"If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter." - Warren Buffett
Obviously, we'd love to find a comfortable business at a comfortable price. But those are rare opportunities. If we find one, it makes it to The Buy List. But let's take it step by step. Let’s unpack Buffett’s statement here. When we're looking for a good investment, it seems we need to answer 2 questions.
- Is the business questionable or comfortable?
- Is the price of the business (or stock) questionable or comfortable?
Here’s how Buffett approaches his investment ideas: First question first – if the business is questionable, go no further. If the business is comfortable, go to the second question – is the price questionable or comfortable? If the price is comfortable, Buffett’s friend and partner Charlie Munger would shout, "lollapalooza!". If the price is questionable, then it’s a subjective decision, depending on your other investment choices. Question 1 clearly most of the weight in this decision. This discussion is primarily about Question 1.
So, is there a way to determine if a business is questionable or comfortable? The short answer is No – there is no deterministic equation that can solve this problem for us; this is not a science. However, there is an effective checklist that will helps us, more often than not, reach the right conclusion.
There are 3 main criteria to look for: The Castle, the Moat, and Management.
The Castle: Competitive Advantage
What does the company do better than others? What is its core competency? To be succinct, we're looking for either a cost leader or a product differentiator. Usually, companies in which it's worth investing can produce a product or provide a service cheaper than anyone or they sell something that they can make better than anyone. Sometimes, companies can do both (think Zara). But mostly, when companies try to do both, they end up doing neither.
So, in most cases the Castle must be either strong economics or strong craftsmanship. One way to spot a strong castle is to think of a product or service and then jot down the name of the first company that comes to your mind. Cheap, fashion-forward clothing – Zara. Books – Amazon, Tickets – Expedia, and so on. These are examples of strong castles that have, over time, attached their name to the very product or service they provide. They may not "own" the entire market. But they’ve carved out sizable niches in peoples' minds. The original giant Castles were Hoover and Kleenex. These brands became synonymous with the product they produced. The modern-day equivalents are Google and Facebook. These brands even entered many languages as legitimate verbs.
Consistency used to be a sign of a strong Castle. There used to be a time when chains were all the rage – offer a consistent experience all over the country for a manageable price. Think TGI Friday’s or Starbucks. Over the last decade or so, consistency hasn't been as important to consumers. They want a differentiated product or a very low price. I believe the reason for this is the smartphone. Consumers have access to reviews and competing prices at their fingertips, 24/7. For a product or service to stand out, it must be very, very cheap or it must be very, very different. Betting on companies whose castle is "consistency" isn’t as reliable as it used to be. We're better off looking for strong economics or strong craftsmanship.
There are many companies we've never heard of that are strong, giant castles. And those companies are more likely to be the "diamonds in the rough”" when it comes to investing. Whether a company is well-known or not, almost none of them can escape this immutable law of economics: the law of creative destruction. If there is money to be made, competitors will enter the market. And they will pummel your castle with everything they've got. Sometimes, they succeed in destroying an established castle to stake their claim on conquered soil. Remember what happened to MySpace? And, more recently, Yahoo? Competitive destruction is the default state. If you're not a cost leader or a product differentiator, you don't have much of a castle to being with; but if you are one of those, you better expect enemies at the gates, with canons and catapults. Then you need a Wide Moat to keep these barbarians away. And you need to keep widening that Moat, continuously.
"You seek and gain advantage. Value flows for a time. But then that advantage is lost and must be renewed again. Even managers in the most powerful companies find that success is temporary. Obsolescence is inevitable. Nothing lasts forever." – Jeffrey Williams, Renewable Advantage.
The Moat: Durability of Competitive Advantage
If the company is a cost leader or product differentiator, it must find ways to maintain or improve that advantage. Otherwise, as Jeffrey Williams points out in his book Renewable Advantage, "Convergence" will happen. That means that unless there is a strong "isolating mechanism", or Moat, competitive advantage will shrink, and converge to an industry average or even to zilch. And the reason is: competitive destruction.
