Investment Qualities
Disclaimer: The information contained in this publication is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in such publications are those of the publisher and are subject to change without notice. You are advised to discuss your investment options with your financial advisers. Consult your financial adviser to understand whether any investment is suitable for your specific needs. I may, from time to time, have positions in the securities covered in the articles on this website. This is not a recommendation to buy or sell stocks.
Some investors use screens to identify stocks with attractive business qualities or valuation such as earnings growth, return on invested capital, price-earnings and price-book ratios, and more. In addition to these important metrics, qualitative factors are also important and may be missed by a screen.
Todd Combs wrote: “I break down my process into three buckets - find a good business, with good management, at a good valuation. You don’t need or expect to find all three of these to the same degree in every investment; there can be a sliding scale with puts and takes. Nonetheless, all three must be present. Think of it as a multiplicative series where a zero in any of the cells will yield a zero overall regardless of how the other elements may rate” (Security Analysis, Benjamin Graham, 7th edition, page 320). Additionally, Combs and others discuss the importance of keeping things simple.
In this post I will discuss the following (mostly) qualitative investment criteria: appealing business and industry characteristics, good management team and other stakeholders, good reasons for mispricings, and a simple investment thesis.
Business characteristics:
Leader in an industry with secular tailwinds. The industry could be new with the company leading its expansion.
Ability to make accretive acquisitions with potential synergies as a bonus.
On William Thorndike's podcast “50X” (at 56’), he said, “for any company where acquisitions are a significant component of the value creation story, it's just hard to model the pacing of those, and the tendency is to model the pacing of them overly conservatively.” By avoiding strict models, one can be open to stocks with long-term predictable outcomes despite the unpredictable timing of acquisitions.
Flexibility to grow and take market share during a recession, or become leaner/cost-efficient during tougher times.
Prudent use of debt to generate high returns on equity.
William Thorndike’s preferred business qualities (discussed with Patrick O’Shaughnessy at 11’30”):
Capital efficient/asset-light: Low maintenance capex requirements and not working capital intensive (short receivables cycle and low inventory requirements). Thorndike also mentions “the incredible power of negative working capital” (receiving payments in advance).
Thorndike looks for a “return on tangible net capital” or “ROTCE” (return on tangible capital employed) of at least 20%.
ROTCE = EBITA * (1-t) / (net WC + net PPE) (assumes depreciation = capex).
Recurring revenue, low churn, decentralized management structure, pricing power, provides a good or service that is a critical yet small component of the customer's total costs, ability to pay special dividends (allowing for discretion regarding dividends vs. share repurchases based on the stock price).
Quality Management and other Stakeholders (board, major shareholders, etc.)
Alignment with shareholders demonstrated by insider ownership.
Decisions made to prioritize the long-term even if it means sacrificing near-term profits. Tom Russo describes this as the “capacity to suffer”, given pressure from analysts to meet quarterly earnings targets.
Executive compensation based on performance.
Reasons for mispricings.
Seth Klarman gives some examples of reasons for mispricings that a long-term investor can exploit: “In General, companies that disappoint or surprise investors with lower-than-expected results, sudden management changes, accounting problems, or ratings downgrades are more likely than consistently strong performers to be sources of opportunity” (Security Analysis, Benjamin Graham, 6th Edition, Page xxiv).
Below are more sources of mispricings:
Market cap is too small to interest institutions.
Temporary challenges.
Seth Klarman wrote in the preface to the 7th edition of “Security Analysis” (page xlvi), “Not many want to buy a stock if the next few quarters look disappointing, since stocks that fail to beat Wall Street’s quarterly estimates are regularly thrashed. Even when short-term negatives have been more than fully baked into share prices, many hold back, waiting for obvious evidence of turnaround or recovery. In effect, they’d rather pay a higher price when the road ahead seems clear, even though by the time everyone can see what they see, the moment of greatest opportunity will have passed.”
Overreaction to a low probability risk.
Bill Miller explained, “what you are trying to do as an investor is exploit the fact that fewer things will happen than can happen. So, you are trying to figure out how that probability distribution works and stay in the middle of what will happen. The market has to worry about all the things that can happen.” The Chandler Brothers historically exploited this source of mispricing during crises which required basing decisions based on optimism rather than fear. It’s important to consider downside risk and appropriately weigh the probability of its outcome.
Complicated accounting practices that don’t affect business prospects.
Current income suppressed for long-term benefit due to investments for future growth, temporarily low prices, advertising expenses, etc.
Volatile or cyclical yet reliable long-term earnings.
Technical market dynamics that may cause forced (non-fundamental) buying or selling such as: addition to–or removal from–an index, special situations including spin-offs that may cause institutional selling, a major shareholder liquidating due to a fund mandate, etc.
A Simple Investment thesis.
