The Investment Approach
To generate great returns, the opportunities have to be seized when they rarely arrive. Our main task it to recognize them when they do so.
“Mimicking the herd invites regression to the mean.”
CORPORATION ANALYSIS
Mindset and First Things To Consider:
What is the story for this particular investment?
Prepare your mental checklist for rationality.
Do you really understand it? Are you 100% sure that you know what’s going on? Are you asking the right questions? Only work on what you understand. Stay within your circle of competence.
Do you use your resources to their best? Distractions aside, what are the facts?
Have you been influenced by something? Whenever you’re influenced by the general view, try to see the very general view.
Do the work from easily accessible through private.
Challenge your statements and judgments. Cross-check and collateral the evidence.
Be aware of the things that you do know and you don’t.
Make sure not to agonise over the data until they tell you the truth.
Provide accurate and complete information.
Focus on the things that can go wrong. Invert.
How would you destroy this business if you had unlimited resources?
Expand your security arsenal. Preferred shares, convertibles, or bonds could also be the options.
Think about the future opportunity cost.
Think probabilistically.
If everything is perfect, it can’t get better.
How will this thing look 20 years from now?
Don’t extrapolate the past without understanding it.
If you could do only 20 investments in your life, would this be one of them?
Think about what companies may benefit from the new technologies.
Factors to be assessed: Risk, Independence, Preparation, Intellectual Humility, Analytic Rigour, Allocation, Patience, Decisiveness, Change, Focus
- Some quick filters: Small, Boring, Out of Favour, Low Analyst Coverage, Obscure, Unwanted, Disappointing, Reviving.
ASSET VALUE + EARNINGS POWER + PROJECTION = TOTAL VALUE
Ideally, EP > AV.
Analysis of Competitive Advantages & Durability
PORTER’S 5 FORCES:
Potential Entrants, Substitutes, Suppliers, Buyers, Industry Competition.
BARRIERS (MOATS):
Economies of Scale, Product Differentiation With Customer Captivity, Switching Costs, Supply & Cost Advantages, Government Policy, Access to Special Assets, Expected Retaliation, Heavy Capital Requirements, Network Economies
- If the cost of capital is considerably lower than the ROIC for a considerable period of time, it’s a moat sign.
- The most successful companies think locally, either in customer base or product base.
- Moats add the most value to the business that has lots of reinvestment opportunities within their moats.
-The greatest gains in a stock are usually made in the business’ development stage of its moat. Rather than having already developed one. The best way to distinguish whether a business is building a moat or wasting money is to monitor the number of customers it serves.
- Determine the duration of the moats.
QUESTIONS:
How easy to copy or replace and how quickly that may happen?
How many competitors are there in the industry?
Do the customers have limited products or services to choose from, or do they have many choices?
Have the moats been filled? How can they be filled?
Does the business have price-raising power? Determine how much of the customers’ budget is spent on the product or service. Is this strength sustainable or temporary? Some indicators are: Multiple years of increases, higher prices than the competition, margin increases…
What are the capital requirements for the moat?
Can the moat be widened? How wide are the moats? Can new moats be produced?
Analysis of the Business and the Earnings Power
First, determine the type of situation:
Spawners
Slow Giants
Stalwarts
Fast Growers
Cyclicals
Revivals
Asset Plays
Disruptors
Spin-offs
- Quality of a business is determined by the quality of its customers. Understand the business from the customers’ perspective. Satisfied customers are the best predictors of future earnings. Customer is the CEO.
- Long term prospects are crucial.
- Almost by definition, a really good business generates far more money (at least after its first years) than it can use internally.
- Business’ impact on life? What would the customer’s world look like without the product or service? What pain does the business alleviate for the people? Need to have or nice to have? If the business has disappeared tomorrow, what would be the impact?
- Make sure to fully understand how the business makes money. Describe how the business operates in your own words. How would you evaluate the business if you were the CEO? Understand both the income and the expenses.
