I often get asked “what attributes do you look for in an investment?” That’s a good question and today I thought I’d explain my high-level answer to that question.
Firstly, Ben Graham – the man who literally wrote the book on investment analysis – famously said that investment is most intelligent when it is most business-like.
What he meant was that thinking about a potential investment like someone who was considering buying a business (and not merely speculating about the price of a stock in the short-term) is a superior way to select investment opportunities and evaluate whether the price one is asked to pay is a fair reflection of its intrinsic value. Again, most people intuitively understand this concept, but fail to apply it consistently when it comes to the stock market.
Consider the economics of a well-loved local coffee shop that the current owner wants to sell for personal reasons. An interested buyer would ask to see financial statements, do some research on the neighbourhood, the sensitivity of the coffee shop to the economic cycle, the expense profile, the size of the local market, the demand for coffee and the local competition before making an offer to purchase based on what they calculated this business opportunity to be worth. Because the prospective buyer must live with the economics of owning this coffee shop, they are much less inclined to overpay for a good ‘story’ – they are thinking like a business owner, not a speculator. On the other hand, if the analysis leads the buyer to believe the economics are sustainably attractive over the long term, they might well elect to pay a premium to own such a business.
I apply this same mindset to the businesses we look to invest in. Even though I will only ever be a minority shareholder, it focuses my mind on committing capital to the best opportunities we can find if we ask ourselves whether we would be happy to own the economics of a business over the long term.
This also speaks to why I look for quality businesses, and why I accept that these businesses generally trade at a premium: I wouldn’t want to own a business that does not have the ability to generate favourable economics only for a very short period of time (or worse, only once.)
This mindset also provides my first line of psychological defence during a market correction, when stock prices are tumbling. Provided my research team and I have done our up-front work rigorously and the long-term outlook for the businesses we invest in is not materially impacted, the intrinsic value is unlikely to have changed much. This approach has helped me make good decisions through periods of volatility.
Focusing exclusively on earnings and earnings growth has several shortcomings in evaluating a business. The full picture needed to assess an investment opportunity must consider the ability of a business to generate cash flows after working and fixed capital requirements, as well as the appropriateness of the overall capital structure relative to the cash flows generated.
What I look for in a business
At a high level, I think along four dimensions when evaluating a company for potential investment: the quality of the balance sheet, the sustainability of the competitive advantage, the medium- and long-term growth prospects, and the track record of the management team.
1. Quality of the balance sheet
Quality has a straightforward definition in my book: is the business conservatively financed? Most financial crises bring into dramatic focus the risk of owning businesses that rely on excessive gearing to generate an acceptable return on shareholders’ equity. Over-optimising a balance sheet can boost shareholder returns in the near-term but proves fragile in a crisis. We believe a business with a ‘just in-case’ approach to its capital structure wins out over extreme financial engineering in the long run.
This does not imply that I only own debt-free businesses, but rather that I seek out companies that have manageable debt levels and – critically – generate substantial amounts of free cash flow in order to service the debt. This will vary on an industry-by-industry basis, and businesses with higher levels of debt require more work to understand just how sustainable the cash flow profile is during a downturn.
2. Sustainability of the competitive advantage
With regards to sustainability, I refer to businesses that have a competitive advantage that allows them to sustainably earn an economic profit over a long period of time. If there is no sustainable competitive advantage, the ability to earn an economic profit will be eroded due to the iron law of economics: excess profits attracts competition, which will see all excess returns competed away, meaning all players eventually earn the cost of capital and no more.
A key consideration when assessing this metric is to understand the industry structure. Industries with low barriers to entry, highly fragmented market shares and a history of poor capital discipline rarely make for good investments over time, as most participants will eventually invest and compete so aggressively as to ensure that no participants can earn an economic profit.
Conversely, a business that sustainably earns an economic profit has to be in possession of some factor that allows it to fend off the competition: a very good indicator that the company likely has a moat or competitive advantage of some sort, justifying further analysis.
Most of my analytical effort is focused on identifying the source of competitive advantage that allows a company to earn economic profits, and then continually testing my assumptions to make sure this advantage remains intact.
3. The medium- and long-term growth prospects
On the topic of growth, I think in terms of both revenue and free cash flow. For the former, I look for businesses that can generate organic growth that consistently exceeds GDP and inflation, generally in industries that have superior growth prospects to the general economy. It is critical to understand exactly what is driving this superior revenue growth profile to evaluate how long it can last and whether competition is increasing.
With regards to free cash flow, I try to understand the capital reinvestment requirements of a business. If a company aims to create economic value, the capital retained and invested by its management must earn an economic profit for us to want to own a business.
I look for companies that can reinvest a portion – or all – of their excess economic profits back into the business, and still earn a high return on the capital thus invested. Over time, this is the surest way for a business to compound shareholder wealth – essentially generating more than a dollar of economic value for every dollar invested.
My preferred businesses tend to grow revenues and free cash flows somewhere between 5% and 15% per year – anything higher reaches into the end of the market where speculation tends to overwhelm fundamental valuation.
4. Track record of the management team
A proven and experienced management team is also an important indicator of quality, albeit a more subjective one, which makes it trickier to assess. I readily admit to being more at home in analysing numbers than trying to gain insights by analysing management. However, since management ultimately functions as the custodians of the businesses I invest in, I have some yardsticks in place to assess their actions.
As a starting point, I consider their track record in being good stewards of the business: do they act on behalf of their customers, employees and investors when managing the business, or are they principally interested in personal enrichment or empire building? Does management reinvest in the business to protect and expand its franchise value and brand for the long term, or are they focused on creating perceived short-term ‘value’ by artificially boosting earnings growth (usually done through acquisitions) or over-optimising the balance sheet (usually done through excess leverage)? These questions are inherently tied to their track record as capital allocators: do management make smart investment decisions that consistently generate economic profits?
I also carefully look at how management behave, particularly when talking to shareholders. Are they frank communicators, spelling out what they intend to do? Do they recognise and pro-actively flag problems down the road, or do they prefer not discussing such challenges until the issue has become a crisis? Do they own up to any mistakes? How do they deal with failure or adversity?
Finally, we are very much concerned with good governance practices. While this may seem like a box-ticking exercise, independent board members are often the true defenders of minority shareholders’ interests. We will not allocate any capital to a company with questionable governance practices, no matter how good the business metrics screen or how attractive the ‘story’ is. We simply do not think it is worth the risk.
Thinking like a business owner and only investing in companies with the attributes above has been a pathway to outperformance in FY20 and most likely beyond.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.