The Best Business
What makes for a high-quality business?
My goal with Axe’s Take is to provide a crystallized investment approach with educational resources for young professionals. I would love to hear from readers if you have any questions or feedback on potential topics.
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Agenda:
Why quality matters?
Who’s the captain of the ship and why that matters?
Revenue vs. Margin
Conclusion
Our last post focused on situations where an individual investor can look for attractive public market situations with the frameworks of edge and patience in mind.
Remember that the essence of investing is making a probabilistic bet on a projected outcome. Where you are making a bet on an unappreciated asset how do you avoid situations where your target may only seem to be on sale? In industry talk these situations are referred to as “value traps” — the price offered by the market implies an attractive return but the company at hand may not be a great business to hold. These situations could remain at bottomed out valuations for many years as the business slowly drudges on and the negative market perception remains (see here for an application in the world of pharma).
Owning high-quality businesses can help avoid value traps. A mispriced, quality business is one that could revert to the mean over time and provide comfort that the asset you own will grow and create value over time. In addition, the tax-deferred aspect of owning a quality business for years can generate higher returns than if you were trying to flip mispriced stocks every year or so and having to pay capital gains tax each time.
This post will be the first of two posts where concepts will be provided in a “primer” format. I will also provide additional reading if you’d like to delve a layer deeper. These concepts are essential if you are going to spend time trying to breakdown a company’s investment viability.
One last thing, if you are going to consider investing in a business or stock you should start with the business model itself. I try gauge how the machine works before moving into other aspects such as who’s running the machine, or how many machines can be built over time. Start from understanding the atomic unit before trying to understand the company as whole.
Management
One of the major checks investors like to cover is who is steering the ship. Considering you’ll be an owner for an extended period of time having confidence in the captain/s is what could help maintain confidence if a business goes through its natural ups and downs on its way to profitability and value creation. How does one assess if management is high-quality? Here are several key topics to understand when assessing management:
Incentives — how is management financially rewarded if the company hits its targets or if the share price rises
Insider ownership
Tenure
Industry experience
Businesses such as Amazon or Costco didn’t have stock prices up and to the right as a 15 year chart may seemingly imply. Confidence and conviction in management helps you, as an owner, trust in their ability to execute as you ride the ups and downs of market volatility.
Book recommendation: The Outsiders
Revenue Growth
Picture an industry as a pie. If a company owns a piece of that pie management is going to try to grow their respective piece if not try to grow the pie itself. Growth is looked at favorably by investors as higher growth is sure to attract higher prices in the market. Top-line growth is also one of the most followed metrics for public market investors. Sell side research and consensus estimates are often driven by specific expectations for growth in future years to justify estimated valuations.
Future growth is directly related to concepts such as a company’s Total Addressable Market (TAM), the competitive landscape, and the company’s ability to create new streams of revenues with additional products or services to layer onto its core offering. These drivers all help illustrate the potential outer limits of the company’s prospects. Imagine Charlie’s Chalk, a fictional company that is the market leader in manufacturing chalk products for schools and universities. Firstly, I can’t imagine that the chalk industry is growing as fast as let’s say, enterprise software. However, considering Charlie’s Chalk already has a massive piece of the “chalk” pie its TAM may be a growth constraint due to its current state — being too small to allow for additional growth — and velocity of growth — the industry it plays in is shrinking year after year.
Side note: There are investors who will look at the stock price of a company like Charlie’s Chalk price and deem that the value of its assets plus whatever growth is left justify a significantly higher price than what the market is quoting, thereby making the stock a “good buy”. While this might make sense with 1-3 year holding period, if you’re trying to compound capital on a tax-deferred basis for 10+ years you’re likely going to avoid owning a company whose existence is questionable in the next decade. Goals and time horizons are key to your investment strategy.
Additional Reading: The Base Rate Book - Sales Growth
Margin Profile
In a steady-state the cost structure should allow the company to see the benefit of revenue in the “bottom-line,” or margin. Depending on the industry, investors may look at:
Gross Margin - Gross Profit / Revenue
Operating or EBITDA Margin - Earnings before Interest/Taxes - what’s left after the company pays out all operational-related costs and before any finance-y costs (think taxes and interest on debt owed) are taken into account
FCF (free-cash-flow) margin- the remaining cash available after capital requirements (e.g. paying suppliers, maintenance capital) are made
Regardless of which margin you are looking at, the stage of the company and the industry it plays in is likely to provide guidance on where margins should be. Companies that are in the growing phase may be looking to optimize for revenue versus margin and will re-invest much of their growth back in the business. If the investments are providing a return greater than the company’s cost of capital (a concept I will return to in the next post) then you’d prefer the company compound on its growth versus than let the cash build up on its balance sheet.
Conclusion
As much as the above drivers of value can help frame an investment opportunity they are all based on backward-looking information. The goal is to marry the past with the future and try to determine what the company will look like in 3, 5 or 10 years relative to the current market expectation. Considering the difficulty of this task, entry valuation helps provide a margin of safety.
If you fail to predict what a company will look like with complete accuracy, buying shares at an attractive valuation to its future state provide some safety if you end up being wrong. The further out in time the projected growth is projected to materialize or the higher the growth is estimated to be, the wider the span of outcomes will be for a respective company.
The next post will provide a couple new concepts which are incredibly important if you want to round out a hypothetical “portrait” of a high-quality company. Feel free to reach out with any comments or questions on today’s post.
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