Investment process

Knowledge Series Knowledge Series (By Invitation)
21

Investment Framework

Industry Study
• Is this a good business?
• What are the key success factors to superior performance in this industry? (VAR)
• Define the market opportunity. How do competitive products address this opportunity?
• What are the barriers to entry (“moats”)? (VAR)
• What is the relative power of: (VAR)
◦ Customers
◦ Suppliers
◦ Competitors
◦ Regulators
• Who controls industry pricing? Does the company/sector have any pricing power?
• How (and how much) can a good company differentiate itself from a bad one in this industry?
• Do you understand this business? Test yourself and describe it to a 10-year-old.

Business Model (VAR)
• What is the selling model: Razor/blades? Services? One-off contracts?
• What are the economics of the base business unit? How does it stack up against competitors?
• Why is the company good (or bad) at what it does? Can the company sustain it?
• Is this company growing by acquisition? How sustainable is that?
• Be able to easily describe the entire sales process – from order to fulfillment.
Management (VAR)
• What is the executives’ background, and what do their former colleagues, investors, and classmates say about them? Have they been successful in the past? (Very important)
• How is management compensated? Are its interests aligned with shareholders?
• Has management been good at allocating capital?
• Are management members buying or selling stock? How much as a percentage of their holdings, and why?

Company/Cultural Issues (VAR)
• Is this a great company? Is it built to last? What could change this assessment?
• Can you imagine holding stock in this company for 20 years?
• If you had access to unlimited capital, how would you feel about your chances of successfully competing against this company?
• Compare to a weak competitor in the same industry. What is the difference and why?
Financial Measures First Step: Check against all the accounting shenanigans in Howard Schilit’s book Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports (Amazon.com).
• What is the company’s capital structure, and how does it compare to its peers?
• What are the trends in inventory turns, days payable/receivable, and working capital?
• What are the company’s coverage ratios on interest payments?

Cash Flow
• What are the company’s capital requirements and cash flow characteristics?
• How is the company choosing to invest its capital? Capital expenditures? Buybacks? Acquisitions?
• Does the company need to access the capital markets? How soon/often?

Earnings/Profitability
• Regarding the company’s sales model, how visible are earnings quarter to quarter, and year to year?
• Is this a fixed or variable cost business? How much cost leverage?
• Do earnings grow as a function of unit sales growth, price increases, or margin improvement? How sustainable is this growth?

Valuation
• Looking forward, what is the company’s valuation in terms of:
◦ Market value/earnings
◦ Enterprise value (“EV”)/earnings before interest, taxes, depreciation, and amortization (“EBITDA”)
◦ Free cash flow (“FCF”) yield (after-tax FCF/market value)
◦ Market value/sales
• What are the company’s growth rates in terms of earnings, EBITDA, and FCF?
• What are consensus earnings estimates versus your own expectations?
• What are the key leverage points in our own and the Street’s earnings models?
• What has to go right, and where is the most chance for surprise?
• Are the company’s accounting policies conservative and in line with its peers?

Risks
• What are the big unknowns? How much can the company control/influence these risks?
• What could cause this investment to be a total disaster? How bad could it be?

Other (Timeline/Timing Issues)
• What are the catalysts (triggers) for the company’s proper valuation to be realized?
• What good news and what bad news will affect the company in the coming year?
• Who owns the stock? Momentum funds? Big mutual funds? Hedge funds?
• How difficult is it to build a significant position (float, volume)?
• Draw a timeline of expected events and dates. What might go wrong and when?

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22

Paul Volcker - The man who saved America A finance documentary

This documentary briefly depicts the economic rise of the US in the 20th century and what led to the high inflation rate in the 1970s. From industrial power house to Bretton Woods Agreement to the US Dollar restricting the convertibility of the US Dollar to other currencies or Gold.

