Investing in businesses

You have elected to become an investor, which is the next step after you have become a saver. You can choose just to remain a saver and never invest, but then your default is cash. I will define cash separately as most people get very confused about what is cash and what is not.

As an investor you buy businesses that progressively develop into passive income streams.  Investment is about putting up cash to own something that creates and returns cash to you later.

So having made the choice to buy businesses you have many choices and many methods by which you can buy a business or an interest in a business.

The NBR rich list is about to come out. Buy a copy and read it. Look at who is rich, work out those who made their own money rather than picking it up from their parents, and  read the stories of the self made men and women.

What you will find in NZ - and by the way we are not unique in this - is that the road to wealth is through business - more particularly business creation and property.  Whether it is business creation or property those who control wealth are the people who took extreme but intelligent and measured risks. Some will have stumbled once or twice before they made it, and having stumbled learned from it. This said, by number, property is a very high contributor to the rich list. But before you say "see property beats business", cross out all those who inherited their property assets.

Now in terms of serious wealth the top 10 in NZ did not make it through property they made it from business which they either created or grew from a family base. The seriously wealthy are those who take risk, back themselves to create, and successfully analyse and manage risk. Our richest man, Graeme Hart, is about as self-made as you can get. He started out as a tow truck driver. He is now one of Australasia's richest men.

Along the way he has stumbled, Burns Philip and spices was very nearly his nemesis, but he was tenacious, determined and brave. Those of you who bought Burns Philip shares when it was a penny dreadful will now be millionaires. How about Steven Tindall, love the Warehouse or hate it, he too is a self-made man.

So like it or lump it, business is what creates wealth. The sooner NZers realise this, encourage it, and respect those who succeed at it, the better off we will be as a nation.

The first choice you have when you are ready to invest is to determine whether or not you want to invest in yourself and your own business. But, and this is important, understand the difference between a business and a job.

Most of NZ's business owners are silly sods who have either bought or created a job that is underpaid and overworked. Some develop really well paid jobs, but until you get out of working in your business you have not got an investment. So if building a business is your path to investing, make sure your plan includes you getting out of it as a worker. Until you have succeed in doing that , you will not have an investment. But in fairness, Rome was not built in a day, so if business is your choice then it will certainly start with you getting your hands dirty doing every single task.

Now the Graeme Harts of this world are rare beasts, but there are many people who understand how to create, and who have passion and determination, who are honest and who work hard. These people are the people who create wealth and jobs for our people. These guys, if they are young, will be like you and have no money, they will need capital.

The second asset class is private equity and venture capital - it is backing these people. The first and second asset class  being direct investment in private, unlisted, non-tradable business assets is the highest risk category of investing. This means you will have the highest prospect of total failure. Only one is five start ups last five years. If they last that long they should make it, but that does not mean they will be rewarding.

I note one of the younger readers said he was avoiding buying a home and was instead buying stakes in just these sorts of businesses. His friends thought he was mad. He is not mad. He just might beat us all to the rich list, and if he fails he will still be ok because he is investing capital, he is avoiding debt and by god he will get himself an education no matter what.

So to recap, starting a business requires trading skills, cunning, street smarts, tenacity, discipline, people management, or shall I sum it up, common sense. It also requires passion for the task, you have to love what you do. By loving what you do you will be good at it, you will inspire confidence, and you will improve your chances of success.

To be an investor in private businesses, you have to be able to identify these people. You have to be able to evaluate a value proposition. You have to be able to visualise the customer and why a customers will buy the product or service. You have to see the pathway to the customers' wallets, and you have to be able to judge people, and be able to sort out those with integrity and passion from the dreamers and crooks.

Investors I have met through the NZSA who have started businesses or invested in private equity are without doubt the smartest investors I have met when it comes to listed business assets. The intuition gained from this direct capital sector, whether you succeed or fail is invaluable.

If you are thinking of spending $50k on a business degree doctorate, having just got your undergraduate degree, don't do it. Spend $50k on investing in a start up. If you get your money back or more that is a bonus, if you fail you just got your doctorate.

The next direct path to investing in a business is listed equity markets. These are lower risk than the direct route talked about above. The skills needed to appraise a listed investment are the same as a direct capital investment. Can you see the customer value proposition? Do the people running it understand the path to the customer's wallet? Is the product offering unique and protectable? Are the people honest, passionate and smart?  Are the reward systems for these people fair and transparent? Are the management in the same canoe as the owners? Is there alignment in purpose and direction?

