In Part 1, I have outlined the Five Questions to ask when looking at a new opportunity. Over the years, I have noted that some deeper issues can make a 10x PE stock a terrible investment while a 30x PE company is still cheap. Passing on a company with no profits could also be a mistake sometimes.
In this Part 2, I focus on more advanced issues based on my personal experience.
Great brands, luxury
Ideally, consumers should love the product and not care about the price. I know that I would still buy a new iPhone even if they raise prices by 20-30%. In rare situations, a higher price increases demand for the product as consumers can prove its status (e.g. ultra-luxury goods). If the Rolex watch price were to drop to just $1,000, this would not go well with its consumers.
Certain companies play a critical role for their customers and are hardly replaceable. Moreover, the fees charged by such companies are often negligible compared to the value of their services to the customers. Moody’s or S&P ratings for corporates are essential to raising debt, and the price of such credit ratings is often less than 0.01% of total capital raised by companies.
Similarly, consumer credit scoring companies like UK Experian play an important role in obtaining mortgages and consumer loans. Most borrowers would not hesitate to pay the fees to know their rating and what to do to improve it.
Or take Rightmove, a UK-based real estate classified company that charges real estate agents or property owners nominal fees for listing their properties. Yet, they can hardly sell or rent out their properties without Rightmove.
Companies that do product testing and certification play similar roles as producers often have to have some certificate, and the price they have to pay for that is not an issue.
Manufacturers of specific medical equipment and tools are in a similar position. A surgent would care about the quality of the tools and equipment first and most, not the price he has to pay for them.
Historically, payment network systems like Visa and MasterCard used to play the roles of ‘hidden monopolies’, although the emergence of various fintech companies may create competition in the future.
Attractive opportunities arise when a company’s product is perceived as one category while it is entirely different in reality. Think of Ferrari or Apple, for example. Ferrari has long been viewed as a car manufacturing company. The auto sector is known for its thin margins and strong cyclicality. However, the market has recently realised that it is in a luxury business where the biggest challenge for a CEO is to say “No” to customers. Pre-COVID, in 2019 Ferrari sold just 10,131 cars and generated $0.7bn of profits ($70,000 per car). GM, the largest US automaker, sold 4,209,000 vehicles in 2019 (415x more than Ferrari) and earned $6.8bn in net profit (just $1,615 per car). It is not so easy to buy a new Ferrari. You may have to remain on a waiting list for a few months, just like when joining an exclusive club. Ferrari needs to spend incomparably fewer resources on its factory, manufacturing, labour to produce its cars and has more money left from the sale of its vehicles that it can distribute to shareholders. On the other hand, GM faces a much more resource-intensive business, which leaves it with considerably less money relative to the selling price.
Apple is somewhat similar. For a while, investors looked at it as a hardware company exposed to traditional cycles in the consumer electronics market with its historically thin and volatile margins. Not everyone had realised that Apple could use the power of its brand to offer consumers a much more extensive experience than just a device. The value of Apple’s services and its AppStore has become a significant value driver for the stock. I owned Apple in the past; here is my presentation on its investment case prepared in early 2019.
Three key issues are important to consider: market shares over time, capital flow and basis of competition (price or quality).
Industry structure - stable market shares
I prefer industries with few players with stable market shares over time. Whether a company is the market leader or is a third player is secondary. Usually, a market leader could benefit from scale effects by enjoying better margins, although its size also limits the growth potential for such companies. I also prefer an industry structure when a leading player accounts for a significant market share (e.g. 40-50%) with other players accounting for diminishing shares (e.g. Player B has 20-30% market share, followed by Player C with 10-20% and Player D with 5-10%). It is better than an industry where all four companies account for similar (25%) market shares. In that case, they could try to win the competition by lowering prices or overspending on marketing, forcing other players to respond. In the end, all companies overspend on their products and marketing, making consumers the only winners.
From my experience, overall demand growth is less important than the industry structure. I prefer stable industries with few players to fast-growing sectors with dozens or hundreds of players.
Any ‘hot’ sector which attracts new capital and human talent should be treated with caution. Historically, businesses faced increased competition in such industries and rarely allowed shareholders to earn attractive returns. A pioneer in a particular technology is also not guaranteed success. Often, players who come later can copy the technology and save capital on marketing as consumers have been already ‘educated’ by the pioneer.