For a low-cost producer, it must find ways to improve on that cost advantage. Pardon the Consultant-speak but a common way to do this is to increase Economies of Scale. That really means reducing per-unit costs by producing a larger volume for the same fixed costs or get larger volume discounts from suppliers. Think Toyota or Walmart. Sometimes, companies buy out a supplier, thereby taking them out of the picture from potential competitors. Another way to widen the moat is to increase Economies of Scope. That really means producing two kinds of products with essentially the same resources. Think Toyota Camry and the Lexus ES Series. Increasing Economies of Scale or increasing Economies of Scope or buying out suppliers or even competitors requires investment – cash investment today - so that the moat is wider tomorrow.
For a product differentiator, some Moats are often driven by laws and regulation. Patents are common moats for pharmaceutical companies, for example. Property rights – maybe a great sea-side view – is a Moat (almost literally) for real estate builders. Sometimes, they take the form of endowments – business licenses to serve a particular market or area. But nowadays many businesses build their Moat around intellectual capital – of designers, engineers, journalists, craftsmen etc. Apple built a moat with top-notch design – in hardware and software, done simultaneously, in unison. It popularized "design thinking" - cutting out unnecessary fat to make products more intuitive. BMW, for example, prides itself on its engineering prowess. And so, it builds its culture around engineering. For example, its engineers, and not (mediocre) MBAs, are regarded as the rising stars in the company. BMW started building this Moat a long time ago, and has been widening it ever since. Clearly, it’s been very hard for competitors to do what they do as well as they do it. Even Daimler-Benz struggled to compete for a long time. They're catching up now, which means BMW must do something to widen their Moat (fixing their awful navigation software, for example, should be a good start). Again, widening a differentiator Moat takes a lot of money. It requires big investments today, so that the Castle stays protected tomorrow.
This discussion of Moat would be incomplete without mentioning the concept of Economic Time, again coined by Jeffrey Williams. Economic Time really means the time is takes for a company's competitive advantage to converge to the industry average (or to disappear completely). This can happen very fast if the Castle doesn't have a wide Moat. If the Moat is wide, Economic Time is longer. This is a powerful concept and an important departure from traditional thinking on Strategy (Michael Porter et al.). Traditional thinking was static – once a competitive advantage is gained, it remained undeterred if there were barriers to entry. But traditional thinking never really entertained the idea that barriers can be broken, and that someone is always trying to break them down. Williams's concept of Economic Time assumes that Competitive Advantage is always under attack and will converge to nothing if it's not proactively protected. And the time it takes for competitive advantage to disappear is Economic Time. Said another way: the time it takes for your profitability to converge to an industry average (or Zero) is your Economic Time.
This is important: Economic Time, then, becomes the link between Strategy and Value. Longer Economic Time would directly translate to Resilient Cash Flows. Companies with wide moats tend to have less variability in cash flows. That makes it easier for an investor like me to estimate a "sustainable" level of free cash flow. The more predictable cash flows are, the more confidence I have in my valuation. And that starts with a wide moat.
"The key to investing,” [Buffett] explains, “is determining the competitive advantage of any given company and, above all, the durability of the advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. The most important thing for me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles."
– from The Warren Buffett Way by Robert G. Hagstrom.
The Generals: Management Team
Management’s role is to strengthen the Castle and widen the Moat thereby increasing the level of profits and extending Economic Time. That directly increases the firm’s value. Higher profits, when higher for longer, discounted back to the present, equals higher value. Evaluating Management Quality is a subjective task. Warren Buffett spends a lot of time on it, especially of companies in which Berkshire Hathaway buys a large portion. He likes to be involved with rational people, who love the business they’re in and who are, above all, ethical people. Then he can leave them be, so he can focus on what he does best – read, think, observe, synthesize, invest. The point is that he can make a more nuanced assessment of Management because he has direct access to them. Most other investors, including you and I, do not. So, how do we evaluate Management?
The short answer is: It’s hard. Again, there is no metric, no formula, no recipe. However, these giants of investing leave us these nuggets that are comforting to us lesser mortals.
