Why Working Capital Works
Moat
“What really counts is the presence of a competitive advantage. You want a business with a big castle and a moat around it, and you want that moat to widen over time.” — Warren Buffett
Competitive Advantage is a Moat
If a business is able to make a large profit, it will naturally draw competitors. These competitors could come in many forms. It could be existing or new competitors, it could be substitute products. It could also be buyers asking for discounts or suppliers charging higher prices. For a company to make large profits over a sustained period, it is necessary to have a defensible competitive advantage, also known as a moat.
New Entrants
A profitable firm or industry will naturally draw new entrants, which will drive down profitability. In order to maintain profitability, a company needs mechanisms to prevent entry. Key mechanisms to prevent new entry can be economies of scale, product differentiation, brand identity, capital requirements, distribution, government regulation, absolute cost advantage, or competitive retaliation.
Industry Rivalry
Industry rivalry is what most people think of as competition. Competition can be on the basis of price, marketing, or research and development, all of which reduce profitability. Less competition within an industry is better. Competition is determined by industry growth, fixed cost, value-added, product differentiation, diversity of competitors, exit barriers, and informational complexity.
Buyers
Buyers typically aren’t happy when a business is making a huge profit. Buyers will want to reduce that profit by paying lower prices or demanding additional services. If the buyers are more concentrated than sellers, than the buyers will have more bargaining power. If buyers purchase in large volumes, they will have more bargaining power. If it is easy to find information about products or switch, then buyers will have more power. How profitable are the buyers? If they are highly profitable, they will probably be less sensitive to price. If the seller’s product is only a small portion of the buyer’s purchases, then the buyer will be less sensitive to price. If the product is highly differentiated or extremely important to the buyer’s output, then the buyer will be less sensitive to price. If the product has a successful brand, often buyers are less price sensitive.
Substitutes
Substitution is when the buyer forgoes the firm’s product for another similar product. For instance, a traveler might substitute bus travel if train tickets become too expensive. The more easily customers can substitute, the less profitable a firm will be. Ease of substitution is determined by relative price performance of substitutes, buyer propensity to substitute, and switching costs.
Suppliers
Suppliers can adversely affect firm profits by charging excessive prices. Key determinants of supplier power include differentiation of inputs, presence of substitute inputs, supplier concentration, threat of forward integration, importance of volume to supplier, and cost relative to total purchases in the industry.
Great Investors
As an investor, you always need to keep learning, and a great source of information and inspiration are other great investors. If you haven't already, you should read the writings of Warren Buffett, Phil Fisher, Benjamin Graham, etc… Learning from other investors is the fastest way to create your own investment framework. Your framework will allow you to distill massive amounts of information into the key points from which you can make good investing decisions
Munger on Buffett’s Success
At Wesco’s 2007 annual meeting, Charlie Munger attempted to explain the success of his long-time partner, Warren Buffett. He started with mental aptitude, but he said that wasn’t the main factor. He cited Warren’s early start in investing, his passion and interest, the positive reinforcement he received from success, individual, not committee, decision-making, and Warren’s ability to maintain objectivity. Munger also described Warren as a “learning machine.” Warren is constantly seeking to learn and become a better investor. In fact, Munger claimed that Warren’s investing skills have markedly increased since he turned 65.
Building and Improving the Model
As an investor, you will ne a model, framework, or strategy. It helps you focus on keep points, stay disciplined, and make good decisions. TheUnderFollowed is our framework based on years of study and experience. Once you develop your model, you will need to continue learning and updating it. Buffett started investing using a value model created by Benjamin Graham. He later modified Graham’s model by adding what he learned from Phil Fisher, and that model has continued to evolve over the years.
Discounting Risk
"By controlling risk and limiting loss through extensive fundamental analysis, strict discipline, and endless patience, value investors can expect good results with limited downside." – Seth A. Klarman
"Risk comes from not knowing what you're doing."
It is commonly accepted among academics, technicians, traders, and pundits that risk is defined by stock's volatility relative to an index. This is also known as Beta. Since we view stocks not as paper assets but as proportional ownership in the underlying business, we have a different perspective. We agree with Warren Buffett that "risk comes from not knowing what you're doing." The permanent loss of capital can be caused by a myriad of factors such as a shrinking market, declining competition advantage, poor cash position, business cycle, bad corporate governance, bad management, etc For that reason, before investing in a company, we spend significant scrutinize all the fundamental factors that could potentially affect the business. This article provides illustration of the broad set of risks we consider.
Capital Structure
A simple capital structure, consisting mainly of common stock, is preferable to a complex capital structure, consisting on multiple classes of common and preferred stock, numerous debt offerings, and warrants. First, a complex capital structure makes it more difficult for equity investors to understand their stake in the company's assets and cash flow. Second, and more importantly, a complex capital structure may be a tool to prevent shareholders from exercising control over the company. For instance, a company might issue multiple classes of shares with different voting rights. Insiders or management will control the super-voting shares, and thus they can control the company. Corporate governance is discussed in greater detail elsewhere in this article.
