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What Small Businesses Can Learn About Diversification From Ferguson

I've been running my investment advisory firm here in the St. Louis area for the last twenty years. My physical proximity to other businesses struggling to keep their doors open in Ferguson might give me a slightly different perspective than the overcrowded hashtag I've been following on my phone. This outer suburb of St. Louis has transitioned to a battlefield where law enforcement has moved from a theme of "protect and serve" to "engage the enemy." On the one side, police officers dressed in camouflage are brandishing assault rifles in the faces of protestors, and on the other side, unlikely activists feel compelled to join the angry mob. This includes a ninety-year old Jewish holocaust survivor who was hauled off after protesting the deployment of National Guard troops patrolling the streets of Ferguson.

Lost in the crossfire between these rival factions are the small businesses operating in Ferguson who did not receive police protection at a time when they needed it the most. What's the point of entrepreneurs in Ferguson paying their real estate tax bill if the police aren't there to protect their business property? Unlike Twitter, whose scalable business model doesn't depend on local patrons, many small businesses in Ferguson need a customer base in close proximity to their storefronts. After the journalists, community activists and out-of-state protestors all go home, will these unlucky entrepreneurs choose to rebuild? I'm inclined to believe many of these frustrated entrepreneurs will take their insurance settlement as severance pay from their bombed-out businesses and join the exodus from Ferguson.

People who have never tried starting their own small business do not fully appreciate how difficult it is to make it as an entrepreneur. According to the Small Business Administration (SBA), only one in four new businesses manage to survive for at least a fifteen-year period. That's a challenging meat grinder for our entrepreneurial class to make the cut even without a "black swan" event inflaming a community and putting everything they built in jeopardy. I feel for the shop owners of Ferguson who, despite the odds, managed to claw their way into the ranks of the merchant class. Many of these independent Ferguson business owners who provide food, clothing and gas to a community where one in four residents lives below the federal poverty level are now finished.

What is the take-away that other business owners can learn from this tragedy occurring in Ferguson? One lesson is not to put all their eggs in one geographical basket. A bit of diversification might be prudent for those risk-takers who want a margin of safety in place between their small-business cash cow and their future retirement nest egg. If most of an individual's revenue comes from customers who live in a tight geographical radius of the storefront, it's prudent to invest some capital outside of the local community. No passive investment can compete against individuals who leverage their time and talent by starting a small business--provided they make it into the promised land of sustained profitability. Where a passive investment has the advantage over a small business is a reduced chance of a catastrophic event destroying everything a person has built.

An example of an investment where success isn't constrained by geographical proximity to the customer base is stock ownership. For the disciplined and patient small business owner, diversifying a portion of profits into a portfolio of stocks has historically kept up with the rate of inflation. It also has the indirect benefit of providing insurance protection against a catastrophic event that results in the business being shuttered.

With stock ownership, don't accept the "black box" of a stock mutual fund embraced by most of the retail public. As a small business owner, choose the path less traveled and learn from one of the great investors of all time, Benjamin Graham. His humble beginnings are not all that different from many independent business owners struggling in Ferguson who don't live in a wealthy community or have the right family connections. Although most people running small businesses aren't blessed with a rocket science I.Q. like Benjamin Graham, we can still piggyback off his smarts and replicate an investment strategy he outlined in his book, The Intelligent Investor.

One type of stock--which Graham classified as a "bargain issue" for the enterprising investor--seems well suited for a small business owner who is gun-shy of investments that are out of his managerial control. There were several ways that Graham defined a stock as a bargain issue. One way is when the share price falls below what a private owner would sell the company for if the entire enterprise went into liquidation. According to Graham, determining the liquidation value is a simple calculation made by reviewing the balance sheet of a public company. Simply subtract all liabilities--including preferred stock--from the most liquid assets on a company's balance sheet and convert the figure to a per-share basis. All fixed assets, such as buildings and machinery, on the balance sheet are assumed to be worth as much as a burnt-out QT in Ferguson.

Let's also assume a small business owner buys into the thesis that diversifying a portion of his or her capital makes good financial sense. Let's also assume that the recent events in Ferguson have scared this person, and he or she is only willing to buy stocks that pass the rigorous conditions listed below:


Small Business Owner Conditions on Buying Stocks

  1. All stocks purchased must trade below 75% of what the business is worth if it were liquidated as a private investor.

  2. A maximum of ten stocks would be in the portfolio at any one time. The ten stocks chosen in the portfolio happened to be the worst performing ones over the next twelve-month period. This assumption of course is a "worst case" scenario in terms of historical performance.

  3. If fewer than ten stocks could be found meeting the sub-liquidation-value criterion, the balance of cash would remain in a money market fund.

  4. Given how busy I am running my small business, I would also hold all stocks in my portfolio for a period of five years. After five years, all stock holdings would be sold and the search process would start again.

 

The historical long-term performance of holding the ten worst-performing stocks using Benjamin Graham's enterprising investor criterion trading below liquidation value is shown below in red.

Average Annual Return
Larger Image

These ten stocks that were the worst picks of the bunch outperformed the S&P 500 over the long term. When investors get nervous, they historically flock to gold as a safe haven to protect themselves from a collapsing stock market. An "unlucky" investor that picked the ten worst-performing stocks using Benjamin Graham's liquidation value criterion also outperformed gold over the long term. Whether it be a bull or bear market in stocks, ones that meet Benjamin Graham's criterion seem to hold their own with limited workload.

The events unfolding in Ferguson reinforce the notion that diversifying some assets away from your small business is a prudent decision. Everyone has to choose their own way of diversifying, but I found the enterprising investor approach outlined by Benjamin Graham to produce excellent returns over the long term. This holds true even if an investor were unlucky and chose the ten worst-performing stocks in the first twelve months of a five-year holding period.

 


I encourage you to follow us on Twitter at @WendlFinancial

 

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