Nick Sleep emphasized the importance of a simple investment thesis in his 2007 annual letter: “Investors see the information (on conference calls they cheer “great quarter, Wal-Mart”) but, in our opinion, they incorrectly weigh the information. It could be argued that lots of things had to go right for Wal-Mart to grow for forty years. That is certainly true but, at its heart, a very few simple things really mattered. In our opinion, the central engine of success at Wal-Mart was a thrift orientation fueling growth with the savings shared with the customers. The culture of the firm celebrated this orientation and reinforced the good behaviour. This is the deep reality of the business. This should have had the greatest weighting in the minds of long-term investors… [instead of] valuation heuristics, or margin trends, or incremental growth rates in revenue… but these items are transitory and anecdotal in nature.”
An investor seeking simplicity should still do rigorous due diligence. Todd Combs wrote: “...the difference between a good analyst and a great one lies in the ability to keep things simple and determine what matters most. People misinterpret this to mean that investors should keep things at the surface level. In fact, it paradoxically takes a great deal of depth to stay simple. The analyst’s job is to tear apart an investment in order to understand its essential elements. A great security analyst is willing to rip a company down to its studs and understand each part before they reassemble it. In the massive sea of information that an analyst is continuously ingesting, there is always one piece that matters more than the others. Finding that morsel is what keeping it simple means.” (Security Analysis, Benjamin Graham, 7th Edition, page 318).
Below are some simplistic investment frameworks, some of which should apply to most investments:
Return to normalcy.
Cheap stock based on its core business with a free option or short-term catalyst.
Plan to return capital to shareholders.
The Chandler Brothers’ model: buying the “crown jewel asset” of a country or region experiencing volatility.
According to Institutional Investor, The Chandlers would buy “big companies in big countries [with] a ready audience of benchmark-following investors who must buy the asset”. Chief Investment Officer and Partner at Legatum Group Philip Vassiliou (at 20’26”) said, "if you're willing to take country risk or sector risk, don't take company risk.” Most crises present an opportunity to buy the most likely survivor at a discount greater than the actual risk of disaster outcomes.
Legatum Group’s (Christopher Chandler) current model: buying quality businesses in regions with secular growth trends.
Legatum Group CEO Mark Stoleson explains “Simple Big Ideas” or SBIs: “...if you think India is growing at seven or 8% and it's got a population of over a billion people, there is an SBI, which is the rise of the Indian consumer, how do we express that simple big idea? And then we'll express it through kind of the sectors that we like that we understand: consumer discretionary tech, maybe financial services and banking.”
Vassiliou explains (at 41’20”), “you start with a big population, big markets, big companies, big needs to serve, world class talent… that offers a backbone to a tremendous amount of opportunities… It’s amazing to look at businesses like HDFC Bank and the returns that they have generated over the last 20 years. These are businesses that are tremendously well-run with huge moats that serve massive markets where there is massive secular growth. And I think oftentimes we underestimate how long that runway is. The market is so focused on what the next year looks like, or two quarters look like, that sometimes we lose the forest for the trees.”
1. Big payoffs.
2. Companies that are in oligopolies, duopolies, or have high market share in a fragmented market.
3. Low obsolescence risk.
In summary, an investor’s goal is to own quality businesses, with good management, at a low valuation. Additionally, it is important to find simplicity within complexity.
Legal and Disclaimer:
THE INFORMATION CONTAINED ON THIS WEBSITE IS NOT AND SHOULD NOT BE CONSTRUED AS INVESTMENT ADVICE, AND DOES NOT PURPORT TO BE AND DOES NOT EXPRESS ANY OPINION AS TO THE PRICE AT WHICH THE SECURITIES OF ANY COMPANY MAY TRADE AT ANY TIME. THE INFORMATION AND OPINIONS PROVIDED HEREIN SHOULD NOT BE TAKEN AS SPECIFIC ADVICE ON THE MERITS OF ANY INVESTMENT DECISION. INVESTORS SHOULD MAKE THEIR OWN DECISIONS REGARDING THE PROSPECTS OF ANY COMPANY DISCUSSED HEREIN BASED ON SUCH INVESTORS’ OWN REVIEW OF PUBLICLY AVAILABLE INFORMATION AND SHOULD NOT RELY ON THE INFORMATION CONTAINED HEREIN.
The information contained on this website has been prepared based on publicly available information and proprietary research. The author does not guarantee the accuracy or completeness of the information provided in this document. All statements and expressions herein are the sole opinion of the author and are subject to change without notice.
Any projections, market outlooks or estimates herein are forward looking statements and are based upon certain assumptions and should not be construed to be indicative of the actual events that will occur. Other events that were not taken into account may occur and may significantly affect the returns or performance of the securities discussed herein. Except where otherwise indicated, the information provided herein is based on matters as they exist as of the date of preparation and not as of any future date, and the author undertakes no obligation to correct, update or revise the information in this document or to otherwise provide any additional materials.
The author, the author’s affiliates, and clients of the author’s affiliates may currently have long or short positions in the securities of certain of the companies mentioned herein, or may have such a position in the future (and therefore may profit from fluctuations in the trading price of the securities). to the extent such persons do have such positions, there is no guarantee that such persons will maintain such positions.
Neither the author nor any of its affiliates accepts any liability whatsoever for any direct or consequential loss howsoever arising, directly or indirectly, from any use of the information contained herein. In addition, nothing presented herein shall constitute an offer to sell or the solicitation of any offer to buy any security.