"When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that stays intact." [says Buffett] - from The Warren Buffet Way by Robert A. Hagstrom
"…averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager." - Charlie Munger
But that doesn't mean we don't do our best to evaluate Management.
Looking for High Quality Management
There is a lot of data and noise out there. If we put in the time, we can get a decent picture of Management Quality. Based on what the giants of investing have shared with us, and based on my experience as a Research Analyst, here is a list of 5 attributes that gives us tacit clues:
1. Good Management makes sensible choices about using cash flows. Allocation of cash-flows should match the overall strategy of the firm. Generally, the choices are these:
- Re-invest a lot of the cash flows back into the business (in a new product or new or new market) to widen the Moat.
- "buy" growth by funneling some cash into M&A.
- pay down debt
- pay dividends
- buy back stock
- hoard all that cash on the balance sheet.
- some combination of the above
Ideally, we’re looking for Management that prioritize Choice #1 over all other choices: Is management re-investing enough into widening the moat? This would generally take the form of Capital Expenditure, of "Additions to Property Plant & Equipment" in a company's Statement of Cash Flows. The quality of that decision is obviously a subjective call. The quality will reveal itself in time, when future cash flows increase specifically because of a particular capital expenditure item. Sometimes, management "buy" growth by acquiring another company. But empirically speaking, acquisitions don't usually end up creating any value. And it gets worse if the acquirer raises more capital – issue debt or equity – to fund overpriced acquisitions. Speaking of debt, choice #3 isn't bad at all. It probably has the most tangible impact on future cash flows - paying down debt today would reduce cash interest charges tomorrow. The rest of the choices – paying dividends, buying back shares, hoarding cash – do nothing to widen the moat.
2. Good Management tends to be revenue-focused rather than cost-focused. They like to increase profits by generating more revenue as opposed to cutting more costs. Sometimes, costs are bloated, and improvements are necessary. But if the focus of "value-creation" is primarily on the cost side of the equation, it usually puts that company on a fast-track to mediocrity. Even if the company is a low-cost leader in its industry, the focus on cost in that case is really a focus on widening the moat, which eventually means more sales, more profits and, hence, more value.
3. Good Management tends to be led by industry experts - not just some "charismatic leader". Think of debacles like Enron or Valeant. You can get a sense of this from the way they answer Analyst questions on quarterly earnings calls. Good managers have the rare ability (and inclination) to get into the weeds to understand a problem and then zoom out to think long-term, simultaneously. They are keen students of the sport they play.
4. Good Management tends to be full of intellectually curious people and they are usually voracious readers. They always ask themselves "is this going to matter in 2, 5, 10 years. Are we playing the right sport?" To answer this, they must have to have a well-informed worldview, not just within their industry but of the larger ecosystem in which their company operates.
5. Good Management tends to talk about their people a lot, which is a sign that they regard employees as paramount to a company's success. Employees in these companies are probably not treated as third-class citizens (after shareholders and upper management). There's no way to know this for sure; even Glassdoor data is spotty. But generally, you can get a hint or two from earnings calls and other articles about the company. One obvious sign of Management shenanigans is compensation and incentives. Some details of these are available in the financial filings. But it's tough to unpack the whole picture. If they get paid millions in a year when the company results were terrible, and they lay off thousands of workers, it's best to stay away.
6. And finally, Good Management has high ethical standards. They don't engage in any shenanigans in accounting or compensation. Buffett puts a lot of emphasis on management ethics when he looks to invest in a business. Again, he has better access than we do, but we can get some clues from accounting practices of the firm and in how often they engage in "financial engineering" exercises such as buying back shares to boost compensation or making unnecessary acquisitions.
If the Management in question, checks all these boxes, well, Lollapalooza! But that will be rare. If they check box #1, then half the battle is won. Chances are that they would check that box if they check most of the others. We must remember that, in investing, we're working with probabilities, not certainties. If Management does the right thing with cash flows and capital, the probability of a insurmountable Moat shoots up. And so, the probability that the firm will become more valuable shoots up. Management has the power to speed up or slow down Economic Time. If they invest the company’s capital wisely, they can widen the moat, extend Economic Time, increase the durability of high profit margins, and thereby increase the value of the firm.