Liquidity
Liquidity is your ability to trade in and out of a stock, which is typically based on the average trading volume of the stock relative to the size of your position. Higher volume stocks are easier and cheaper to buy or sell in big chunks. Higher volume stocks tend to have a smaller bid-ask spread, and your order is less likely to dramatically affect the price. Higher liquidity tends to decrease risk, as you can quickly exit a position.
Exchange
The best exchanges are the Nasdaq and the New York Stock Exchange (NYSE). After those two, we prefer the American Exchange (AMEX), followed by the Over the Counter Bulletin Board (OTCBB), and the Pink Sheets. Stocks on the Nasdaq and NYSE tend to trade at higher volumes, and those exchanges tend to have stricter rules for allowing companies to list.
Cash conversion
It is less risky to invest in companies that quickly and reliably convert sales into cash. This can be measured by the company's cash conversion cycle and days sales outstanding. The ideal case is a company that collects cash or credit card receivables. Selling to reliable customers, such as Fortune 100 companies, is also good. Selling to less reputable customers and offering generous terms puts the company at risk.
Cyclicality
The business cycle is notoriously difficult to predict. Highly cyclical industries introduce more uncertainty, and therefore more risk, into your investment thesis. For instance, consider the task of estimating earnings for a chewing gum company and an oil refiner. The chewing gum company, which is not cyclical, should be relatively easy. If you look at historical sales and make a few adjustments based on growth, new products, pricing changes, competition, etc, you can probably make a reliable estimate. Now, consider the highly-cyclical oil refiner. Can you predict the price of oil for the next few years? How much will industry capacity increase or decrease? What will be the demand for energy? There is a lot of uncertainty in forecasting.
Customer and Supplier Concentration
If a company has a few customers that represent a very large share of revenue, it presents an additional risk for the company. Large customers have significant leverage to negotiate for reduced prices. This will significantly reduce profitability for the company. Also, the company could see a huge reduction in revenue if it losses one of the large customers. As an example, consider a Michigan-based auto parts supplier. Suppose that 80% of the company's business is with Ford and General Motors. If Ford or General Motors asks for a price reduction, the company will hardly be in a position to refuse. Either they comply with reduced prices (and reduced profits), or they surrender a huge portion of their sales. Suppose either Ford or General Motors choose a different vendor. What if Ford or General Motors go out of business? The same risk types of risks apply to concentrated suppliers. Computer makers only have a few choices for buying processing chips. They can buy from Intel, AMD, and a few other companies. This makes it very hard to negotiate for reduced prices. What if Intel and AMD shut off supply?
Margins
We associate less risk with high margin businesses. High margins are typically associated with a strong competitive position. High margins also provide a company with some leeway. Falling from 25% to 20% EBIT margins is disappointing, but it doesn't destroy the value of the business. Falling from 5% to 0% EBIT margins is a serious problem.
Competitive Advantage
A sustainable competitive advantage, or moat, reduces the risk of an investment. Even if you paid a little too much, or management is less competent that you hoped, you can still make money on a company with a solid moat. The key is that the competitive advantage is sustainable, and ideally, we like a competitive advantage that increases over time. Before investing in a company, we actually spend time imagining how, if we were a competitor, how we'd put the company out of business. If it seems difficult or impossible over time, then it is probably a good investment.
Growth
Extremely weak top line-growth over time presents a significant risk. A falling top-line often indicates that the fundamentals of the company or industry are deteriorating. For example, consider the wave of recent bankruptcies in the newspaper industry. On the other hand, steady top-line growth reduces risk.
Business Complexity
Business complexity is a definite source of risk. It limits your ability to understand and value the business. Citigroup and AIG are good examples of the risks associated with business complexity. Because of the complexity inherent in those businesses, investors weren't able to foresee huge future losses. Simpler businesses bear less risk.
Communication
Open and honest communication from management tends to reduce the risk for investors. Accurate information reduces uncertainty, which reduces risk. As such, we prefer companies that disclose segment information, provide reasonable guidance, answer questions honestly, and provide key industry metrics. We also like CEOs that admit to mistakes or a bad quarter. We dont like CEO's that speak in clich's, make excuses or refuse to disclose information.
Corporate Governance
Obviously, better corporate governance reduces risk. Bad corporate governance allows management or a small shareholder groups to use the business for their own personal gain. Examples of bad corporate governance include extensive anti-takeover measures or dual-classes of shares with different voting rights.
Insider Ownership
High insider ownership tends to reduce risk. It ensures that management's incentives are aligned with shareholder incentives. When management is a significant owner, they tend to be more motivated improve the business. They also tend to make more responsible capital allocation decisions.
Operational Track Record
All other things being equal, past performance tends to be a strong indicator of future performance. If management has a long and impressive track record of generating shareholder value, it reduces the risk of your investment. Conversely, investing with a management team that has limited history or a history of destroying shareholder value tends to be more risky.
Capital Allocation
Profits technically belong to shareholders, but management has significant discretion in how profits are used. Irresponsible allocation of capital can create tremendous risk. Consider how much shareholder value was destroyed by Time Warner's merger with AOL at the height of the internet bubble.