1. Return on Invested Capital (ROIC)
When we first look at a company and think about whether it could be an attractive investment, our analysis always starts with building an understanding of its Return on Invested Capital (ROIC) characteristics. We always ask ourselves ‘Is this a good business?’ (I.e. high and sustainable ROIC) or if not, ‘Can it become a better business?’ (I.e. has it got potential to improve its ROIC profile). We are rarely interested in investing in companies that do not meet one of these two criteria. There are many facets to ROIC analysis but the majority of the work involves looking at historic margins structures, working capital characterises and fixed capital needs. It then requires us to try to ascertain whether the conditions that have existed to enable a particular ROIC profile are likely to be transient or sustainable in nature. We ask ourselves questions such as ‘Are these barriers to entry being challenged?’ ‘Is the competitive environment getting tougher or easier?’ ‘Does this business have pricing power and can it be maintained?’ This is complex analysis that necessarily takes up a lot of our time.
"Good is the enemy of great.” – James Collins.
This is a great concept that James Collins articulates in his book entitled “Good to Great - Why Some Companies Make the Leap... and Others Don't”. We see many companies that are simply ‘good’; the founders are capable, the end markets seem strong, the customers like the product etc. But the majority of these ‘good’ companies will never be able to transition to becoming a great company. Every now and then, we find a really special company that has such a powerful market position or such an attractive product that they transcend being merely ‘good’. Finding these companies is something that really drives us.
2. Opportunities for the deployment of capital
Next, we tend to look into where a business is deploying capital, the ROIC it is able to generate from this investment and the scale of investment opportunities that it has. This is an important area of analysis. Ideally, what we want to find is high ROIC businesses that are able to deploy lots of capital in further high ROIC opportunities. However, these extremely attractive types of businesses are rare. At the other extreme would be low ROIC businesses that have plenty of opportunities to deploy capital; these companies tend to be highly value destructive. These two examples highlight why a focus on ‘growth’ is far too simplistic; in some cases growth is highly attractive and should be encouraged, whilst in other cases growth can be unattractive and should be avoided at all costs! We spend a lot of time thinking about how companies are investing and what investment opportunities they may be faced with in the future.
The Reinvestment Moat
Outstanding companies are often described as having a “moat”, a term popularized by Warren Buffett. The presence of a moat implies a durable competitive advantage which enables a business to earn a high ROIC for many years. These businesses are very rare. We agree with the Charlie Munger-inspired approach of splitting the group further into businesses with “Legacy Moats” and those with “Reinvestment Moats”. Most businesses with a durable competitive advantage belong in the Legacy Moat bucket, meaning the companies earn strong ROIC but do not have compelling opportunities to deploy incremental capital at similar ROIC. An even more attractive category of quality companies are those classified as having a Reinvestment Moat. These businesses have all of the advantages of a Legacy Moat, but also have opportunities to deploy incremental capital at high ROIC. Businesses with long runways of high-ROIC investment opportunities can compound capital for long stretches of time, and a portfolio of these exceptional businesses is likely to produce years of strong returns. It takes a lot of work and discipline to identify these true compounding machines. In future write ups we will outline the factors we look for and how many of these “bargains” hide in plain sight.
Can management be trusted? This is a simple question that we are always asking ourselves. We like to fully understand the history of a particular management team. Where have they worked before? What is the history of their capital allocation decisions? Is there a history of value destructive/(creative) M&A? It is also important that we understand the incentive structure for management teams. What are the key metrics they have to focus on to get paid? Do they own lots of equity in the company? Do they care if the share price goes up or down? These are all things that we think about. This area of analysis highlights one of the reasons why we see meeting management teams on a regular basis as a crucial part of our job. It enables us to look them in the eye, question them over capital allocation policy and get a feel for their temperament and the things that they are driven by.
“Two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders” – William N. Thorndike
This quote is from the book “The Outsiders” in which William Thorndike teaches us, through eight real examples, how the capital allocation of a company’s managers makes a significant difference for its shareholders over time. As Thorndike explains, a company’s management team have five fundamental choices when it comes to allocating capital. Specifically, they can reinvest in the business, acquire other companies, pay down debt, issue dividends and repurchase their own shares. The choices made are just as important as the way they are financed. Issuing debt, raising equity capital or using the cash internally generated by the business will all have different impacts on the shareholder. Therefore, capital allocation is not a trivial issue and must be given the attention it deserves as part of a sound investment process.
