurel Kenner owned or controlled shares in any of
the equities mentioned in this column.
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