Sediment Capital’s valuation for passive business owners – Jeffrey’s 8 item checklist

1.        Catastrophic Risk and durability of business model  (tell me where I will die and I won’t go there)

-Too much leverage? Easily disrupted space? How will it look a decade from now?

2.        Is this business understandable?   (Are first hand sources written to mislead and confuse?)

-Are there too many segments? Complicated conglomerate?

- Back of the envelope calculations (net quick, inventory, earnings)

3.        Competition, Cash conversion cycle, financial ratios, and industry specific metrics  (What didn’t kill us, just made us weaker)

-          Industry size, how many competitors?

-          efficiency relative to industry

4.        Tangible book value and capital employed to owner’s earnings on a long term basis

Tangible assets, working capital, debt relative to consistent cashflows/owner’s earnings, ROIC

5.        Ethical Management & Efficient Capital Allocators aligned with shareholder’s interests  

 (How can these people screw me over? Who is the pansy?)

-          Is management ethical? How do they deal with tough situations? Look at the lawsuits. Are there interested aligned with ours? Who are the owners? What do suppliers, customers, distributors, and customers say about them?

6.        Sustainable Competitive Advantages (barriers to entry, is first mover advantage relevant? How long will these advantages last?)

7.        Price Paid  (if you pay way too much for a good thing, it makes it bad)

-          Was there a margin of safety? How much growth is expected? Did I adjust the price for additional risk?

-          Inflection point?

8.        Opportunity Costs, concentrated portfolio and when to sell

(Murphy’s law "Anything that can go wrong will go wrong".)

-          What did I miss? Where are my blind spots? With limited diversification, are these industries too similar? Will they be hit by the same type of risk?

-          Friendships- How many true friends do you have? Friend you spend quality time with?

If you’re honest, only a handful.

-          Concentrated Portfolio- How many companies are relatively cheap with quality management that I truly understand? If you’re honest, only a handful, maybe less than 5.

“The information you have is not the information you want.

The information you want is not the information you need.

The information you need is not the information you can obtain.

The information you can obtain costs more than you want to pay”

– Peter Bernstein

When purchasing shares to become a partial, passive business owner, here are the things to look at:

1.     Catastrophic Risk- Will this business last? Will it be here a decade from now?

Is there catastrophic risk? Before thinking how we can succeed, think about how this can go wrong. How can we lose our investor’s money?

A decade from now, will this company still exist? Is there too much debt on the balance sheet? Will it be disrupted by another technology or government regulation? Most companies listed in the Fortune 500 don’t last a few decades. It is important to invert and think about what to avoid before digging deep.

In order to compound, we need a long runway. Cigar-butts are great, but long term compounders give us for more time to think instead of worrying about when to sell. We also pay less taxes and brokerage fees. A real owner of a public company would not go in and out of his holdings frequently, so why should you?

2.     Is this business understandable? Are there too many parts?

Some businesses are understandable but are conglomerates or require a sum of parts analysis. While conglomerates may be underpriced due to unaccounted real estate, etc. additional analysis may make you conclude it is undervalued.

However, conglomerates are sometimes flawed in my view. Why? They lack focus. I talked to a Chinese State Owned Enterprise which helps different countries with power generation through coal, nuclear, hydro-electric, etc. They said General Electric has proprietary technology in steam turbines which is hard to replicate. This is an advantage an America corporation has over other countries. Yet GE is in a mess now and can’t capitalize on this situation because they’ve spread themselves too thin with too many unnecessary projects.

In a conglomerate, even if you have enough capital and funding, your focus is always diverted and management can’t concentrate all human resources on winning the important battles. You can’t answer in a concise manner to your customers the simple question, “what the hell do you do?”

If you fight too many battles you can’t win the war. You have to pick your battles wisely. Some industries are winner take all. If you can’t gain a reasonable market share, you should leave.

What did Steve Jobs do when he returned to Apple? He had to cut out important projects that were interesting but not crucial and reduce the number of products, whether software or hardware, from hundreds to a dozen. When his favorite singer, Paul McCartney of the Beatles asked him what was he most proud of? He said it was the things he decided not to do. As Steve use to say, “People think focus means saying yes to the thing you’ve got to focus on. But that’s not what it means at all. It means saying no to the hundred other good ideas that there are. You have to pick carefully. I’m actually as proud of the things we haven’t done as the things I have done. Innovation is saying ‘no’ to 1,000 things.”

