Strategy

My overall strategy focuses on two factors: the intrinsic quality of the company, and the price. In both of these factors, the past, the present, and the future are to be considered.

The present is  important, because that is the starting point for the future. The present is the state at which you are given the opportunity to enter (or leave) an investment. If you dislike the present, that should be reflected in the price you are willing to pay. The future is most important, since that is the promise you are investing in. The value of a company is determined by its future. The past matters because it is the only data from which the future can be guessed. Here is a great question to ask: “What past brought us to this present, and what events must occur to move the investment into a favorable future?”

Quality

The quality of a company can in my view be brought down to one key aspect: Cash flow to shareholders. In order to deduce the possible future cash flow an investment can generate there are many factors to consider.

There are several important aspects regarding the quality of a business, here are some examples of what I consider.

  • Profitability
    • Are the margins good?
    • Is the return on invested capital good?
  • Growth
    • Is the company growing from topline all the way through the income statement?
  • Solid balance sheet, is the company carrying a sustainable leverage
    • Debt to EBITDA
    • Current ratio
    • Solidity

To elaborate on the list above, margins I’m most concerned about in general are ebitda-margins and ebit-margins. This is because I’m mainly focused on the cash flow from the operations, and the operational earnings. Ebitda and ebit are decent proxies of the respective numbers. As far as returns, we prefer a company that is efficient in its employment of capital, so I prefer a company with higher ROIC. It’s important to know that certain industries employ less capital than others, and thus may appear more efficient than others. 

Furthermore, I prefer if a company is growing, and it’s important that the growth manages to roll through the income statement. It’s relatively easy for a company to grow their revenue, it’s not as easy to grow revenue while defending their ebit margins. Measures of growth that I generally use are revenue growth, EBIT growth, and equity growth. Keep in mind the number of shares outstanding.

Finally, we want a company that has the ability to increase its leverage while we own the stock. Thus, as we acquire it the general debt burden on the company should not be strained. I use debt to EBITDA to gauge the level of debt, and current ratio and solidity to check the short and long term solvency.

Price

A good company can make a bad investment simply by overpaying for it. The same cannot be said of a bad company. This is something that Charlie Munger said at one of their annual meetings (I’m not sure which, sorry.), and it is the reason I care about the price I’m paying. Now, I rarely care about the P/E ratio or dividend yield, which are very common measures. Since I focus mostly on the operations, it makes sense for me to consider metrics using EBIT and EBITDA. Furthermore, I prefer using Enterprise Value instead of the common P-multiples. 

Usually I check the companies EV/EBITDA and EV/EBIT, and put them in relation to the growth in EBIT and Equity. This creates a measure similar to the PEG ratio, but using EV-multiples instead of PE and other growth metrics than earnings. 

Holding

This is always the tricky part. I try to be long term in all my investments, so ideally I would have a very long holding period for my investments. This is something I have to improve on, since it’s far too easy to want to take the profit already netted and jump into the next interesting investment opportunity. 

So a note to myself here would be another Munger quote along the lines of: the value creation comes not from the purchase or sale of a stock, but from the waiting. I’m not sure when or where he said it, but he also said something about it being damn hard doing nothing. So, make a purchase that ticks the boxes, then… Do nothing!

Valuation

Now, I have noticed that I am very vague in how exactly I value a business, or how I determine how much I want to pay for a business. So here I’ll attempt to make it clear, both for you and for myself.

When I value a company I first try to get a “feel” for the company’s quality. After I have seen the margins, return on capital, growth, financial stability etc, I decide how much I am willing to pay for that quality. In order to do that, I consider my alternative cost. This probably could use a post of its own, but for now I’ll just state it. I use the S&P as my alternative cost. How and what measure? Well, this is another fluffy part, but I try to evaluate the question: “Is this company that I have before me ‘better’ or ‘worse’ than the S&P?”. In other words, do I think this company will outperform the S&P.

If it seems to me that the company is better, it deserves a higher price than the average, and vice versa. Here comes another bag of ‘difficult-to-asses moving parts’. What multiple does the S&P deserve? What are the expected returns of the S&P? To be fair, i’m not sure, and I don’t think anyone can be sure about that. What we do know are the past average returns and the past average multiples. So, the S&P has returned about 7% per year, and some sort of average P/E has been about 15. These are not clear cut, and there is no cookie-cutter answer in my opinion. For example, will the S&P earnings going forward be similar to the historic earnings, and should the multiple be the same as the average? The short answer is that I don’t know. The long answer is: If I wouldn’t pick stocks, I would invest in some index fund. So that is what I’m trying to beat, and thus the companies I pick must be better and purchased cheaper.

I don’t fix the multiples, and don’t use target prices etc. but rather try to think ‘does this seem reasonable?’. If it seems reasonable I buy it. Here is where I currently don’t have a strategy. What exactly is reasonable? and when to sell?

To be honest, I’m not sure. It’s easier to see something and determine that it’s unreasonable, than to determine what is reasonable without any example. As to selling… I guess the answer would be when it’s unreasonable. But when is it unreasonable, and it could always be even more unreasonable couldn’t it? Yeaaah…

Let’s take two fictional companies:

Company A:

  • Growth 10%
  • Good balance sheet
  • ebit margin ~15%, ROIC 12%

That’s pretty good isn’t it? Yeah I would agree. Now what ev/ebit multiple would we want to pay? 50? nope. 40? no. 20? Well, that’s a bit pricey… 10? ev/ebit 10 would give a price to growth of 1. given high margins and good ROIC with a solid balance sheet… I’d probably  take it. I would probably be pretty excited to buy this at ev/ebit 10. However, if the s&p ev/ebit is higher, but this looks better than the average s&p company, or does it? If we give this company a rock solid history, I’d probably bet that this is better than the average S&P company, so closer to ev/ebit 20 than 10, right? That means above 15 but under 20. 

This is somewhat true to what I actually think, and how I reason when trying to evaluate companies. Let’s take another example.

Company B:

  • No growth
  • good balance sheet
  • ebit margin ~15%, ROIC 12%

Hmm, zero growth huh? Yeah this is also fine to me, given the great margins and returns, I assume this spits out a lot of capital that it cant employ well to grow the operations. To me that is also fine. But for this I don’t want to pay a premium. Lets say somewhere between ev/ebit 10 and 15?

Looking at these two quickly made up examples I notice that I would pay a premium for growth. That makes sense to me, because a growing company will contract the multiples if the stock price does not increase. So if there was another example with negative growth, it would have to be heavily discounted.

Now we could do more examples, but I think It’s relatively clear that there are two value adding points and one “environmental variable”. Growth and quality (margins and returns) add a premium, and seeing an OK balance sheet is something we like, but does not necessarily increase the premium. If the balance sheet is very levered and risk is pushed all the way up, I would be careful, and might pass on the investment opportunity unless offered at a significant discount. On the contrary, a GREAT balance sheet is not something I would pay a premium for over a company with an OK balance sheet. I don’t know if I’m alone in thinking this, or if it is justified. I just don’t care about the balance sheet as long as it is something that I don’t feel I have to worry about.

Conclusion and Summary

This really went out of hand and way longer than I intended. But to summarize:

  1. Determine the quality
  2. Determine a reasonable multiple
  3. Buy and DO NOTHING untill the facts change

Over and out.

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