- Think of the world’s future demand or need for the company.
QUESTIONS:
Where is the growth coming from and when and how is it likely to slow down?
What are the FCF percentages by products or services, geography, population etc.?
What are the plans to increase the earnings?
Can the company continue to reinvest with high returns?
Does the company have products or services with sufficient market potential to make possible a sizable increase in sales at least for several years?
Is it a cluster of product and services (Like Apple)?
How effective are the company’s R&D efforts in relation to its size? (R&D/Size)
Does the company have an above average sales organisation?
What is the quality of the Production, Research and Sales organisation?
Does the company have a worthwhile profit margin? Is the profit margin currently-influenced-therefore-good?
What does the company do to maintain or improve profit margins?
How good are the company’s cost analysis and accounting controls?
How has the business evolved over time?
Check if there’s a delayed gratification that the market hasn’t realised.
Understand the customer loyalty. Identify core customers. Are they concentrated or diversified? Is it easy or difficult to convince them to buy the products or services? What is the customer retention rate? How do they invest to improve it? Are there incentive structures related to customers? If they’re selective about the customers, it’s a good sign.
What are the signs of customer orientation? The more frequently a business interacts with the customers, the more critical it is to keep them happy. Ask yourself if the business is easy to do business with? Does the business solve customer problems quickly and easily? 40% of customers who’ve had bad experiences stop doing business with the business. How does the management stay close to the customers?
What is the demand volatility of the industry?
How has the industry evolved over time?
Understand the competition from the customers’ perspective.
How does the business compete in the industry?
What risks does the business face from substitute products?
Can low-cost country competition impact the business?
Which competitors set the industry standards?
What type of relationship does the business have with its suppliers?
What are the risks the business faces? Adapt the mentality of an insurance underwriter. Frequency and Severity. What can go wrong?
Read the income tax note. Compare the differences between the income tax provision and current taxes 5-10 years. If you discover that a business is reporting the earnings but not yet paying the taxes, a red flag.
Does the business generate revenues that are recurring or from one-off transactions?
To what degree is the business cyclical, countercyclical, or recession-resistant? All recessions aren’t created equal.
What is the Operating Leverage (Percentage change in EBIT / Percentage change in Sales)?
What is the cost structure? A business that has a large percentage of long term assets compared to total assets typically has a higher fixed cost structure. Go deep with the costs. Are they variable or not?
How does the working capital impact the cash flow? What are the capex requirements?
Does the growth come from secular trends?
Which phase of the growth is the company in?
Has the growth slowed? (Paying more dividends, targeting new customers, attempting to change the business model…)
1$ Rule
Analyse past problems.
What is the industry share of the company?
How able is the company to adapt to the current and future demands from the customers?
Analyse the sales web and sales percentages.
What are the factors that keep the company profitable and what would reverse them?
What’s the vision of the company?
Has the company proved themselves for whatever project at hand?
Analyse insider holdings and transactions.
Are the company’s achievements sustainable?
Why and how has the company been successful in the past?
What’s the people’s view (Customers, suppliers, media, etc.)?
Can the company grow more?
Bureaucracy or decentralised?
“We want to be in a business that 10 years from now is earning a whole lot more money than it is now and we still feel good about the prospects of the business at that time.
Assess the Market Cap rationally.
Balance Sheet:
It’s often useful to determine the motivation behind a business’ debt.
OFF-BS debts usually disclosed in the footnotes under the title of Commitment & Contingencies.
Coverage ratios. They measure a business' ability to meet fixed obligations. EBIT/Interest Expense, CFO/Interest Expense.
Static Ratios. They measure the ability of a business to repay its debt obligations. Current Assets/Current Liabilities, Debt/Equity, Debt/Total Sales.
As a starting point, take a look at the credit ratings of the business.
Current Assets Liquidation Value.
A/R Turnover Ratio: Net Sales/Avg AR x 365
Determine whether the interest expense is fixed or variable.
