Process & Valuation Framework

The approach I take is fundamentals based and bottom-up. I consider myself a quality biased investor. I simply enjoy the process of researching quality companies more than value companies.

I usually assume a medium-term holding period (3-5 years) when examining a security. With a quality company, this may be extended out 1-2 years and with a value company, this may be shortened by 1-2 years.

In addition, I tend to avoid VC-like companies. Companies that are years away from being self-sustaining, require continuing inflows of cash from investors, have unproven and untested business models, or have cutting edge technologies that I do not have the specialisation to evaluate. This approach means I will miss whatever the next Amazon may be but hope that avoiding ‘duds’ will more than make up for whatever I may miss out on when the next Amazon comes along.

 Cost of Capital

I do not use the Capital Asset Pricing Model for calculating my cost of equity, instead preferring to use a fixed rate based on a risk-free rate and an equity risk premium. I will adjust the risk premium up during market downturns and adjust down when valuations are stretched.

Cost of Capital is not a true cost, but an opportunity cost reflecting other investments an individual most forgo given they had limited capital. Under CAPM, a security with a smaller Beta has a lower cost of capital than a security with a higher Beta, despite the fact that by investing in the lower Beta security you have reduced the amount you can invest in other securities by the same amount as if you had invested in the high Beta security. You may argue that I can use leverage to bring up the risk profile of the lower Beta security to a similar level of the higher Beta security. There is some merit to his argument for other investors, but I do not use leverage, so my opportunity cost is the same.

 

In the event a security has a asymmetric payoff profile and chance of permanent capital impairment, I would not use a higher cost of capital to reflect higher risk but use the same cost of capital but would estimate likely future outcomes, their respective probabilities and estimate a future value based on its expected return. This allows for me to better reflect the potential range of outcomes. While a positive expected value is an attractive value in a security, the potential for a permanent capital loss must be reckoned with and considered.

I use a 5-step process for examining potential investments:

1)      Business

2)      Industry

3)      Competitive Advantages

4)      Valuation

5)      Risks

 

The following is a non-exhaustive list of questions I try ask before making an investment.

  1. Business

  • What does or services does the company offer?

  • What would a biography of the business look like?

  • Do the goods or services offer a good value proposition to customers? Are they enthusiastic customers (Amazon/Costco) or forced customers (Verisign/Standard & Poor’s)

  • What are the company’s unit economics like?

  • Does management create value for shareholders? Is it a good steward of Capital? (Buybacks, dilution, dividends, opportunistic acquisitions)

  • Does the business have either a high ROIC or high ROIIC?

    • If so, how much capital can it deploy and over what timeframe?

2. Industry

  • Does the industry enjoy secular tailwinds (software) or headwinds (tobacco)?

  • Is there currently a market leader that enjoys strong competitive advantages over competitors?

    • If so, how does the company plan to overcome these advantages?

  • Is there a competitor gaining market share over other competitors?

  • Is the industry fragmented or consolidated?

  • Are companies in this industry capital light or capital intensive?

  • Is the industry cyclical/counter-cyclical?

3. Competitive Advantages/Barriers to entry

  • Why is this business difficult for competitors to replicate?

  • Does this business enjoy barriers to entry?

Does the business have:

  • Economies of Scale

  • Network effects

  • Switching Costs

  • Intangible assets:         — Brand

— Operational Excellence          

— Counter Positioning/A new business model

— Cornered Resource

4. Valuation

  • If we are anticipating the winding down of the business or the business operates in a non-viable industry, what does its liquidation value looks like? (Tangible Book value with appropriate adjustments)

  • If the business is quantitively cheap but has no competitive advantages/barriers to entry, what is the reproduction cost of its assets? (DCF)

  • If the business has competitive advantages/ barriers to entry, how much FCF can it produce? How much capital can it reinvest, at what rate, and for how long? (DCF)

  • The majority of companies value is often tied up in terminal value. This is highly sensitive to changes in exit multiple, especially with ‘quality’ companies. Always conduct a sensitively analysis and have a reason to justify the exit multiple.

  • Other Valuation Methodologies: SOTP, Relative Valuation.

  • Companies value creation does not follow a normal distribution. Over the long term, a small percentage of companies will be responsible for the majority of value created. Investing in these companies over the long term can lead to impressive outperformance. There are still opportunities to make money with ‘value’ stocks, but the holding period should be shorter.

  • Valuation will always determine whether or not an investment is attractive. There is no such thing as an investment that is attractive at any price.

5. Risks

  • Debt/Leverage (EBITDA/Interest Expense, EBITDA/Net Debt)

  • Potential Competitors/Technological obsolescence

  • Cash flow – Can the company fund itself internally or is it reliant on external financing?

    If the company is reliant on external financing, what does it borrowing capacity and cost of debt looks like?

    If the company is reliant on external financing, what would an equity raise looks like?

  • Key man risk (Warren Buffett at Berkshire Hathaway, Mark Leonard at Constellation Software)

  • Key Customer/Supplier Concentration

  • Tail risks/Acts of God (COVID, War with Russia) – Usually unpredictable, focus on diversification.