Having 2 or 3 complementary businesses in one holding is mildly acceptable; anything more than that is convoluted. If a business is overly complicated or misleading, it is best to stop reading and look for the next investment opportunity.

3.     What is the industry like? What are the important metrics? Who are the competitors? How big is the entire industry?

For example, in retail, you would like to know the comparable store sales, the terms for rent, whether it is NNN, etc. For manufacturing, you would like to know the utilization rates, cost of each factory, product quality, etc. For insurance, the combined ratio, for banking, the capital adequacy, etc.

Then you want to compare these metrics and with the competitors by reading their annual reports. You’ll quickly see who the leader in the industry is. Sometimes the leader is overpriced. This is where patience and temperament comes in. Don’t buy it until it is the right price. If there’s a temporary blimp or bad news, swing for the fences.

4.     Are the assets inflated/fabricated? What is the capital employed/tangible book value? How can this business be more efficient compared to its peers? What is the capital employed? What is the return on capital? Is cash flow stable over the next few years? If not, when?

Double check if the quick assets were real, what percentage is in cash? Which assets can be liquidated? How much you could reduce the inventory and increase the turnover, and how much you could increase the earnings (or cash flows)?

Check how days payable, inventory and days receivable compare relative to peers.

For capital employed, think in terms of an owner—which is working capital and tangible fixed assets used to generate owner’s earning. Are there hidden assets or real estate which is undervalued? What comprises tangible book value?

Then think about the amount of leveraged used to generate the operating cash flows each year. Once you find out if the company can sustain its return on capital and if it is high, what the company did to accrue these advantages and what it could do to lose it?

What is the capitalization? If it is debt free and does not require capital markets, why is the company issuing more shares?

5.     Is management ethical? Are they aligned with shareholders? Is there a long enough financial track record?

Is it family owned? How much do they own? Who has the controlling vote? Does management have a stake? What are the related party transactions?

Management leaves a paper trail- dig deep into the lawsuits and news articles and employee reviews. How do they deal with things in time of a crisis?

You want management to be good capital allocators who don’t make too many acquisitions and reinvest retained earnings in projects which will create value.

When you go through the entire due diligence process of analyzing a company, you will come to the conclusion that companies which have been listed for 5 years or less won’t give you the necessary history to know about how it deals with mishaps, recessions, or bad fortune, and how the company evolved financially and culturally over time.

6.     Durable Competitive Advantage

Low-cost Provider

-          Economies of Scale (Amazon, Costco, GEICO)

-          disadvantages

Pricing Power

-          Brands(America Express, Coke, Apple, Nike)

-          Product Differentiation

-          Patents, trademarks, etc.

Barriers to Entry

-          Government Regulated (Duke Energy, Waste Management, Shell Gasoline)

-          Network Effects (Facebook, Ebay, Priceline)

o    First mover advantages vs. certain situational disadvantages

-          High Switching Costs (Oracle, SAP, IBM)

-          Distribution (Wal-Mart, Kraft, Gillette)

Low Cost Provider

Economies of scale and efficient operations keeps competition out by being the low cost provider. This can be a significant barrier to entry and can build brand loyalty, as demonstrated by Amazon Prime, which has a huge competitive advantage. Scale over competitors helps drive down costs and pricing, given leverage with purchasing (Walmart), volume production (Samsung), marketing (Coca-Cola), fixed costs (Costco), and partners (AT&T).

Commodity products lacking differentiation such as iron, steel, plastics, rely on lower pricing to gain more customers. In the long term, this strategy may hurt profit margins of the company, especially if there is a rise in raw material prices or operating expenses.

Sometimes as a shareholder you have to worry about a new breakthrough which brings prices further down. Does this new manufacturing technology benefit the customer, or the owner? The manufacturer or shareholder may not benefit if every competitor buys it.

Pricing Power

A company that can increase prices without losing on volume has pricing power. Companies that have pricing power are usually taking advantage of high barriers to entry or have earned a dominant position in their market. Pricing power is created through patents, a strong brand, or product differentiation.

Brands

Strong brands ensure a certain quality from its reputation such as Disney, Apple, Nike, etc. This creates a goodwill with a customer in which a premium can be charged for a product. It takes a large investment in time and marketing costs to build a brand and very little to destroy it. A good brand is invaluable because it causes customers to prefer the brand over competitors such as Coke.