Analysis of the Management and the Culture
QUESTIONS:
Does the management have skin in the game?
Enthusiasm, Talent, and Integrity are key qualities that you’re looking for in a management.
Do they actually care?
Do they do what’s wrong despite knowing?
Is the company loved by the employees?
Are they widening the moats?
Do they fish where the fish are?
Capital Allocation Skills?
Check out the salaries and stock options.
Are they experienced in the field?
Do they love the business or the money?
Do they have Intrinsic Value Orientation?
Understand the incentives.
What is the company culture?
What is the employee turnover? Do people want to work there?
Does the management focus on cutting costs and increasing profits?
Can you identify a moment of integrity?
Do they personally write to shareholders?
Which questions do they avoid in conference calls?
Do they think independently and remain unswayed by what others in their industry are doing? Unique or me-too?
Finance & Control, Product Line, Target Markets, Marketing, Sales, Distribution, Manufacturing, Labor, Purchasing, R&D. Objectives.
Determine whether the management understands what increases the value of the business and acts accordingly.
Valuation & Qualitative Factors
QUANTITATIVE:
P/E, P/S, P/B, P/FCF, PEG
ROA, ROE
Operating Expenses/Sales, R&D Exp/Sales
Net Income/Sales
Current Ratio, Quick Ratio, Debt Ratio
EV/OE (Owner’s Earnings = Net Inc + DDA - Capex Avg. and Future - Changes in Working Capital)
EPV
Total Asset Turnover
Average Life of All Items = Dep / Cost of Plant
Day Sales in Inventory
Inventory Turnover
Total Costs / Customers Count (For understanding competition)
CFO/Net Income
Cash Conversion Cycle
QUALITATIVE:
Future Multiple
Future Opportunity Cost
Performance Metrics
Growth rates of sales and AR should be roughly equal.
Discretionary costs (Advertising, R&D, Maintenance…) can easily be manipulated.
Margin of Safety
Which place are we in the cycle, if it exists?
Check out the shareholders.
Timing is also important.
3 year rule.
If someone’s fat, it’s obvious. It doesn't matter if they’re 270 lbs or 250 lbs.
Will they need equity financing for future prospects?
How much will the company earn 5-20 years from now? About the same? Up moderately? Up a lot? Up tremendously?
Determine the investment catalysts.
ROIC:
- What does the company do to improve it?
- Higher inventory turns
- Higher AR collection
- Online Sales
- Being more productive with long-term fixed assets
- Accounting differences
- Depreciated capital will cause higher ROIC
- Fast growers may have lower ROIC
- Investments to niches will decrease ROIC.
Sources of Investigation
Talk to industry experts.
Bankruptcy Week, Distressed Company Alert
Barron’s, WSJ, FT, Forbes, Fortune
ValueLine
Trade Journals for specific industries, such as American Banker, LA Review, Gemfinder Spinoff, Organization Report…
Articles, Books, and Success stories in industry.
International Directory of Company Histories by Gale
Last 5-10 years 10-Ks.
Doing Business Report by World Bank and Business Monitor International’s Country Reports for understanding the country’s business environment.
Interview with customers. Determine if they’ll continue to do business. Understand how the customer decided to use the company rather why they decided?
What would change customers’ opinion about shopping there and vice versa?
American Customer Satisfaction Index and other indicators. More satisfaction means less volatile cash flows.
S&P Industry Surveys
Industry Conferences
Articles.
Wall Street Transcript, Charlie Rose, Management Interviews.
Local Newspapers. Both for the company and the management.
Dow Jones Factiva, LexisNexis.
Article author journalists.
Deans and professors in business school who are close to your business.
Talk to headhunters.
Direct information from the corporation.
Operating metrics to be monitored:
- Reuters Operating Metrics, S&P Industry Surveys, Fisher Investment Guides
- Money Trade Associations and Trade Journals
- Make sure of the same accounting standards.