My Investment Strategy

My overall strategy focuses on two factors: the quality of the business, and the price.

  1. High profitability historically and in the future
  2. Reasonable balance sheet
  3. Fair price

Quality

Here are some examples of what I consider when trying to determine the quality of a company.

  • Profitability
    • Are the margins good? (EBITDA, EBIT, and OPCF)
    • Is the Return on Invested Capital good?
  • Growth
    • Is the Sales, EBITDA, EBIT, and OPCF growing?
  • Solid balance sheet
    • Is the company carrying a sustainable amount of debt?
    • Debt to EBITDA and Current ratio

To elaborate on the list above, margins I’m most concerned about in general are EBITDA-margins, EBIT-margins and Operational Cash Flow (OPCF) margin. This is because I’m mainly focused on the cash flow from the operations, and the operational earnings. 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 OPCF 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 to check the short term solvency.

Note that the most important aspect is what these measures will look like during the period where we own the investment. In other words, we need to be able to answer the following question: “What will the quality of the business be in the future?”. Looking at what they have been in the past is usually a good enough starting point, but we must not forget to lift our gaze and try to predict the future of the business. It’s really difficult most of the time, but if it were easy there would be little to no profits in investing…

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 OPCF, EBIT and EBITDA. Furthermore, I prefer using Enterprise Value instead of the commonly used price-multiples. 

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

Holding and Selling

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!

So when to sell then? I have turned to using mainly two rules for when to exit a position:

  1. When the facts change, or the case is no longer intact
  2. To move into a better investment opportunity

Valuation

When I value a company I first try to get a “feel” for the company’s quality. After I have seen the margins, ROIC, 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 a broad cheap global index fund as my alternative cost. I try to answer the question: “Is this business ‘better’ or ‘worse’ than an index fund?”. In other words, do I think this company will outperform the index. The logic behind this is the simple fact that 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.

This is not a very clear answer to the question of how to value a business, so here is the short answer: a business of high quality deserves a higher valuation than a business of lower quality. In practice, I usually put the multiple in relation to the growth rates and the ROIC, while taking the margins and level of debt into consideration.

Conclusion and Summary

Growth and quality (margins and returns) add a premium to the valuation. A “good enough” 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 even justified. I just don’t care about the balance sheet as long as it is good enough so that its nothing I have to worry about.

To summarise my process:

  • Determine the quality
  • Determine a reasonable price
  • Buy and DO NOTHING until the facts change

Are Preferred Shares Useless?

Preferred shares are a relatively popular asset class, especially for Swedish, so called, dividend investors. This is due to the fact that most preferred shares pay a quarterly dividend unlike common stock, which usually pay an annual dividend. But how good are preferred shares as an asset class?

What are preferred shares?

First of all, all preferred shares are not created equal, and one must read all details for each company’s preferred share series in the prospectus for each series of preferred shares. However, they can be described in broad strokes.

Preferred shares are a part of the firms equity, with a preferred dividend. preferred shares usually have a nominal value for which the firm can repurchase the shares, usually at, or after, a specific date. Some preferred shares have a changing dividend or repurchase price depending on certain dates. For example the repurchase price may drop after some years, or the dividend may increase after such and such date. (Such details are the reason why each preferred share is its own, and why reading the documents are important before purchasing preferred shares)

Generally, preferred shares have the following traits:

  1. Predetermined repurchase price
  2. A date, after which they can be repurchased
  3. A fixed dividend, often fixed as a dollar amount
  4. They appear in the equity part of the balance sheet

Even though the name draws similarities to common shares, and the first point in the list above, preferred shares have more in common with bonds than common shares. This may sound strange, but let’s take a look at bonds.

What are Bonds?

Bonds are loans from the holder of the bond, to the company emitting the bond. For the holder of the bond, it is an asset. For the company, the bond is a part of the debt.

An interest paying bond has the following traits:

  1. An amount, called face value
  2. A date at which it will be repaid, the maturity date
  3. A coupon, an interest rate, stated as a percentage of the face value
  4. Appears in the debt part of the balance sheet

Bonds vs Preferred shares

Comparing preferred shares and bonds we see lots of similarities and one major difference.

  • Both have a predetermined value (Repurchase Price, Face Value)
  • Both have a date where that value can be exchanged for the paper (Repurchase Date, Maturity Date)
  • Both have a predetermined yield (Dividend, Coupon)
  • They appear in different parts of the balance sheet (Equity, Debt)

The similarities sum up to a fixed upside, or return. The difference lies in the downside, or risk.

How does that add up?

Given that an investor holds the preferred share until it is repurchased, the return is defined by the dividend plus the difference between the purchase price and the price at which the company repurchases the shares.