On the contrary, sectors which have been neglected often see less competition which creates good conditions for shareholder returns.
Basis of competition: Price vs Quality
Different industries have different competition basis. In some sectors, companies compete purely on price, while in others, they compete based on quality and various differentiating features. Shareholders should expect to earn better long-term returns in the second type of sector. If competition is based on price, companies often face low margins, leading to low returns on capital (ROIC).
Financials and Valuation
The three financial ratios that drive a company’s value are 1) sales growth, 2) profit margins, and 3) returns on capital. Below I discuss some additional issues to keep in mind.
A few accounting tricks could show higher profits than the business earns in reality. Checking FCF (operating cash flow after investments) is useful. FCF/Net income ratio should be high or rising.
Maintenance vs Growth CAPEX
Each company requires a minimum investment level to maintain its operations in the current form (‘Maintenance CAPEX’). Cash operating profits less this Maintenance CAPEX is the real FCF of a company. Most companies, however, report total CAPEX, which includes Growth investments.
It is necessary to understand what results Growth investments will achieve in the future in terms of additional revenue and profits. This incremental return on capital (additional profits relative to additional CAPEX) indicates the direction of the overall ROIC. Often, a company that enjoys exceptional ROIC today invests current profits in inferior projects driving its returns down. If you can spot this early on, you can get a good sense of the prospects for its shares.
A company can boost its cashflows by periodically issuing shares. Tracking share count over time and key financial metrics on a per-share basis is an excellent way to make sure the business is sound.
The main focus of my financial analysis is understanding the ‘normal’ level of earnings that the company can earn in the long run and be able to either pay as dividends or re-invest back in the business. This requires several accounting adjustments (removal of FX losses/gains and other one-off factors) and analysis of the industry cycle. It is a gross mistake to use financial results achieved during the latest expansion phase in the market as the basis for valuation.
In a section on Leverage, I discuss the role of ‘one-off’ factors later in this note.
Perhaps, one particular important ‘one-off’ factor is M&A. Most companies acquire other businesses at some point. Sometimes acquisitions are relatively small and not discussed in detail. This creates risks of overestimating sales growth and the quality of the business. If a company is growing its sales at 20% per year in a stable market because it continues to acquire smaller rivals, it cannot maintain such a growth rate for more than 2-3 years.
I strongly advise checking the contribution from M&A transactions to the company’s growth or profit margins (sometimes, an acquisition of a high-margin business can improve the company’s performance). M&A could be wildly misleading when they are carried out as share mergers. If the company pays for a target with its own shares, such acquisition negatively impacts leverage or cashflows.
Another risk of an M&A-fuelled strategy is potentially rising multiples in the future. If the company could buy new businesses at 10x earnings and then sector valuation increased, forcing the company to offer 15x or 20x PE, the company’s financial results would look much less attractive in the future (more share dilution, higher debt, lower net margins).
Fixed costs vs Variable costs
The share of fixed costs (in total costs) drivers the company’s operating leverage and potential earnings growth in the future. A high percentage of fixed costs (e.g. at a software company) and low variable costs (e.g. software companies have close to zero marginal production costs) can lead to exponential earnings growth if the business can grow its revenue. For example, a business that sells 10 software products for $10 a year generates $100 in sales. If it employs 10 people and each is paid $10, the costs are also $100 (I know the numbers look screwed, sorry). So the company generates zero profits. Now, imagine they sell one extra software next year, growing their sales by 10%. Profits turn from zero to $10. Another 10% growth in the following year would lead to a twofold (100%) growth in earnings.
Of course, fixed costs also make a company more vulnerable to adverse developments.
In cost analysis, it is helpful to compare all key costs relative to sales over time and see if any trends raise questions. I also try to understand the key cost items the company relies on heavily (e.g. a specific type of natural resource, special licence, key employees etc.). Ideally, it is the soft factors like culture, innovation, and brand loyalty built over time that allows the company to beat the competition, rather than heavy marketing spending, one lucrative contract with the government, exceptional sales team, and so on.
‘Expenses’ vs ‘Investments’
Many well-known experts have recently pointed out that some expenses in traditional accounting should be viewed as investments. From an accounting point of view, the difference is that expenses are ‘consumed’ within a year (operating cycle) to produce the final product or service (e.g. jet fuel by airlines). At the same time, investments create assets used over several years to make more stuff (e.g. a factory).