Luxury Brands

For luxury brands, the higher the price charged the more perceived value and quality of the product.

Product Differentiation

A unique product or niche builds customer loyalty and is less likely to lose market share to a competitor than an advantage based on cost. The quality, number of models, flexibility in ordering (i.e. custom orders), and customer service are all aspects that can positively differentiate a product or service.

Companies (such as fast moving consumer goods, food processing, and service based business) that create durable competitive advantage based on product differentiation successfully create better moat, and cause discerning buyers to pay more for a better solution.

The resulting brand name virtually locks up the customer base or niche market for the product or service for the foreseeable future. If the customers have no other source to turn to for a product, technology, or service that has a high demand, then that guarantees a large amount of sales until someone manages to penetrate their market.

Strategic assets- Intellectual Property, contracts, etc. 

Patents, trademarks, copyrights, domain names, and long term contracts would be examples of strategic assets that provide sustainable competitive advantages.

Companies with excellent research and development might have valuable strategic assets (i.e. International Business Machines (IBM).

Take the National Cash Register—John Patterson was struggling to make money in retail due to employee theft. When the cash register was invented, Patterson started making money. Being the shrewd man that he is, he went into the cash register business instead—he bought all the patents, hired the best salesman, and had a monopoly. In fact, one of his employees, a former Piano salesman, T.J Watson, started IBM after he left the National Cash Register.

Proprietary Information

In the form of knowledge (Glaxo Smith drug research), process (Tesla battery manufacturing) customer data and preferences (Amazon), and many other types.

 Location 

In the form of prime physical locations for the given customer segments (Starbucks) or the sheer number of locations (7 Eleven). If you are a property developer, winning a prime location or building a mall with a lot of traffic is an advantage. Exhibition centers, stores, malls, and various segments all benefit from good location.

Barriers to Entry

Cost advantages of an existing company over a new company is the most common barrier to entry. High investment costs (i.e. AT&T (T)) and government regulations are common impediments to companies trying to enter new markets. High barriers to entry sometimes create monopolies or near monopolies (i.e. utility companies).

Locked-up Supply 

When there are few to no other alternatives in the supply of product or service (DeBeers Diamonds).

Innovation- First Mover Advantage and Disadvantage

The first mover advantage may generate network effects afterwards such as smart phone operating systems like android and IOS where developers continue to support it with new software, making hardware suppliers reluctantly compliant to popular operating system. The network effect is so pervasive that it becomes winner takes all. Now there are only two operating systems for smart phones. This is the same for Facebook, Ebay, etc.

In other situations, you would want to wait for the startup to make the mistakes and copy their business model later as an incumbent.

Innovation based on constant uniqueness and novel use of technology (Google) and design (Dyson). Google wasn’t the first company to create the search engine, and Apple was not the first company attempting to create a smart phone.

Sometimes it pays off to be the first, other times, it is best to copy later after opponents have had a few iterations. This reminds me of the non-transitive dice Warren Buffett plays with his friends and guests. He asks his guests to choose a set of dice first. There are 3 sets with different colors. Each cancels out each other like rock paper scissors. Once your opponent picks first, rolling the other colors in succession will guarantee a victory.  

R & D /Talent

To illustrate, patents filed by pharmaceutical companies provide exclusive right to the company to manufacture the product for a specific period of time. However, this requires research and development, which requires talented people and facilities. Talented people can be hired away from other companies. Research and Development expense may be futile, since drugs still have to pass through 3 stages of clinical trials and various approvals. Should all of these go through, drug companies have the ability to mark up a ridiculous amount on their product. Not all Research and Development costs will materialize into an actual, profitable product, and uncertainty creates risk for owners.

Distribution Network:

Companies with strong distribution network allows them to penetrate deeper in the market and successfully cater to larger customer base, adding more sales and profit. In India and China, some companies deliberately target their new product to tier 2 and tier 3 cities, which is easier to penetrate. In China, Pepsi got into Disneyland instead of Coke due to their connections and shareholding with Chinese soft drink distributor TingYi.

Switching cost:

Switching cost refers to how difficult it is for a customer to switch to its competitor, despite lower prices or other perks. To illustrate, Apple has created an ecosystem which locks you in. If you are an Apple I-phone user, switching to an android may be difficult as you have to reload or copy all the apps, contacts, and other data from I-phone to android, and some of the files may not be compatible with the new operating system.

