The cracks you can’t see

It’s been three decades since I developed Blackstock Center in Spartanburg, South Carolina. It was one of my first large shopping center jobs, with a project cost around $10 million – which was a very big deal for me at that point in my career.

I secured national anchor tenants including PetSmart, OfficeMax, Party City, and Red Lobster. Construction financing was all signed and sealed, and I’d gone through the long list of due diligence requirements such as conducting environmental studies and soil reports.

So I was both confident and excited when the construction crew I’d hired got started. I visited that site frequently to check in on progress and watch the structure take shape.

There’s just something special about standing right there with blueprints in hand, watching those lines slowly but surely manifest themselves in concrete foundations, steel frames, and solid walls. Until, one day, you have a shopping center ready to be filled with profitable tenants and happy customers.

PetSmart, for its part, had agreed to about a 25,000 square-foot space in Blackstone Center. So when that segment’s concrete floor base was poured, I had the company’s construction representative, Mike, come over.

Our contract called for a “crack-free” slab, and I was sure that’s precisely what had been laid. I had no fears at all as we walked across that enormous space.

But then Mike literally got down on his hands and knees to inspect the floor. That’s how he found the first hairline crack.

And the second…

And the third…

They wouldn’t have been visible any other way, and most of the “flaws” he found would eventually be covered up by shelving. More importantly, there was nothing structurally wrong with the space.

Absolutely nothing.

Yet the contract didn’t say “mostly crack-free” or “noticeably crack-free” or even “crack-free to anyone other than Mike.” It simply said “crack-free.”

And I had signed for it.

That definitely put a damper on my enthusiasm for the project. But there was nothing to be done about it.

I had to go back to the research phase. As in researching concrete and why it might show hairline fractures. And here’s what I learned…

There’s no way around it: Concrete cracks.

It shrinks as it cures. And temperature, moisture, loads, settling, and other forces can make it expand and contract. That’s why concrete slabs include expansion and control joints.

It’s also why knowledgeable landlords don’t put clauses in their contracts about perfect-looking slabs.

Mike didn’t care about my explanation though. He wanted what had been promised. So we ultimately agreed to bring in sophisticated, laser-based measuring equipment to evaluate the slab for its flatness, levelness, and overall performance.

It took extra time and money that way, but it did change the conversation. Mike finally gave PetSmart the all-clear, and I finally moved forward with completing the shopping center.

I learned two valuable lessons from that whole ordeal:

Both are true in construction, and they’re just as true in investing. (In fact, they’re probably true in just about everything.)

There’s no such thing as a crack-free slab. And there’s no such thing as a crack-free company.

There are always risks associated with any business, no matter how big, established, or otherwise impressive it might be. Every balance sheet has vulnerabilities. And every management team makes mistakes.

You can’t get around it, even with the sleep well at night (SWAN) picks we target here at Wide Moat Research. Nobody gets everything right all the time, and nothing is ever a sure thing.

In the same way, economic conditions change. Often and sometimes drastically. They’re in a constant state of flux.

So even the highest-quality kind of companies that make the least possible amount of errors will eventually encounter headwinds. Recessions, rising interest rates, inflation, competition, technological disruption, regulatory changes… plain old bad luck…

They’re all possibilities lurking around the next business corner.

Once you realize that, you can get past the question of whether there are cracks and tackle the real issue at hand… whether you've accounted for them properly.

As I already noted, we use expansion joints when laying concrete because we know movement is inevitable.

That’s not an option in investing, of course. So we use something else: a margin of safety, which means we buy in below a business’ intrinsic value.

That's why I pay so much attention to balance sheets, cash flow, debt maturities, liquidity, management’s capital allocation record, payout ratios, and tenant concentration. And then I measure that all against the company’s valuation.

Is it trading for more than it should be or less? Or maybe right around the right price?

Under certain market circumstances for certain companies, I’ll buy at the right price. But usually, I want a bargain that can soften the blow if anything goes wrong and boost my profits if market sentiment improves.

Here’s another thing you have to know about cracks: They aren’t always failures. Sometimes they’re just a sign of change – the kind that’s expected and manageable.

For instance, one disappointing quarter for a real estate investment trust (REIT) isn’t necessarily the end of the world. If it’s a SWAN, it can usually handle a temporary decline in occupancy or even a tenant bankruptcy.

But excessive leverage? That’s different. As is an unsustainable dividend, persistent cash flow deterioration, a weakening business model, or too much borrowing.

Those cracks aren’t cosmetic. They’re structural.

Wise investors learn to distinguish between the two.

That’s why, when something doesn’t appear ideal with one of my investments, I look into the cause first and foremost. What made it happen, and is it likely to get worse?

Does it affect the business’ structural integrity? Can it be repaired and, if so, what will that fix cost?

And most importantly, does my original investment thesis hold up?

That’s what ultimately matters. So that’s where your focus should be.

Here’s my final piece to the concrete analogy – and probably the most important one…

Expansion joints aren't installed after a crack has been found. They’re not an afterthought. They’re added in right from the beginning.

The engineer in charge might not know exactly when or where the concrete will move. But he does know that movement is inevitable, so he plans for it accordingly.

In the same way, investors shouldn’t wait for interest rates to spike before they examine a company’s leverage. And we shouldn’t wait for a dividend cut before studying the payout ratio.

The idea behind “margin of safety” is beautifully simple. You simply refuse to pay a price that requires everything to go right, knowing that it won’t.

This doesn’t mean you cut corners on quality. You only recognize that quality doesn’t mean perfection.

So it’s always going to contain a few cracks.

Happy SWAN investing,

Brad Thomas
Editor, Wide Moat Daily