If a company pays software engineers to develop a new product such as a customer application or accounting software, payroll expenses could be considered investments. In that case, they should be taken out of P&L and added to Cashflow from Investing. This would increase reported profits without any impact on FCF.
If a company has constantly been spending on high-quality advertising campaigns over many years, it could have developed a strong consumer brand (e.g. Coca Cola). In a way, past marketing expenses were investments in brand.
Even heavy discounting could be viewed as investments in brand loyalty, and if adjusted for that, the company’s profits would be higher. One can argue that Netflix has historically charged lower for its subscription than the value its customers received to build trust and win more customers and a more significant share of consumers’ minds.
You have to be very careful not to go too far here. The critical question is whether these ‘expenses’ create something long-term that could benefit the company beyond one operating cycle. If the answer is a confident Yes, such ‘expenses’ could be added to investments that reduce total costs and boost profits.
Customer retention rate
Analysing a customer base is an important element to understanding how good the business is doing and its true earnings potential. Usually, this rate indicates the share of customers that have stopped using the company’s product after 12 months. If it is approaching 20%, it usually means the business faces problems. Overall sales dynamic can be masked by heavy marketing spending, which would bring new customers and replace those who left so that the total customer base continues to grow.
But if the retention rate is low (which is usually the case with unexciting products), constantly rising marketing expenses will permanently drag the company’s financial results.
A good ratio is marketing expenses as a share of revenue and its progress over time. A stable or declining ratio is a good sign. I also like to calculate incremental marketing expenses relative to changes in sales and a customer base.
More on Valuation
Traditional textbooks teach you how to build a DCF model to estimate the value of a company. Over time, I made a significant discovery that it is far more helpful to estimate your future returns than to estimate a single valuation number. Many variables impact the value, and it is easy to make a mistake or lack the necessary information to make the correct assumption. DCF creates a false sense of knowledge and overconfidence.
Here is what I prefer to do instead. Imagine you buy 100% of a company, and there is no more stock trading to check the price of that company. How would you track your investment? Your returns over the long term would match the profits earned by the underlying business. Suppose you pay $1bn for a company with $100mn annual profits and no debt. You should expect to make a 10% return over the long term. If the company can grow its earnings in line with the overall GDP growth (e.g. 2%) and inflation (e.g. 3%), then your total return would be 15% (earnings yield + growth). Earnings growth could come from overall business expansion (sales growth), improved economics (higher margins due to cost-cutting, new technologies, changes in taxes or scale effects) or reduction in share count (buyback).
Such an approach (price paid for the business plus future long-term growth) removes the issue of future ‘exit’ multiple. Often, an investor buys a company because it looks ‘cheap’ (e.g. it is trading at 10x PE). The rationale is that he expects the shares to re-rate to 15x, for example, at which point he may start selling his shares.
My experience has taught me that relying purely on future stock re-rating is dangerous. Instead, your priority should be strong and improving business fundamentals. If the business is stagnant, then a low PE price could be justified by high dividend distributions and/or buyback or a bet on some turnaround plan (e.g. asset disposals, debt reduction, new product launches, entering new markets etc.). But suppose the company is not doing much to address its low valuation and its earnings remain flat. In that case, you may end up earning zero returns or even lose money if business fundamentals deteriorate (which is often the case with ‘lousy’ companies).
The last point on valuation is that it is helpful to think in scenarios. I usually start with the base case, the most realistic scenario assuming average economic growth, rational competition and ongoing strategy. My downside case could include weaker macro, rising competition, cost inflation, higher interest rates, and similar developments. In the bull case, I try to consider the upside associated with the bigger addressable market (new geographies or market segments), less competition, benefits from business scale, cost optimisation, a successful launch of new products and so on.
My ideal investment would be the one where the value (using conservative multiple / or expected return) is close to the spot price, while in the base case, I could earn at least 20% a year and closer to 50%-100% in the bull case. Total return could be, of course, much bigger in the case of long-term compounders (‘multi-baggers’).
Before looking at more specific leverage ratios, it is essential to establish if the sector is cyclical or not. In cyclical sectors, producers compete on price and have little differentiation. Companies often become loss-making for a period of a few years. In such cases, you can lose money even if a company has no debt initially. A multi-year period of heavy losses would force it to either lever up or raise new capital and dilute you.
