The 5 M's
The five M's is an easy framework for thinking about an investment. The components are: Management, Moat, Margin, Mr. Market, and Multiple. These elements are all interconnected: Management builds the Moat, the Moat determines Margins, and Mr. Market uses all these factors to place a Multiple on the business, which determines market value.
Management
What actions is management taking to fortify the company’s competitive position? Is management a good steward of the brand, is management making smart investments in new products, does management have a strategy to beat rivals?
Moat
How large and sustainable is the company's competitive advantage? An easy way to evaluate a company's moat is to use Michael Porter's Five Forces model. How is the company positioned relative to buyers, suppliers, substitutes, new entrants and substitute? How will its position change over time? Imagine yourself in the position of trying to build a competing business. Imagine negotiating a supplier or customer. How difficult would it be?
Margins
How profitable is the company? A well-managed company with a wide moat will typically be very profitable. Operating margins and returns on capital will be very high.
Mr. Market
If the firm has executed its game plan and shown strong profitability, then Mr. Market (Ben Graham's fictional character used to describe Wall Street manic depressive trading patterns) will pay a higher price for the company on average. This translate to a higher multiple.
Multiple
When Mr. Market pays a higher multiple, assuming no change in cash flow or earnings, then the company's stock price will go up. Obviously, when buying, you're looking for a low multiple, and when selling, you want a high multiple.
Track Record of Success
When assessing a company and management, we like to see a track record of success. Our reasoning is simple--people that have succeeded in the past are more likely to succeed in the future.
The exact criteria of success are hard to define. You will need to use substantial judgment. However, there are a few key indicators that we like to consider. First, has the CEO previously managed, improved and sold another company for a premium? This demonstrates the ability to build value in a company, which is recognized in market, and to generate returns for shareholders. Second, has the management team displayed outstanding performance in the existing business? For instance, if the company has steadily increased market share and improved margins over a multi-year period, it demonstrates that the company is well-managed. Third, what is the background of the current management? We appreciate managers that have previous senior leadership experience, in the current company or another. Senior leadership positions, such as CEO, CFO, or COO, entail significant responsibility, and people typically don’t attain those positions without proven abilities.
Conversely, we avoid managers that seem to have come to their position by luck or nepotism. Often, particularly with smaller companies, top management positions are kept “within the family.” Be wary of these types of situations.
Investor Psychology
“Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ…Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”—Warren Buffett.
Humans are genetically prone to make mistakes in investing. We don’t naturally think in probabilities, and we have numerous built-in biases. Consider social proof bias, the tendency to follow the herd, or confidence bias, which results in people overestimating their abilities. Consider denial bias, which causes people to ignore contradictory evidence and avoid cognitive dissonance. Combine all of theses biases, and the result is panic and manias, stretching through all of history from the original tulip mania to the dot-com bubble.
As an investor, your success will depend on your ability to control your emotions and behaviors. You don’t want to get caught up with the herd, and you don’t want to damage your portfolio with a foolish mistake. To avoid that, Whitney Tilson of T2 Parnters suggests patience, humility, having a trusted partner, using written checklists, and actively seeking out contrary evidence. We agree with advice, and we also suggest having a very rigorous investing and decision-making process. By diligently following a formal process and criteria, like the TheUnderFollowed, you’ll be less likely to fall into cognitive traps.
© 2007-2009 theunderfollowed.com All Rights Reserved
What Are You Paying For?
When purchasing a tangible good, like a car or a house, people usually have a good idea what they’re paying for. When shopping for a house, people evaluate square footage, distance from public transportation, quality of schools, soundness of construction, etc., and they naturally understand why you’d pay more for some houses, and less for others. Unfortunately, this thought process doesn’t easily translate to purchase stocks. That is why, although it seems very basic, we find it very valuable to ask: “What are you paying for?”
Assets and Future Earnings
When you purchase a stock, you’re a partial owner of its assets, and you’re entitled to future streams of profit. As such, when buying a stock, you’re buying assets and future earnings. What are the assets (cash, equipment, inventory, receivables, etc.) per share, and what is debt per share? How much free cash flow per share does the company currently generate, and what do you expect in the future? How much risk is involved in both the assets and earnings? By simply asking these questions, you’ll ensure that you don’t fall prey to bad stock tips, and you won’t end up buying a worthless company with lots of impressive promises, but no tangible economic value.
© 2007-2009 theunderfollowed.com All Rights Reserved
Top Questions for Management
Our objective in any investment is to be one of the three most knowledgeable shareholders in the shareholder base. This usually takes a great deal of time and research, and one of the key sources of information is management. By talking to management, you’ll quickly gain an understanding of the industry, you’ll hear the company’s strategy first-hand, and you’ll have the opportunity to evaluate management. By talking to multiple management teams in an industry, including customers and suppliers, you will really develop deep knowledge of that industry.
Before meeting with management, I would suggest studying their business by reading annual reports and quarterly filings, which can be found at www.sec.gov or www.edgar-online.com. I would advise learning all you can about the business. The more you know about the business, the more serious management will take you.
You should also prepare a list of questions for you meeting with management. It will help ensure that you cover all the key areas. In the interview, focus on getting management’s perspective on issues and their prediction for the future. For instance, don’t waste time asking about the company’s current level of accounts receivable. You should already know that. Instead, ask what drives payment terms. Ask how trends in the industry may affect customer payments in the future.
Below is a generic list of sample questions to use as a starting framework. During your pre-meeting research, you will probably want to modify the list to include more industry- and company-specific questions. If all else fails, remember the advice of Charlie Munger: if you really want to understand something constantly keep asking the question why.
