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Checklist Definitions and General Concepts

The following section will describe specific aspects of the partnership and expand on topics addressed in the checklist.

 

Risk Defined by Permanent Loss of Capital

Permanent loss of capital will be the Partnership’s definition of investment risk.  As General Partner, it will be my primary concern and most important factor considered in the evaluation of a potential investment.     Risk in the investment community is typically defined differently, as the volatility of price, the standard deviation of returns.   This is a highly important difference of opinion.   It is possible to find two companies that are in the same industry, trade at a similar P/E multiple and that have a similar level of price volatility but that are very different in terms of the risk of permanent capital loss.  A company can have a volatile stock price but have a very low risk of permanent loss of capital.  Ironically, some of the safest companies have the most volatile stock prices and vice versa.   I will not be deterred by stock price volatility and I cannot promise that the partnership will not experience periods of above average volatility.   I do promise that I will devote much time and energy to recognize and avoid situations in which a company’s intrinsic value is permanently impaired to a level below its stock price.

 

50% Margin of Safety   

The 50% Margin of Safety rule was first communicated by Benjamin Graham and has been advocated by Warren Buffett for many years.  I believe in the 50% Margin of Safety Rule and interpret the rule as follows.  The value of a company (what the stock price is meant to represent) is the “present value of all future cash flows.” To simplify the “present value all future cash flows” calculation, I will break down the process into three “easy” steps.

1st Step:  Forecast the amount a company will earn every year out to . . . forever.

2nd Step:  Add all the numbers up (all the earnings out to forever).  Call the number “Forever Earnings”

3rd Step:  Calculate what you would pay today for “Forever Earnings” based on a forecast of interest rates during each year in the future.

That number, generally speaking, is “Intrinsic Value”

Not an easy number to calculate.  Frankly, it is a miracle that anyone can settle on an exact price at all (XYZ Company is worth $15.27 a share).  The Margin of Safety Rule is recognition that no rational person could ever reach a reasonable level of certainty on the exact price/value of a company.  The slightest change in the forecast often drastically changes the company’s value calculation.  Imagine if a company forecasted to grow at 10% a year forever, only grows at 8.5% a year.  It can make a big difference because forever is a long time for a company to underperform.  As a result, a prudent investor will only initiate an investment if the purchase price is so far below (at least 50%) the calculated Intrinsic Value of the company that even if many of the assumptions used are way off (which they often are) the investment is still protected.  In other words, I’m only certain that I’m half right.  As a stock investor you can never expect to be exactly right, (the situations are just too complex) the trick is to control the extent to which you are wrong.  Much like a good pitcher who misses outside the strike zone as opposed to in the middle of the plate (where the batter will hit the ball out of the park), a good investor misses well. 


Business is easy to understand

 An attractive company is one whose business can be described to a lay person in one sentence

 

High Return on Invested Capital (ROIC)

A core quantitative metric for evaluation is what the company earns in relation to its capital needs.  Return on Invested Capital in its most basic form is a company’s earnings divided by its total capital.  An unattractive business is one that continually needs an infusion of new capital to maintain its current earnings stream.   An attractive business can and does invest its capital at high rates of return.

 

Competitive Advantage

“The key to investing, is determining the competitive advantage of any given company and above all the durability of that advantage.  The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”  - Warren Buffett

The competitive advantage of a company will be a heavily weighted component to the evaluation of risk and the evaluation of return potential for a given investment.  The partnership will generally apply the concepts of Harvard Business Professor Michael E. Porter in the assessment of competitive advantage.  According to Porter, a company can obtain a competitive advantage in one of two ways.  Either as the member of an industry whose competitive forces are so favorable as to by itself create a competitive advantage to any company within that industry or through the creation of a competitive advantage through leadership in one of three generic strategies (cost, differentiation, focus) within a given industry.

In choosing a favorable industry there are five factors or “forces” that define the long term profit potential of an industry, known as Porter’s Five Forces, they are in no particular order:

      1. Barriers to Entry 
      2. Bargaining Power of Buyers
      3. Bargaining Power of Suppliers
      4. Availability of Substitutes
      5. Rivalry amongst Competitors

If the industry is not so favorable in regard to the Five Forces to by itself create a sustainable competitive advantage, the ability to sustain above average long term profitability is dependant upon the ability of the firm to succeed within its industry at one of three potential generic strategies:

Cost:  To operate under a superior cost structure
Differentiation: To provide superior quality for equal or greater price
Focus:  To operate within a specific sub-sector of a given industry, where the firm can effectively compete with respect to cost or differentiation.

A company and its competitors will be evaluated to assess if a competitive advantage exists and if so, if it is sustainable. 

 

Prudent capital allocation decisions

A significant difference between sole and partial ownership of a business is control over capital allocation decisions.  The investor of a public company is a partial owner and as a result is reliant upon the capital allocation decisions of management. That reliance can be good or very bad.     I will look for a management team that makes prudent capital decisions.  Prudent capital allocation avoids big bets (the investment of significant/material amounts of capital on an uncertain outcome.)  The compensation structure of management can help identify CEOs that are more likely to make big bets with the company’s capital.  Management who participates heavily in the upside (via stock options) of the company but not in the downside will naturally take bigger risks with the company’s capital.  The money spent is not their own.  Think about how one spends money in a store with a free gift certificate.

I am not interested in companies or managers that excessively spend or that make big bets.   Big bets are the enemy of prudent capital allocation   An attractive company is one whose management and/or directors take an ownership view of capital allocation decisions.  An ownership view means they are as concerned with the downside of an investment as they are enamored by the upside.  This idea may best be explained by an example of possible commentary by an owner and non-owner CEO:

Non-owner management spending: “As a result of extensive analysis, we are excited to announce a store remodel strategy to better align our customers with our products.  Over the course of the next two years we will remodel all of our 900 locations.  We anticipate the remodel will result in much greater levels of customer satisfaction and higher total revenues.”