The difference however with listed markets is the disconnect between ownership and management - something that does not exist in private capital. In private capital, ownership and management are joined at the hip. In listed businesses, boards sit in the middle of this process and act - or should act - as fiduciaries, agents and proxies of the owners. These days, mostly boards understand their. Ten years ago mostly they did not.

It is really important to understand the mentality and philosophy of the board. All fish rot from the nose, so this for a passive investor in listed companies means you need to have a feel for the chairman and the support the chairman has from his board as well as the CEO.

Boards are appointed in theory by owners. Some listed companies will have major shareholders, and it is important to know what drives and motivates these major shareholders. By exerting ownership control these people can change the direction of a listed company. Some are quite predatory and see minor shareholders as freeloaders. Some major shareholders in a listed company behave like an owner of a private company, they will be proprietal and will be thinking about and contributing to the strategic direction of the business.

They sometimes do this through board representation, and sometimes through board manipulation or duress. So part of your due diligence on a listed company is understanding the party who pulls the strings.

I guess you have now worked out that investing in a listed company is even more work that investing in a private company - at least at the beginning. Private companies are more hands on.  Once you have invested you will be treated like - and be expected to behave like - a partner. In listed companies you will be reported to but not asked to participate at all once you are in.

Listed companies are more work, a lot more work at the front end, less work in the middle, and lower return than private business, but also lower risk. What you get however, and this is important, is you get liquidity, and this is why you trade off prospective return. Liquidity also means that if you do make a mistake you can get out fast. It means that while you should do lots of work, you can trade away the hard work, which increases your risk, in the knowledge you can mitigate your risk by exiting.

So much for the direct and obvious paths to investing in a business - now to the indirect paths. These generally create different risks require more work  and generally trade off return for sometimes less risk, but mostly not.

The first indirect route is corporate debt. If you own a debt instrument over a business in the event of a default, guess what, you own a business. If you are being sensible you will do at least some of the work you would do to buy equity in order to determine if you want to buy a corporate debt. Thus your prime concern should be collecting your interest and getting your money back.

Do not be confused a debt instrument IS NOT CASH, but it is still an investment in a business. What you get is a fixed rate of return. If this is greater than the dividend return from owning the equity it is at least worth considering a debt instrument. The difference however is that  the debt instruments return is fixed and will never grow, so to compare dividends with interest you have to consider growth. You will not have liquidity, you will not be able to get your money back until maturity and maybe not even then, unless the debt instrument is listed. The liquidity in NZ for second tier debt instruments is worse than it is for equity, which is in itself bad.

When you buy a debt instrument, you also have to analyse the contract, the loan agreement, what the company is promising you in return and security. In the middle of all of this will be an agreement that aggregates your investment, and the management of this will be a trustee. There is a new bunch of relationships you have to understand.

The trust deed is important as it will define voting on key events. Guess what? These deeds disenfranchise investors even more than listed company voting does. In terms of residual risk when a default occurs the remedy is to convert into equity and own the business. So you are in effect taking the same risk , for a fixed and preferential return while things are going ok with worse liquidity. But if fixed return is important to you then bonds are a way to consider investing in a business, but again to do this properly is even more work that just buying an equity.

Now the complexity around corporate debt is alarming, the instruments available include perpetual notes, capital notes,  preference shares, and they are all different and you must, must, must read the terms, never think of these fixed interest securities as cash.

Take for example perpetual notes. What these mean is that you give the company your money and they never have to give it back. Many dumb sods bought ASB perpetual notes or preference shares (a misnomer, preference implies security), and now they trade on the secondary market at a large discount, meaning that the capital the investors put in is now irretrievably lost as they can never redeem the principle. My guess is that these idiots were sold it as a high yielding term deposits, and of course those who sold them these useless instruments would have received a commsion.

There are two more things to talk about in terms of business assets. This is the use of intermediaries, managed funds and property. If you think I have used up too many words talking about businesses both of these topics can easily consume the same, so I will break now and deal with managed funds and how to think about these separately. Sorry investing is going to be more than three or four blogs.

But I will conclude each one of these investing blogs with this simple mantra.

KEEP IT SIMPLE, CUT OUT THE MIDDLE MEN, IF YOU ARE TAKING A RISK MAKE SURE YOU ARE PAID FOR THE RISK YOU ARE TAKING, AND FOCUS ON THE HUMAN AND BUSINESS ESSENCE OF INVESTING. AVOID ANYTHING THAT LOOKS COMPLEX OR IMPOSES LAYERS BETWEEN YOU AND THE CUSTOMERS CASH WHICH UNDERPINS THE CASH YOU EXPECT TO SUPPORT PASSIVE PREDECTABLE INCOME.

 

See my disclosure statement here.