Industry Trends
What are the key pricing and demand trends in the industry?
Where is demand coming from> what is driving GDP growth?
Where is the industry in terms of business cycle?
What is capacity like in the industry?
Do you anticipate any important regulatory changes?
Sales
What are you expectations for sales growth over the next several years for your company and the industry as a whole?
What percentage of your revenues is recurring?
Is your sales cycle lengthening?
What the average sales size?
What is the quota per sales person, and how many sales people do you have?
How does advertising and marketing affect sales?
Customers
What problem do you solve for your customers?
What are your key distribution channels?
Who are your end users?
How is the health of your customers’ industry?
How do you segment the market?
What niche or segment do you focus on?
How concentrated is your customer base?
Who are your key customers?
What is the value of an average customer?
Who makes the buying decision, and what drives the buying decision?
How do you measure customer satisfaction?
What operating leverage does the company hold with customers? Explain any changes AR, bad debt expense, etc.
What are you customer’s switching costs?
What is your churn or attrition rate for customers?
Costs
Who are your key suppliers?
What is happening to the costs of raw materials?
What are your costs on a unit basis?
Can you use advanced/new technology for further/enhanced productivity or cost reduction in your operating structure?
Capital Allocation
What is the best use of the company’s current cash?
What drives your financing strategy?
How do you evaluate different options for allocating free cash flow?
What type of opportunities do you have for reinvestment or acquisition?
Are you focused on growth or profitability?
How do you intend to return money to investors?
Competitors
Who are your primary competitors?
What are your strengths and weaknesses vis-à-vis your competitors?
What is your company’s value proposition or advantage relative to competitors?
What are the barriers to entry or exit?
What is your company’s biggest weakness?
Who are emerging competitors?
Financial Reporting
How are Revenues recognized?
Can you take me through a typical sale and how it flows through the P&L?
How long does it take for the company to report EPS from the close of the Quarter?
What mechanisms are in place to ensure accurate forecasting measures?
What type of visibility do you have into future quarters?
Wall Street
What kinds of expectations are priced into the stock?
What do investors fail to understand about your company?
Do you have any analyst coverage?
Are you planning to do any presentations for the investor community?
Analyzing Failures
We like this old saying, "an idiot will never learn from his mistakes, a smart person will learn from his mistakes, but a genius will learn from other people's mistakes." In this article, we will outline potential investing pit-falls and help you learn from other's mistakes. Broadly, we group investment failures into two categories: business-related and investor-related, both of which will cause you to loss money. Business-related failures include poor management, too much debt, unsustainable competitive advantage, etc. Investor-related failures include overpaying, lack of patience, stepping outside your circle of competence, etc.
Business-Related Failures
As an investor, your primary job is assessing businesses, and it is important to understand what understand what factors could cause a business to fail.
Inadequate Leadership at the company is inadequate, and the company moves in the wrong direction. This might includes empire building (growing sales at the sake of profitability), making bad hires, failing to react to competitors, destroying customer relationships, and failing to inspire employee confidence.
Complacent Management and Board that is not aligned with shareholders. They are complacent, comfortable, and focused on enriching themselves at the expense of shareholders. For instances, management and the board may own a small portion (1-5%) of the company, pay themselves exorbitant salaries, and entrench themselves via staggered boards, poison pills, etc. In this case, the company becomes a recurring earnings stream for management and the board, not shareholders.
Employee Turnover is significantly above industry average. When an employee leaves, assets and ideas go out the door, sometimes to competitors. The company also needs to train new, unproven employees.
Flawed Business Strategy. This includes focusing on revenue growth without profits, acquiring too many businesses using stock, over-paying for acquisitions, promotion over results (management trying to hard for multiple expansion without the underlying cash flows), etc.
Heavy Debt Load compared to the company's underlying cash flows.
Low Barriers to Entry businesses are unlikely to earn excess returns on capital over a sustained period of time.
Business Cycle and Cyclicality at the wrong time in the cycle. A lot of money can be made in cyclical businesses, but this requires an added degree of expertise in order to invest in a business when it is extremely out of favor and sell at the right time. It requires the investor to be right on several difficult calls: the business, the valuation, and the market cycle.
Investor-Related Failures
As an investor, you can fail even if the underlying business succeeds. As such, you need to be wary of potential mistakes, which we have listed below.
Overpaying for a business. Even the best businesses can be bad investments if you pay too much. For example, Cisco's net income has grown from $2.7B in 2000 to over $8 billion in 2008. In spite of this tremendous growth, shareholders lost money (the share price fell from $51 to $18 during that same period) because investors simply paid too much in 2000. In March of 2000, Cisco has a P/E multiple of 203.
Lack of Research before purchasing a stock. As a focused, long-term investor it is vital to know as much as possible about a company. Buying stock based on a tip from a friend or Jim Cramer's Mad Money is a certain way to lose money.
Impatience or Lack of Conviction in the investment. It often requires years of waiting before the market will appreciate an undervalued stock. Investors that are not willing to wait or who lack conviction in the idea, are bound to sell to early and lose money or miss out on gains.
Lack of Understanding of the underlying business. It is very important to stay within your circle of competence. If you don't understand medical research or oil exploration, then you will probably lose money buying stocks in those industries.
A Value Trap is when a stock that stays cheap for many years and fails to compound out at any rate or declines in value. Obviously these types of situations frustrate and disappoint investors. The problem usually resides in company leadership. Shareholders will sometimes revolt and pressure the board to unlock value, but it is a time consuming and frustrating process.