It is also essential to differentiate between liquidity and leverage. A company may technically have a very low debt (relative to assets or EBITDA) but may still experience liquidity problems. For example, a traditional clothing retailer buys inventories ahead of high season at the end of each year, so it would most likely face negative cashflows in Q3 and then a robust cash inflow right at the beginning of a new year. It is no wonder that many traditional retailers prefer to close their annual accounts in January and not on 31 December as most other companies do. This deferred reporting date allows retailers to show accounts after they have sold off their inventories, received cash from consumers and before they start a new purchasing cycle.
Debt maturity is also critical. A ten-year debt or longer would not usually be a big problem even if it exceeds the company’s EBITDA by 5x. However, a smaller debt amount due in less than 12 months could become an issue during an economic crisis.
Net Debt / EBITDA may sometimes make the situation look better than it is (e.g. the case of Follie Follie). Additional checks should include FCF / Net income ratio (you should have a clear answer if it is low, e.g. 10%) change in Net Debt vs Revenue over ten years (if Debt is constantly outpacing Revenue, the business may be struggling). It is also important to track Accounts Receivable vs Accounts Payable. Suppose the former is low while the latter keeps growing. In that case, the company may temporarily enjoy strong cashflows by delaying payments to suppliers, but one day the situation will reverse, creating problems for shareholders.
Non-financial liabilities could also cause problems. For example, high leasing expenses may put a retailer into trouble during a recession. High tax liability or a penalty that the company was challenging previously may become a problem when the time is due to settle the bills.
A less discussed issue is a currency mismatch. I have experienced this myself as a shareholder in VEON, an emerging markets telecom operator. This happens when a company borrows in one currency (usually in Euro or US dollar) at a low rate but generates revenues in another currency where it conducts business. If the company operates in emerging markets that often experience currency devaluation, one day it may find itself in a problem if its EBITDA suddenly drops by 10% or 20% in USD terms due to depreciation of a local currency.
Another issue I have come across is linked to minority interests. This is an accounting term for situations when a company does not fully own a business and other shareholders hold a minority interest. For example, VEON used to own just over 50% of Global Telecom Holding (GTH), a company with operations in Algeria, Pakistan and Bangladesh. VEON showed the total EBITDA of this GTH since it controlled it. But this overestimated its actual cash flow generation since VEON was not entitled to distribute 100% of GTH. Moreover, GTH did not own 100% of businesses in Algeria, Pakistan, and Bangladesh but had local investors in each market.
On the other hand, VEON showed in its presentations EBITDA and FCF as if it owned GTH entirely.
The last helpful check is to track share count change over 10-20 years. If it matches revenue growth, the company is not generating real growth but rather ‘buys’ this growth by raising new capital. This could happen less visibly when management pays itself through share options. Amazon, for example, has increased its share count by about 15% since the mid-2000s.
By paying management in shares, the company may improve its FCF.
Look for any one-offs, non-recurring factors
In financial analysis and assessment of leverage, it is critically important to weed out anything that does not relate to the ordinary course of operations and which cannot be expected to repeat regularly in the future. This could include positive and negative factors related to P&L and Cashflow statements.
Some examples include cost-cutting, tax disputes, disposal of assets (boost cash position and cash flows, make leverage look better), natural events like hurricanes or pandemics. A company may hold a stake in a JV that is not consolidated (i.e. revenue, profits and debt of the JV is not included in the accounts of this company). If in one year this JV decides to borrow and pay a special dividend to the JV partners (including the company in question), then this company would receive a one-off dividend which it could include in its FCF and definitely in its cash position (reducing leverage). Realistically, the JV cannot borrow every year and pay such special dividends. Using FCF in the year when the special dividend was paid as the base for a valuation could lead you to over-estimating the value of the business.
The launch of major upgrades or new products could materially improve a company’s revenues, but if this happens every 5 or 10 years, then using the most recent year after the latest launch would be wrong. Often, a too optimistic picture may emerge if you look at a company in a ramp-up phase of some product. Sales would rise faster than the industry, while profits could be meagre or negative, suffering from high marketing expenses. You may conclude that marketing expenses would decline once the launch phase is over, leading to significant profit growth. Considering the most recent sales growth, it may be tempting to apply above-average multiple to future estimated earnings rewarding the company for exceptional growth.