If an investor hold a bond until maturity, the return is the same. The interest rate, plus the difference between the purchase price and the face value.

However, the downside in bonds differ from the downside in preferred shares. This is due to the difference in debt versus equity.

The downside in both cases is 100%, in other words the preferred share or bond is worthless. However, should a company enter into bankruptcy, the company has to cover as much of its most senior debt, before any junior debt is paid out. If there are any funds left after the senior and junior debt has been repaid, the equity gets covered. Usually in a bankruptcy, there is not enough funds to cover all the debt, which means the owners (the holders of the company’s equity) gets nothing.

This leads to bonds having a lower risk, because they are debt in the balance sheet. Preferred shares carry the same risk as common stock, which is concealed with “preference”. The “preferred” part in preferred shares means that if a company can’t pay the dividend to its preferred shares, it can’t pay a regular dividend until the preferred shares dividend has been paid.

Risk-Reward

Bonds come with a capped upside, given that they are held until maturity. This comes with an associated level of risk. Higher risk leads to a larger coupon as a percentage of the face value.

Preferred shares come with the same capped upside, but have no protection if the company goes into bankruptcy. Holders of preferred shares take a risk which is very close to the risk in the common equity for the same company, but they don’t have the same potential upside.

Preferred shares come with the worst of both worlds, the capped upside of an obligation, and the 100% downside of common stock.

Are preferred shares a bad choice?

The simple answer is often yes, except for special cases often unattainable for retail investors.

Preferred shares can be very useful, if the problem of a capped upside is fixed. This can easily be remedied by adding another word to the name of the security: “convertible”.

If a preferred share is a “convertible preferred share”, which can be converted into a predetermined number of common shares, at some point in the future, the upside is no longer limited to the dividend. If the venture is very successful, the common stock gets a boost in value, but the preferred shares still get only the predetermined dividend. If the shares are convertible, the increased value of the common stock is also baked into the value of the convertible part of the convertible preferred shares.

Convertible preferred shares have the following advantages for the investor and the company emitting them:

  • Unlimited upside
  • Downside smaller than that of the common stock
  • Increases the equity part of the balance sheet (lowers the debt-to-equity ratio)

The third point is something that makes convertible preferred shares better for the company than convertible bonds, which increases the debt burden on the company. Unfortunately there are no convertible preferred shares available for smaller investors as far as I know. These are not uncommonly used in venture capital deals and similar types of investments.

In Summary

Preferred shares have an upside similar to bonds, and downside similar to common stocks. In other words, preferred shares are the worst of both worlds, because of the associated risk/reward. Convertible preferred shares are much better, but not available to smaller investors.

I hope you enjoyed my thoughts on preferred shares. Remember to do your own research before making any investment, which includes understanding the security you invest in.

Förbättra din analysmodell med VOS Indicator

Venture Capital-firmor är väldigt rutinerade investerare, som dagligen blir uppsökta av entreprenörer på jakt efter kapital. För att klara av det trycket, har de utvecklat sofistikerade modeller för att snabbt kunna sålla agnarna från vetet. Ett sådant verktyg kallas Venture Capital Four Factors, eller Venture Oportunity Screening Indicator (VOS indicator).

VOS indicator är ett verktyg för att utvärdera hur intressant ett bolag i ett tidigt skede kan tänkas vara. VOS går ut på att man skapar en matris där faktorkategorierna ställs mot dess attraktivitet. Antingen kan man använda ett mått på attraktivitet, men bäst är att ta fram minst två scenarion.

Nedan finns ett exempel på hur en VOS screening kan se ut. Exemplet kommer från ”Entrepreneurial Finance”, sixth edition, av Leach och Melicher.

I tabellen ser man de fyra kategorierna/faktorerna, och fyra underfaktorer. Exemplet använder ett bra, mellan, och dåligt scenario. Notera blandningen av hårda och mjuka variabler, samt ett tydligt fokus på när man kan göra en exit. Detta är bara ett exempel, vad som är bra eller dåligt måste man avgöra i varje enskilt fall, antingen genom att titta på peers, eller på liknande branscher.

För att sammanfatta hela tabellen skulle jag säga att man letar efter ett bolag som leds av en kompetent ledning, som har entreprenöriella drivkrafter blandat med ägarandel. Bolaget ska vara lönsamt och verka i en intressant bransch, plus att det ska finnas en potentiell exit inom en fördefinierad tidsram. Jag tycker VOS är ett bra och tydligt verktyg för att överskådligt screena hur intressant ett bolag är.

Jag hoppas du finner något värde i den här modellen, jag tycker det kan vara ett intressant verktyg, och kommer försöka arbeta in något liknande i min nya analysmodell!

Ha det fint!
/T