On Markets & Investing

A New Investment Opportunity? My First Five Questions (Part 1)

Successful investing requires a good process. Knowing what to look for is the first step. Over time, I have developed a simple framework based on the Five Questions that I ask myself on every company that pops up on my screen. With these Five Questions, I decide within an hour or two if I should take a closer look (Deep Dive) or pass and move to the next opportunity.

This is In Part 1. In Part 2 (which I will publish next week), I will focus on more advanced issues to help investors avoid falling into some common traps.

Here are my Five Questions:

1. Product

Ideally, I want to be a user of a company’s product or know people who use it. If I am not a customer, I want to make sure I understand the value of a product for those who use it. What customer’s need does the product satisfy? If the product is average, I would need a very compelling price to remain interested. It is a pass if the price is not attractive and the product is unexciting. I also try to imagine what would happen if the company disappeared. Would anyone notice? Would my life change? How much would I miss its products?

Looking beyond the next three years is quite helpful too. Can you be sure there will be demand for this production ten years from now?

2. Industry and competition

I put the company’s product into a broader context, trying to understand how unique it is relative to alternative offers. How difficult it would be for competitors to replicate the same product. How easy it is to start a similar business. The first two questions also help me understand its competitive advantage and sources (Moat), including barriers to entry, switching costs, network effects, economy of scale, access to a unique resource, and regulation.

Another vital point to consider is the current and future size of the market and the company’s market share. This determines its growth potential and usually the level of margins (high market share helps achieve better margins as overheads can be spread over a larger quantity of items sold).

I also ask myself if the company is operating in a cyclical industry and whether cyclical factors could have boosted recent results.

Finally, I look at the capital flow in the sector. A slew of IPOs in a particular industry is a potential red flag. Neglected sectors with falling investments offer more exciting opportunities.

3. Business model, Financials and Valuation

How does the company make money? Does it differentiate by offering the best product or the lowest price? How much does the company have to spend on the product itself, on attracting new customers and retaining the old ones? What are the critical resources used by the company, and does any of the resource holders have more power (e.g. employees usually have a big say in investment banks)? Does the company need to spend a lot of capital to maintain its productive assets (e.g. oil & gas companies suffer from the constant need to replace their reserves often at increasing costs)?

There are three key financial indicators that I look for:

1) Historical Growth Rate of sales and whether there has been anything extraordinary in the past that could have inflated sales (e.g. acquisitions, high inflation);

2) Margins (absolute level and the trend);

3) Return on capital (operating profit relative to the company’s asset base, which I calculate as the sum of net debt and equity) in the interest of time.

The key issue I try to work out is what the sustainable level of the current and future earnings is. 

As for a valuation, I am interested in companies that could generate at least a 15% return. I prefer to look at FCF than earnings, and I take only maintenance CAPEX and exclude the growth component. If a business can generate $100mn in FCF and grow it at 5% per year, I would not pay more than $1bn. I estimate total return as FCF yield plus a growth rate. I could agree on a lower earnings yield as long as the business can grow at a faster rate.

I do not exclude loss-making companies immediately. I will discuss how I value such business in Part 2 next week.

4. Leverage

In simple terms, this is the ratio of net debt to EBITDA. Different businesses can sustain different debt levels depending on how stable their revenues are, what their investment (CAPEX) needs. From my experience, a ratio above 3x significantly limits a company’s options, and if it reaches 5x, the risks to the business reach a dangerous level.

The assets-to-equity ratio can also be a helpful benchmark for financial institutions.

Another important metric is the share of EBIT spent on interest payments. Be careful with companies that capitalise their interest expenses, reporting them in Cashflows from Investing segment. Such companies under-report their true interest costs.

Net Debt to Free cash flow (CFO from operations after CAPEX) is another good way to test the leverage. A ratio level close to 10x looks quite high to me, and it would be a ‘No go’ in most instances.

Finally, I look at how the company funded its operations over the past ten years. In particular, I check if a company has raised equity capital and what it has been used for. It is a red flag to me. The easiest way is to compare the latest share count with the one ten years ago. 

Occasionally, a company may have hidden liabilities related to ongoing litigation or long lease commitment. A search for keywords such as ‘off-balance sheet liabilities’ is usually quite helpful.

5. Management and other stakeholders

Since I look at a stock as an interest in a business, I want to understand what team I am partnering with. Management’s past track record is essential, especially in capital allocation. Value destructive M&A transactions or rapid expansion fuelled by new share issues or huge debt are some of the red flags.

An ideal case is a company run by its founders or management closely aligned with the founders like Amazon, FedEx, Charles Schwab.

It is important to check insider transactions over the past two years. I normally pass on companies whose top management have been selling shares, although I also check their total holdings and compensation structure. Often senior management receives stock options with a low cash component. If they decide to exercise their options especially after being in their roles for many years, it is understandable.

A shareholder list is my final check. A family-run business would be my preferred option. If there are a few ‘quality shareholders’ in the company’s register, it is important, although not a critical factor.

In Part 2, I will focus on some of the pitfalls and a little more advanced tools that I use to analyse a business.

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Disclaimer: this publication is not investment advice. The main purpose of this publication is to keep track of my thought process and improve my decision-making. Readers should do their own research before making decisions. Information provided here may have become outdated by the time you read it. All content in this document is subject to the copyright of Hidden Value Gems. The author held a position in the stock discussed above at the time of writing. Please read the full version of Disclaimer here.