Government regulated

Electric utilities and steel factories all require government permits and are limited in number. Some countries have a limited number of quarries for producing cement. The limitation in government licenses restricts supply and creates pricing power.

Strong Balance Sheet / Cash

Companies with low debt and/or lots of cash have the flexibility to make opportunity investments and never have a problem with access to working capital, liquidity, or solvency (i.e Nike (NKE). The balance sheet is the foundation of the company. Banks and insurance companies usually expand abroad by buying up struggling financial firms with existing clients and assets.

7.      Is this business reasonably priced?

Thinking in terms of share price is wrong since there are stock splits, etc. Thinking in terms of market cap and enterprise value (marketcap + debt – cash) is the right way to go. But sometimes I like to add the debt and only subtract a portion of the cash. You never know if management will actually employ all of the cash via buybacks, dividends, or reinvest it back into the business.

Measuring the market cap or enterprise value to operating earnings or owners earnings which can be sustainable for the next five years is a better approach.

Looking at owner’s earnings or free cash flow recently to the market cap or price you pay is myopic or short-sighted, since cash-flow may not be abundant now due to a wise investment deployed on resources which will generate more cash in the future. Capital expenditures wisely invested in may distort cash-flow temporarily and make you feel that the multiple is too high, when in the long run, it will reward owners.

“If a business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital employed over 20 to 30 years, even if you pay an expensive looking price, you’ll end up with a fine result” – Charlie Munger

In the example above, if you hold the same company with the same earnings but purchase one at 20x earnings at an ROIC of 25% with all earnings reinvested, versus paying a cheaper company at 10 times earnings with only 50% of earnings reinvested at a rate of 10%, you will see that in 5 years, the first company gave you a 48% IRR, while the second company only gave you a 25% IRR.

In the long run, consistent return on invested capital (which takes debt into account) may play a bigger factor than a small premium paid on price. Should you choose between 2 similar companies in the same industry, one with a higher and consistent ROIC, but priced slightly more expensive and one with a lower price, but inconsistent and lower ROIC, you should, in general, pick the better business. When I mean priced slightly higher, I mean multiples of 8x to 15x. If you pay something like 35x to 100x earnings, you will surely get a bad result.

Looking at the table above, the company on the left was purchased at 20x, while the company on the right was purchased at 5x. Because of the price difference, despite superior management with great capital allocation skills, the price negates this performance.

Another point is the inflection point. While I believe that no one can truly time the market, there is a time when a company accrues enough significant advantages to warrant an inflection point. Li Lu of Himalaya capital bought the Chinese liquor company MaoTai when it was starting to accrue advantages from a mishap of a competitor, WuLiangYe when they had pricing and marketing errors. MaoTai also started to entrench themselves by selling to key political figures and influential figures, thus raising the status of the brand and commanding pricing power. Li Lu bought at an opportunistic time and all he had to do was hold on.

8.      A concentrated Portfolio- Everything is life is weighed in terms of opportunity costs.

If you only had 3 girls to choose from –Betty is stunning and a beauty pageant winner, but she has a terrible personality. Jenny is homely, has a good personality, but is 20 years older than you. Finally, Carol understands you, is willing to help you with your family and occasionally your business, is average looking, but has many positive traits. She is a few years younger than you. She fits like a glove.

I don’t think it takes a genius for you to choose the right girl. Over diversifying would be choosing them all and making them your mistresses. A cigar-butt would be choosing the beauty pageant winner for a short term fling. There are only so many spouses who will fit your specific requirements, and if you can’t find her, you sit on your ass and wait. Otherwise you don’t marry. This is true for investing as it is for life. It is as simple as that. As Thomas Jefferson said something along the lines of, “better to be single than in bad company.”

Having looked at these five points, inevitably there are few choices in the market which offers such a great opportunity. But why should there be? Bettors who win don’t bet frequently, and when the odds are in your favor, you bet heavily. Therefore, you always end up with a concentrated portfolio of less than 8 stocks.

If you truly know your company inside out, you won’t sell at the wrong time and will buy more. Once you research a new company and find that it can replace your weakest holding in your portfolio, you will naturally swap it out. Ideally, the companies should not be in the same field so the risks won’t be correlated.

Also, always choose the safer, more probable bet for the bulk of the portfolio. As long as you mitigate the losers— compounding will ensure you will become rich. Don’t add too much of situations where it is— high risk high return.