Part 3 – Lesson 3

Overview


There are good companies that can be bad investments, and there are bad companies that can be good investments.  How is this possible?  In a nutshell, it comes down to how a company’s underlying fundamentals are reflected in the valuation and investor sentiment.

For example, most investors would agree that Google is a very high-quality company.  It has built incredible products that have quite literally changed the course of human history, and their competitive moat around their products is significant.  However, whether Google’s stock is a compelling investment boils down to how much of those positive fundamentals are already reflected in the stock price.

Investor sentiment often manifests itself through valuation multiples.  If investors are bearish on the outlook of a company, the valuation multiple typically trades lower, but if investors are bullish on the outlook, the valuation multiple trades higher.

Let’s outline a few scenarios overlaying valuation on the fundamentals of Google to make a judgment on the attractiveness of the investment:

Google fundamentals strong and stock trading at 10x P/E – Very attractive investment since an investor can buy a company with strong underlying fundamentals at a cheap valuation.

Google fundamentals strong and stock trading at 20x P/E – Depending on the expected growth rates, this could also be an attractive investment, but the investment is clearly not as attractive as it was when the P/E multiple was at 10x.

Google fundamentals strong and stock trading at 100x P/E – Unless there is an expectation for a massive acceleration in Google’s business, many investors would find it unattractive to purchase Google’s stock at such a high valuation multiple.  If you refer to Part 2, Lesson 10, you will recall that the historic P/E range of the S&P 500 is generally been in the 9x – 18x P/E range, so a company with a P/E of 100x is significantly above where the market typically trades and significantly above the historic Google P/E multiple.

Google fundamentals weak and 30x P/E – If Google’s underlying fundamentals are weakening, most investors would find it unattractive to pay a premium P/E multiple for fundamentals that are going in the wrong direction.

Google fundamentals weak and 10x P/E – This could potentially be an attractive investment since the cheap 10x P/E ratio helps to compensate an investor for taking risk when fundamentals are weak.  If an investor believes the weak fundamentals will improve, then, purchasing the stock at 10x P/E may ultimately turn out to be a bargain.

As you may gather, the attractiveness of an investment is dictated not just by the qualities of the company and strength of the fundamentals, but by the valuation at which you purchase the stock.

What attributes should an investor analyze in judging the quality of a company?


While not a comprehensive list, the following are key topics that an investor should research when evaluating a company for a potential investment:

  1. Product or Service – First and foremost, what does the company do and what is the quality of the product or service? If the company produces a consumer product, investors can read online reviews of the product to judge how consumers view the company’s product or service.  If you are researching a brick and mortar retailer, you should walk their stores.  If you are researching a restaurant chain, you should eat at the restaurant.  If you are researching a software company, you should try to use the software.  An investor should research how the company’s product or service compares to the competition and how it is viewed by customers.

  2. Brand Loyalty and Perception – How do consumers perceive the brand? Companies with a valuable brand don’t need to fight as hard to attract consumers back to their business for repeat purchases, and repeat purchases create a steady stream of recurring revenue.

  3. Competitive Moat – Within any given industry, companies are constantly trying to take market share from each other. For a company to avoid ceding market share to competitors, the company needs to have a strong competitive advantage.  Competitive advantage can come in the form of a product or service that is difficult to replicate, a cost structure that is superior to peers, a brand image that is superior to peers, etc.

  4. Diversity of Revenue – Companies with multiple successful products or different business divisions that contribute to revenue growth have less risk all else being equal. Additionally, high customer concentration and low credit quality customers can add to the risk profile of a company.

  5. Pricing Power – Investors love being involved in industries that demonstrate strong pricing power. Increases in price are typically 100% (or very high) incremental margin, so the ability for a company to increase price over-time is a significant positive.  Many of the previously mentioned items on this list contribute to pricing power (brand loyalty, competitive moat, quality of product).

  6. Margin Structure and Incremental Margins – Top-line growth is great only insofar as it ultimately converts to incremental profits and cash flow. Companies in a high-growth phase may initially re-invest revenue growth back into the business, limiting the production of near-term cash flow.  However, long-term, valuations depend on the conversion of revenue into cash flow.  Below is an interesting quote from the Wall Street Journal on July 17, 2018 with regards to potential margin pressure of the mega-cap tech companies:
    “Results for the June quarter coming over the next two weeks from the five giants (FB, AMZN, AAPL, MSFT, GOOGL) are expected to show combined growth of 26% year-over-year compared with 8.7% growth projected for the S&P 500, according to FactSet.
    But the cost to generate that growth is going upward as well—at a faster clip. Combined spending on research and development is expected to rise 24% in 2018, while capital expenditures for the five are expected to surge by 48% compared with last year. For Big Tech, these expenses reflect the rising costs of running their current businesses while also developing new ones to stay more competitive—in a world where their most significant source of competition is mostly each other.” – Wall Street Journal

  7. Management Team – Oftentimes, the investment thesis of a company is built around the quality of its management team. As an investor, you are entrusting your capital to the care of the management team.  Their decisions on strategy, capital allocation, pricing, cost structure, etc. affects the amount of free cash flow the company will earn.  From the 2017 Berkshire letter: “Betting on people can sometimes be more certain than betting on physical assets.”

  8. Culture of Innovation – The quality of the human talent at a company is just as important as the quality of the management team. Not every company will be the next Apple or Google, but it is important for management teams to foster a culture of challenging the status quo and trying new ideas.

What are the characteristics of a good investment?


We will spend most of the rest of Part 3 trying to answer this question, and many investors will answer this question differently.  Here are a few of the major characteristics we look for in a good investment:

  1. High quality company – Our bias is to invest in high quality companies at good valuations vs. investing in mediocre to low quality companies at great valuations. Over time, we have found that high quality companies display higher growth making long-term valuation metrics look much cheaper.

  2. Attractive valuation – We want to make sure we are purchasing a company at a valuation that allows for future upside in the stock. High quality companies that trade at nose-bleed valuations don’t make for great investments. We are biased towards investing in high quality companies that trade below 20x cash flow.  This is not a line in the sand, and there are many great investments that justifiably trade at higher valuations due high expected growth rates.  However, we prefer to invest in companies that will ultimately generate cash flow and to a pay a price that implies a reasonable multiple of that cash flow.

  3. Non-consensus view – Some of the best investments you’ll find are situations in which you have a more positive view on a company than what is believed by the rest of the market (the consensus view). Stock prices typically react very positively when a company reports good news that was not expected by the market.  For example, if you believe Microsoft will grow revenue at twice the rate that analysts are forecasting, then, the stock will react positive as expectations are reset higher.

Fortunately, the formula for identifying great investments is not overly complicated.  Finding high quality companies at attractive valuations where you ideally have a non-consensus view is an easy enough formula to memorize.  The hard part, however, is finding companies that fit this bill.