After surviving an assassination attempt, Paul Volcker put everything on the line again in order to save America from hyperinflation. Mr. Volcker helped in shaping American economic policy for decades, notably by leading the Federal Reserve’s campaign to subdue inflation in the 1970s and ’80s.

A reporter asked how much unemployment he was willing to accept, Mr. Volcker responded, “My basic philosophy is over time we have no choice but to deal with this inflationary situation.”

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23

It’s Supposed To Be Hard
Collab Fund

In 1990, David Letterman asked his friend Jerry Seinfeld how his new sitcom was going.

Every investor knows, or should know, the truth about money management: More than 80% of professional investors underperform their benchmark (more depending on how you calculate it). Those stats are used in an often cynical way to show how the industry is broken, crowded, and ineffective. But wouldn’t it be weirder if it were different?

Wouldn’t it be strange if every slightly ambitious investor could pick a few stocks and earn returns capable of generating dynastic wealth with other people’s money? Or even most of them? How and why could that world possibly exist? The reason Warren Buffett is interesting is because there’s only one of him.

Professional investors generally need other people’s money to invest…There is more collateral damage in investing than other pursuits.

The barriers to entry in investing are low. There are now more than 16,000 mutual funds and 10,000 hedge funds in the US. For perspective there are 15,444 Starbucks locations in the U.S. It’s inevitable that the vast, vast, majority will be mediocre at best.

24

The Learning Mindset for Investors with Alix Pasquet
Neckar’s Minds and Markets

There’s so much information that you have to use filters to learn. The problems you have to solve serve as filters. Also smart people, your goals, even the investments you make.

“If your behavior hasn’t changed, you haven’t learned. Learning is not sitting on a desk, and cramming your brain with knowledge that you’re going to recite one day.” “A desk is a dangerous place from which to view the world.” John le Carré

The first mindset is don’t do this job for the money. This is a very painful business. You’re constantly faced with your mistakes.

The first condition you want to create is having mentors. Stanley Druckenmiller says, if you’re early in your career, and they give you a choice between a great mentor or higher pay, tick the mentor every time it’s not even close.

So how should you study a hero? You want to study their initial conditions. What was the early context, circumstance and environment that shaped them? One thing that is often ignored by Buffett and Munger, for example, is that they grew up in the aftermath of the Great Depression. That really impacted the way they saw things. No wonder they were infatuated with value investing early on.

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25

Good Enough
Collab Fund

Spare a thought for the poor guppy fish, who lives a miserable existence but teaches us something important about forecasting.

The point is that nature is very good at assessing future risk and uncertainty and allocating resources accordingly.

It takes a realistic look at future threats and says, “There are so many risks lurking. Don’t even bother trying to plan for the future.” For others it says, “Your future is clear and foreseeable – predict away with confidence.”

Fish are masters at this balance. Birds are masters at this balance. Insects are masters at this balance. But people trying to forecast the economy? Different story.

Everyone knows the economy is hard to predict, and the history of economic predictions is abysmal. But leaving it at that is too simplistic. I think we’re actually very good at predicting the future – except for the surprises, which tend to be all that matter.

It’s less about admitting that we can’t forecast, and more about acknowledging that if your forecast is merely good enough, you can invest your time and resources more efficiently elsewhere.

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26

Mental Models I Find Repeatedly Useful
Medium

There is a much smaller set of concepts, however, that come up repeatedly in day-to-day decision making, problem solving, and truth seeking. As Munger says, “80 or 90 important models will carry about 90% of the freight in making you a worldly‑wise person.”

Therefore, here are two suggestions for using this list:

  • For mental models you don’t know or don’t know well, you can use this list as a jumping off point to study them. I’ve provided links (mainly to Wikipedia) to start that process.

  • When you have a particular problem in front of you, you can go down this list, and see if any of the models could possibly apply.

Most of the mental models on this list are here because they are useful outside of their specific discipline.

