Simpler is (almost) always better

The Steinhoff story hit the headlines days after my last 2017 print deadline, so I’ve had a lot of time to think about it. One of my thoughts is around complexity in investing. As a rule, humans tend to trust in complexity: we’re hardwired to believe that simple is never going to be better.
 
We see this in everything from menus (where a modest burger can be described using a 100-word magnum opus), phones (with more power and ability than NASA sending people to the moon, yet all we do is browse social media) and especially in the markets with our trading (with overuse of indicators and oscillators) and investing (various very complex valuation methods). We love complexity.  

But surely it is best to keep it simple. Occam’s Razor teaches us that out of the multiple possible answers to a problem the simplest answer is usually the better one.  

However, we continue to embrace the concept of complexity and it costs us dearly – Steinhoff is the latest example.  

The company’s business model is certainly very simple: own the entire value chain. If, as Steinhoff does, you sell furniture, then also manufacture it. And as wood is the largest input into furniture, then also own the forest. But where Steinhoff gets complex is with its results.

I remember trying to understand the company’s balance sheet many years ago – something that should generally be easy. I couldn’t get to grips with it and couldn’t even work out its total debt position.

I walked away from the business because of that complexity. This very issue has seen the company come crashing to the ground.

When investing I always want to put my money into a simple business – one that is simple to understand, such as Famous Brands*.

It owns not only the franchises but also the central kitchen and distribution. Simply put, it owns the entire value chain, making profits along the entire process from manufacturing to the final sale.
  
Coupled with this simple business model, Famous Brands has very simple results.

Revenue is from franchise royalties, profits on products manufactured and sold to the franchise stores, and the logistics.

Margins are generous and very leverageable, as more stores make for more demand for the central kitchen, and adding new brands and products further adds to margins and profits.  

This business model was simple and extremely profitable – well, until Famous Brands bought an overpriced UK burger chain, but that’s another story.  

With this all front of mind, I do own a very complex business in the form of Discovery*. It is the only complex one I have in my portfolio.    

I understand the broad business model; making people healthier reduces claims and tracking their health across many different products also enables cross-selling.  

But truth be told, the results statement every six months leaves me with a headache. The contents of its balance sheet make Sumerian look easy to decipher.

The point is that I understand the risk here. I am not accusing Discovery of doing anything underhanded, but I have to accept that the results are beyond my understanding and that could cost me dearly one day.

I balance this with the company’s potential, the fact that it is the only complex stock I own, and that it is a small part of a diverse portfolio. A Steinhoff-style collapse in Discovery will hurt, but it won’t be ruinous for me and it is a loss I am prepared to risk.
  
So, keep complexity in mind when investing and as a rule shy away from it, accepting that when you do buy complexity, you add risk to your portfolio.

*The writer owns shares in Famous Brands and Discovery.

This article originally appeared in the 18 January edition of finweek. Buy and download the magazine here.