Cost Structure Is Key

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. 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.