He describes various mental models under the heads- Explaining, Modeling, Physics, Brainstorming, Experimenting, Interpreting, Deciding, Reasoning, Negotiating and so on

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27

Buggy Human

Without planning to, I ended up sharing our luddite valuation approach in a hotchpotch of tweets. I thought I’d gather them in one place. Before that, what you choose to own matters way more than what you choose to pay. But valuation matters & we’d like it to be a tailwind.

Over 15-years & ~40 decisions, our average/median is 15x entry PE (on historic/trailing E) for 40% ROCE business.

15 is outcome. Approach is, if multiple starts with 2, better be very special. Starts with a 3, I should be fired.

Normalized, especially if cyclical business (we take 5-10 Yr avg). Adjusted down if margin above trend.

If over cycle numbers clear our bar & we’re convinced of future sustainability of decent economics, it’s OK for recent numbers to be poor due to external factors

PE is a valuation heuristic, amenable to getting historic reference ranges. Our more basic criterion is having a reliable sense for future cash without xl jugglery.

https://twitter.com/sridharananand/status/1568431893024219137?s=48&t=2Hh36SvEl8QnwxucRKEehw

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28

Big Beliefs
Collaborative Fund

A trick to learning a complicated topic is realizing how many complex details are a cousin of something simple. John Reed writes in his book Succeeding: When you first start to study a field, it seems like you have to memorize a zillion things. You don’t. What you need is to identify the core principles – generally three to twelve of them – that govern the field. The million things you thought you had to memorize are simply various combinations of the core principles.

A few big things I believe:
The inability to forecast the past has no impact on our desire to forecast the future.
No one’s success is proven until they’ve survived a calamity.
It takes less effort to increase confidence than it does ability.
Incentives are the strongest force in the world.
Sitting still feels reckless in a fast-moving world, even in situations where it offers the best odds of long-term compounding.
It’s hard to determine what is dumb luck and what is unfortunate risk.
Calm plants the seeds of crazy.
Stories are more powerful than statistics, because they’re easier to understand and contextualize to your own life.
As Aldous Huxley writes, “Man has an almost infinite capacity for taking things for granted.”
Most people are blind to their own faults.

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29

Transcript of my conversation with @kuntalshah on #TheOnePercentShow
Vishal Khandelwal @safalniveshak
By FLAME University

  1. Anything multiplied by zero is 0
  2. Happiness is a function of achievements plus aspirations, divided by regrets
  3. Disappointment is a function of expectations divided by reality
  4. Kinetic energy is equal to ½MV^2. This equation is important in this era where the rate of change is accelerating, an organization or a person can use his mass or velocity to gain competitive advantage and velocity being exponential, speed is of essence
  5. Opportunity cost is always higher than sunk cost
  6. Destruction is far swifter than construction
  7. EBITDA is not equal to cash flows
  8. Formula of luck, is joy square divided by effort
  9. Despair is equal to suffering minus equanimity
  10. Returns decrease as motion increases
  11. Future Value = Present Value (1 + R) ^n
  12. Gratitude + the right attitude = permanently high altitude

A marriage of convenience leads to a life of inconvenience. For a proper perspective and equanimity in life, maintain a decision as well as gratitude journal.

Macro matters and interlinkages can lead to a ripple effect.

All IT enabled businesses are not tech businesses.

Businesses are run by people, regulated by people, assets are created by people and the pricing of those assets are set by people. Those who don’t remember the past are condemned to repeat it.

In science and in life, progress is linear but in the financial word it is cyclical. Cycles – more frequent, shorter duration and far higher amplitudes

In the short-term volatility is guaranteed. A long time horizon and an unlevered, stable capital base can help overcome volatility.

What makes a great investor is not the number crunching or having differential insights, but the ability to make good decisions in extremely uncertain times.

Vishal Khandelwal on Twitter: “Transcript of my conversation with @Kuntalhshah on #TheOnePercentShow. https://t.co/NZnWboNKM0” / Twitter

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