In reality, this could be a mistake. For example, I lost some money on my investment in Fitbit, a tracking device manufacturer (eventually acquired by Google). After the launch of its new products, the company was reporting over 100% revenue growth in 2015 and over 20% growth in the following year. Yet, having a relatively simple technology, the company was on a hook of continuously rising marketing expenses as the primary tool to fend off competition from Apple, Samsung and other players. Moreover, without heavy R&D spending, the company failed to win consumers and was eventually acquired by Google.
Capital allocation - how management spent capital in the past, how successful it was.
Culture - this is a factor that keeps growing in importance for me. Hard to overestimate it. The right culture can lead to spectacular business results. Employees should be excited about their work; they should be encouraged to take reasonable risks, experiment and innovate. The whole company should be obsessed with customer satisfaction. The thinking process should be focused on the long term. The Glassdoor website could be a good place to check a company’s overall rating among its employees. Knowing employees (including former employees) personally is even better.
Ideally, key managers should have a significant share of their net worths in the company’s shares.
A low turnover of key personnel is also a good sign.
I also try to check the KPI’s of top managers, their old plans and actual results. The more plain language in annual reports, the better (I think Buffett’s shareholder letters are the benchmark).
I have tried to outline some key steps in analysing a company (see Part 1 here) and more advanced issues in this article (Part 2). However, the art and science of business analysis and valuation are much more complex. I have decided to provide a list of books that I personally found the most helpful.
- ‘Quality Investing: Owning the Best Companies for the Long Term’ by Lawrence A. Cunningham, Patrick Hargreaves, and Torkell T. Eide
- ‘Invest in the Best: Applying the Principles of Warren Buffett for Long-Term Investing Success’ by Keith Ashworth-Lord
Competition & Strategy
- ‘The Five Rules for Successful Stock Investing’ by Pat Dorsey
- ‘Competition Demystified: A Radically Simplified Approach to Business Strategy’ by Bruce Greenwald
- ‘Competitive Advantage: Creating and sustaining superior performance’ by Michael Porter
- ‘7 Powers: The Foundations of Business Strategy’ by Hamilton Helmer
- ‘The Three Rules: How Exceptional Companies Think’ by Michael E. Raynor and Mumtaz Ahmed
Financial Analysis & Valuation
- ‘Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage’ by Marry Buffett and David Clarke
- ‘Valuation: Measuring and Managing the Value of Companies’ by McKinsey & Company and Tim Koller
- ‘Value: The Four Cornerstones of Corporate Finance’ by McKinsey & Company, Tim Koller, Richard Dobbs, Bill Huyett
- ‘Value Investing: From Graham to Buffett and Beyond’ by Bruce Greenwald, Judd Kahn, Tano Santos, Erin Bellissimo, Mark Cooper
Management & Culture
- ‘No Rules Rules: Netflix and the Culture of Reinvention’ by Erin Meyer and Reed Hastings
- ‘The Everything Store: Jeff Bezos and the Age of Amazon’ by Brad Stone
- ‘Sam Walton: Made in America My Story’ by Sam Walton
- ‘Invested: Changing Forever the Way Americans Invest’ by Charles Schwab
- ‘McDonald's: Behind the Arches’ by John F Love
There are many other great books on extraordinary companies and their founders which are worth reading beyond this list.
I can definitely recommend reading Warren Buffett’s shareholder letters and Phil Fisher’s Common Stocks and Uncommon Profits. Both of them focus on the importance of a great product, business fundamentals over price, management and long-term focus.
By all means, this is not a complete overview of all financial tools and techniques required for a successful evaluation of a business. I have not covered many more advanced accounting issues, various sector-specific issues (e.g. normalised earnings of a commodity producer), impact from macro or regulation, innovation factor and so on. Some of these issues are covered extensively in the books listed above. I plan to keep sharing new tools in the future.
My final message is that, ultimately, any analysis boils down to just one question: “Do I understand the business, how the company makes money, what its competitive edge is”. You should be completely honest with yourself. Spending weeks on research does not automatically give you an edge but may create a false feeling of superior knowledge and overconfidence. Take a look at how the earnings of Lehman Brothers and Enron grew a few years before they went bankrupt.