My overall strategy focuses on two factors: the quality of the business, and the price.
- High profitability historically and in the future
- Reasonable balance sheet
- Fair price
Here are some examples of what I consider when trying to determine the quality of a company.
- Are the margins good? (EBITDA, EBIT, and OPCF)
- Is the Return on Invested Capital good?
- Is the Sales, EBITDA, EBIT, and OPCF growing?
- Solid balance sheet
- Is the company carrying a sustainable amount of debt?
- Debt to EBITDA and Current ratio
To elaborate on the list above, margins I’m most concerned about in general are EBITDA-margins, EBIT-margins and Operational Cash Flow (OPCF) margin. This is because I’m mainly focused on the cash flow from the operations, and the operational earnings. As far as returns, we prefer a company that is efficient in its employment of capital, so I prefer a company with higher ROIC. It’s important to know that certain industries employ less capital than others, and thus may appear more efficient than others.
Furthermore, I prefer if a company is growing, and it’s important that the growth manages to roll through the income statement. It’s relatively easy for a company to grow their revenue, it’s not as easy to grow revenue while defending their EBIT margins. Measures of growth that I generally use are revenue growth, EBIT growth, and OPCF growth. Keep in mind the number of shares outstanding.
Finally, we want a company that has the ability to increase its leverage while we own the stock. Thus, as we acquire it the general debt burden on the company should not be strained. I use debt to EBITDA to gauge the level of debt, and current ratio to check the short term solvency.
Note that the most important aspect is what these measures will look like during the period where we own the investment. In other words, we need to be able to answer the following question: “What will the quality of the business be in the future?”. Looking at what they have been in the past is usually a good enough starting point, but we must not forget to lift our gaze and try to predict the future of the business. It’s really difficult most of the time, but if it were easy there would be little to no profits in investing…
A good company can make a bad investment simply by overpaying for it. The same cannot be said of a bad company. This is something that Charlie Munger said at one of their annual meetings (I’m not sure which, sorry.), and it is the reason I care about the price I’m paying. Now, I rarely care about the P/E ratio or dividend yield, which are very common measures. Since I focus mostly on the operations, it makes sense for me to consider metrics using OPCF, EBIT and EBITDA. Furthermore, I prefer using Enterprise Value instead of the commonly used price-multiples.
Usually I check the companies EV/EBITDA, EV/EBIT, and EV/OPCF and put them in relation to the growth. This creates a measure similar to the PEG ratio, but using EV-multiples instead of P/E and other growth metrics than earnings growth.
Holding and Selling
This is always the tricky part. I try to be long term in all my investments, so ideally I would have a very long holding period for my investments. This is something I have to improve on, since it’s far too easy to want to take the profit already netted and jump into the next interesting investment opportunity.
So a note to myself here would be another Munger quote along the lines of: the value creation comes not from the purchase or sale of a stock, but from the waiting. I’m not sure when or where he said it, but he also said something about it being damn hard doing nothing. So, make a purchase that ticks the boxes, then… Do nothing!
So when to sell then? I have turned to using mainly two rules for when to exit a position:
- When the facts change, or the case is no longer intact
- To move into a better investment opportunity
When I value a company I first try to get a “feel” for the company’s quality. After I have seen the margins, ROIC, growth, financial stability etc, I decide how much I am willing to pay for that quality. In order to do that, I consider my alternative cost. This probably could use a post of its own, but for now I’ll just state it. I use a broad cheap global index fund as my alternative cost. I try to answer the question: “Is this business ‘better’ or ‘worse’ than an index fund?”. In other words, do I think this company will outperform the index. The logic behind this is the simple fact that if I wouldn’t pick stocks, I would invest in some index fund. So that is what I’m trying to beat, and thus the companies I pick must be better and purchased cheaper.
This is not a very clear answer to the question of how to value a business, so here is the short answer: a business of high quality deserves a higher valuation than a business of lower quality. In practice, I usually put the multiple in relation to the growth rates and the ROIC, while taking the margins and level of debt into consideration.
Conclusion and Summary
Growth and quality (margins and returns) add a premium to the valuation. A “good enough” balance sheet is something we like, but does not necessarily increase the premium. If the balance sheet is very levered and risk is pushed all the way up, I would be careful, and might pass on the investment opportunity unless offered at a significant discount. On the contrary, a GREAT balance sheet is not something I would pay a premium for over a company with an OK balance sheet. I don’t know if I’m alone in thinking this, or if it is even justified. I just don’t care about the balance sheet as long as it is good enough so that its nothing I have to worry about.
To summarise my process:
- Determine the quality
- Determine a reasonable price
- Buy and DO NOTHING until the facts change