Owner management spending:  “We have decided to test the profitability of a store remodel initiative.   As a result we have selected 10 of our 900 stores for remodel that are broadly dispersed throughout the country.  We will test the return on the dollars spent in each remodel location, if the strategy proves to provide attractive returns we will slowly expand the strategy to other stores.”

 

 Stock Ownership on Board of Directors

The role of the Board of Directors is to monitor and evaluate management on behalf of the shareholders. Although in theory the Board should provide a level of protection for shareholders, not all Boards are created equal.   A favorable Board consists of knowledgeable individuals with a material ownership stake in the company.  An unfavorable Board consists of members who could be more interested in preserving their Director fees than evaluating management.  An ownership Board reduces the likelihood of excessive management compensation and unnecessary risk taking (like a large acquisition) and/or spending.  

 

Management Compensation

Management Compensation is a highly important and arguably unrated area of evaluation.  In general most business individuals will act in a manner that maximizes personal profit potential – business people are Profit-Seekers.  A good way to forecast the actions of management is to identify their manner and level of compensation.  In general, I believe there is greater risk of excessive spending and excessive risk taking in a company run by a management team with an ill advised compensation structure.  In addition, over compensated management teams are a greater risk to report aggressively or to materially misstate financial performance.

 


Qualitative Aspects of Management Evaluation

When one purchases stock in a company, they form a partnership with the management of that company.  It is vital that management is a partner you can trust with your money.   In management I look for the 3 H’s:  Honesty, Humility and Hard Work.   The best CEOs are generally the ones nobody knows about.  They don’t seek the attention of the press or the massive compensation packages.  As Jim Collins states in his excellent book, Good to Great, a great CEO looks in the mirror when something goes wrong and out the window when things go right.  Too many CEOs are the reverse.  Many CEOs are more skilled at the politics of business than the business itself.   And while there are a number of arrogant attention-seeking CEOs that have generated great shareholder value, those attributes are also much more prevalent in the cases of deception and bankruptcy.  In my opinion the risk of a material loss of principal that accompanies an arrogant and self-absorbed management team is typically too great to justify an investment.

 

 

Financial Reporting

Financial Accounting involves a high degree of assumptions (the technical term is “accruals”). 

How much profit does a company earn if its sales are subject to warranty? 
Over how many years does a company’s widget machine depreciate?
How many loans in a portfolio will default?  If they do default, what can be recovered? 
What is the probability that Mrs. Smith has a costly auto accident? 

There is little that is black or white in accounting, there are many areas of “grey.”  While this point further highlights the benefit of a management team with integrity, the size of the “grey” area (or the materiality of accruals) is not the same for all businesses.  Some businesses and industries inherently require more assumptions than others.  The more that is “assumed” the greater the risk of misstatement. 

The Headache Rule: It is not uncommon to evaluate two companies, in which one company’s financial report will communicate very clearly the company’s business model, its balance sheet etc . . .while the other company’s report will be so complex that it gives me a headache.  Yet the companies are in the same industry.  I will typically avoid a company whose reports gave me a headache, especially when its competitor’s report I can clearly understand.

 

 

Stocks with Low Implied Growth Rates 

As alumni of the University of Michigan, and a passionate football fan, I am far too familiar with the dangers of high expectations.  I once read an analysis that identified the University of Michigan as the college team that most frequently finished the season ranked lower than their pre-season ranking.  This can make for a very frustrating experience for the passionate football fan.  Every year we expect to go undefeated and win the National Championship.  Every year (except for 1997!) we don’t.

In a similar fashion, the price of a company’s stock is a reflection of the expectation of its future success.  Some stocks have high expectations, some stocks have low expectations.  It is not complicated to extract the “implied growth rate” from a company’s current stock price.  Superior performance is achieved when the company’s actual growth rate exceeds the growth rate implied by its stock price.   The lower the company’s implied growth rate, the easier it is to exceed.  This concept may sound somewhat counterintuitive, but high expected growth is bad for the investor because it is fraught with the risk of not meeting expectations.  Failed expectations cause a loss of capital.  Low “expected” growth is preferred all things equal because it is easier to exceed.  This is a powerful concept.  Imagine if you could be accepted to Harvard University with a C average, if you could convince the admissions board you had been “expected” to flunk.  To follow the same analogy, a student could fail to gain acceptance into a lesser college with a B average if he/she had been expected to have an A average.  Generally speaking, money is made when expectations are low, money is lost when they are high

 

 

Portfolio Volatility

Given the potential for above average volatility, I believe the partnership will experience periods of underperformance.  Performance success is dependant on my ability to stay focused on the identification of long term value opportunities.  I will look for opportunities in which the true value of a company is not reflected in its stock price (stock price is less than company value).  It is irrational for a company’s stock to trade significantly below its true value.   To speculate on when an irrational situation becomes rational is a fool’s game.  This sentence bears repeating.   To speculate on when an irrational situation becomes rational is a fool’s game.  It is impossible to know with a reasonable level of certainty that a company I value at $10 per share but is trading at $5 per share, won’t at some point in the future trade at $3 per share.  This type of price movement will not concern me if I am confident that the company is indeed worth $10 per share.  If my evaluation of intrinsic value is correct, over time price and value will converge.  However, if I become overly concerned with forecasting increased or decreased levels of irrationality (otherwise know as “movements of the stock price”), I fear I could lose sight of the fundamental factors that drive the company’s true long term value calculation.  As a result I am interested in partners who have a long term view of their investments and of the partnership. 

 

 
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