ROE: The Generals' Scorecard
ROE or Return-on-Equity is not a perfect metric, and we can’t depend on it entirely to seek out “comfortable businesses”. But it’s as good as it gets. It tells us a lot about the all 3 basic attributes of a comfortable business – a Strong Castle, a wide moat, and a High-Quality Management.
Basically, ROE is defined as Net Income divided by Book Value of Equity. It’s a proxy for the underlying return the business generates with shareholder capital. And, over the long term, it’s a decent proxy for the overall annualized return shareholders will earn through this business.
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns.” – Charlie Munger
Essentially, ROE can be broken down into 3 components. And it struck me that these components (commonly taught in business schools) are decent numerical proxies for Castle, Moat and Management. Many of us have been taught that ROE equals Asset Turnover times Net Margin times Leverage.
Asset Turnover (Sales/Assets) is a decent proxy for a Castle. The fact that a company sells a lot relative to its capital investments is good sign. It may be because they offer a differentiated product or maybe because they outprice their competition.
Net Margin (Net Income) is a decent proxy for a Moat. If the Moat isn’t wide, margins will be declining. If margins are razor thin to begin with, chances are that the Moat isn’t wide.
Leverage (Assets/Equity) is a decent proxy for Management’s financial decisions – how much debt they’re comfortable with, how they spend that cash inflow, and whether they depend primarily on leverage to boost razor thin margins and asset turnover. But come to think of it, all 3 components say something about Management Quality. If they’ve made the right capital investments in past, Asset Turnover and/or Net Margins will be high or increasing. That’s a sign of good things to come.
If Asset Turnover and Margins are razor thin, Management may try to pull some shenanigans by increasing Debt. This is usually a red flag. A company that depends primarily on leverage to appear productive is one we’d best avoid. ROE is a good numerical screener if used properly – broken down to its components. My gripe with it is the numerator – Net Income (or Earnings), which has too many Accounting shenanigans. I like cash numbers instead. So, I use Free Cash Flow as the numerator instead, which is similar to Buffett’s concept of “Owner’s Earnings”.
Free Cash Flow brings us back to the something we’ve set aside for all this time – Calculating a Comfortable Price for a Comfortable Company.
A Comfortable Price - A Whole New Can of Worms
This was question #2 in the beginning, We'll have to tackle this in detail in a separate discussion. The Castle, the Moat, the Management – all 3 – combine to make a subjective call on whether a business is comfortable or not. But these 3 things also provide all the fodder we need to determine the intrinsic value of a company. In other words, the very factors that we're looking for in identifying a comfortable business flow right through to identifying a comfortable price. That's because a comfortable price depends on 2 data points:
- The intrinsic value of the business
- The market price of the stock
The second one is easy to find. The first one is a bit more cumbersome. Everything we've talked about so far goes into calculating intrinsic value. Economic Time, especially, plays a massive role in the calculation of intrinsic value. The wider the Moat, the longer the firm can maintain or improve its profit margin. And that means more value. The difference between the two data points – intrinsic value and market price – is what Buffett calls Margin of Safety. The higher the difference, the Margin of Safety. A comfortable price would be a market price that's much, much lower (by 25-30%, at least) than our estimate of intrinsic value. A significant Margin of Safety is the key to my favorite style of investing: "Sleep-at-night-investing".
Determining a company's intrinsic value may look like an algebraic exercise – discounting estimates of future cash flows. But as with most numerical exercises, it's garbage in, garbage out. What goes into the any sort of estimate of intrinsic value – estimating those cash flows – are these questions:
- Is there a strong castle – what is the company’s competitive advantage?
- Is there a wide moat – how does the company protect its competitive edge?
- Does management widen the moat – is it making the right kinds of investments?
In short, is it a "comfortable business"? If so, let’s figure out a comfortable price.
Many Happy Returns.