Through reading historic financial statements we try to assess whether capital deployment has been value accretive or destructive. Not surprisingly, what we have found out as we conduct our research is that alignment of interests goes a long way into predicting whether management’s actions will be value creative or destructive.
“What matters isn’t what a person has or doesn’t have; it is what he or she is afraid of losing” — Nassim N. Taleb
The skin in the game is a concept recently popularised by Nassim Taleb (an author we closely follow) in his book “Skin in the Game: Hidden Asymmetries in Daily Life”. However, it is not a new concept in the world of investment. Warren Buffett has defended for years the idea that managers should be shareholders of the companies they manage and invest their money along with the rest of the shareholders. In this way, they will have a clear incentive not to make decisions that destroy value for their shareholders. For this reason, when looking for companies with appropriate capital allocation, we often find companies in which the ownership is controlled by its management team, which is often made up of its own founding family. However, we realize this is not possible for the entire set of opportunities we study. Hence, we often focus on management incentives.
"Show me the incentive and I’ll show you the outcome" – Charlie Munger
The business world is no stranger to the power of objectives or incentives. A management team with an incentive system whose ultimate objective is to generate value for its shareholders will tend to allocate capital sensibly and vice versa. A good remuneration system should have long-term incentives aimed at maximizing shareholder returns. This can be achieved by establishing direct incentives, such as establishing variable remuneration based on the evolution of the company’s stock price, in absolute terms or by comparison to its peers. However, we tend to prefer indirect incentives focused on long-term ROIC, profitability, cash generation and the like. In the end, if the business performs well operationally, the shares will end up reflecting this and indirect incentives will also stop managers from focusing excessively on the evolution of their share price in the short term.
4. Where we might be wrong, behavioural biases
We think that it is extremely important to analyse mistakes on an ex-ante basis as well as on an ex-post basis; in our opinion, investors tend to carry out far more of the latter (post-mortem) than the former (‘pre-mortem’). Our pre-mortem analysis, which is a formal part of our investment process, forces us to consider where an investment could go wrong and how material an impact this event/occurrence could have. In addition, there are several ways in which our analysis can become negatively impacted by behavioural biases. We see this as a very important area and we always try to add an element of introspection into our work. We will be writing on this subject in a future thought piece.
This concept is taken from the discipline of social psychology. The exercise involves reverse-engineering explanations for how a company could hypothetically become the worst investment we have ever made. It’s an interesting exercise because it can show how strong or weak our investment thesis is; the harder it is to come up with plausible pre-mortem scenarios, the more likely an investment is to work well.
Finally, although never the first thing we consider and rarely the most important part of our investment case on a particular company, valuation is always something that we consider carefully. We try to look at valuation through a few different lenses and do not rely on one particular method. For example, we will almost always construct a discounted cash flow (DCF) based analysis, usually considering several different sets of assumptions. We will then compare valuations to similar companies both within Europe and in other geographies as well; price-to-book multiples tally with our ROIC-focused approach and earnings and cash flow multiples are also considered. Finally, we may consider a Sum-Of-The Parts (SOTP) perspective or even construct a simple Leveraged Buy Out (LBO) model to consider what the business may be worth to a potential acquirer. We generally take the view that no one valuation method is ‘the right one’ and a blended approach is best.
“Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto,- Margin of Safety” - Ben Graham
Seth Klarman comments that the best investments tend to have a considerable margin of safety. This is Benjamin Graham’s concept of buying at a sufficient discount that even bad luck or the vicissitudes of the business cycle won’t derail an investment. As when you build a bridge that can hold 30-ton trucks but only drive 10-ton trucks across it, you would never want your investment fortunes to be dependent on everything going perfectly well, every assumption proving accurate, every break going your way.
Hence, scenario analysis and stress testing are crucial parts of our valuation work. We try to keep estimates conservative and focus on high quality companies where business surprises tend to be positive rather than ones that tend to cause pain to shareholders.
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