Magic Investment Formula
Principles for Investing in High-Quality Businesses
People often ask me for the formula to successful investing. In response I offer good news and bad news. There is no magic formula and no one gets it right all the time. But there is a process that will ensure that the odds are skewed in your favour. If you are right more than you are wrong, then that’s the winning combination.
Let me spell out what to look for and why.
Returns
Investing in high-quality businesses involves seeking those with a robust and lasting return on operating capital, preferably in cash.
Avoid cyclical revenues, for example the steel manufacturers, and lumpy revenues such as property development. These aren’t durable. They result in unpredictable cash flows which makes managing the operation difficult and sometimes precarious, which is why some of these types of businesses die during a downturn.
This also implies that one ought to favour staples over discretionary items. When consumers hit hard times, they can defer replacing their cars, houses and appliances, but not food and toiletries.
Invest in companies that earn a high return on their capital on an unleveraged basis. The companies may utilize leverage, but critically they don’t require borrowed money to function. These financially healthy companies are better equipped to weather credit shocks.
If you choose to invest in cyclicals, only buy them when they look expensive. This is because when they have little or no earnings, they are at or close to the bottom of the cycle. The converse applies - sell them when they look cheap, as they are then at peak earnings. This is difficult to achieve and so avoiding cyclicals is often the best policy.
It is all about Risk Adjusted Returns, which I covered here: Strategy Matters
Intangible Assets
Over the past century there has been a huge shift from tangible to intangible rich businesses.
Businesses with intangible assets, difficult to replicate and creating a wide moat, are especially valuable. These companies defy mean reversion, ensuring sustained super-normal returns. Notably, replicating such intangible assets through borrowed funds is challenging, as banks often prefer tangible collateral. Microsoft and Coca Cola are great examples.
Lenders seem to crave the often false sense of security from lending against tangible collateral, and so intangibles are not easy to finance with debt. This creates barriers to entry and so provides a better moat for incumbents, meaning that the return on intangible assets is likely to be higher. It also follows that intangibles are mostly funded with equity and so the business is less leveraged.
Intangible assets can also last indefinitely if they are well maintained by advertising, marketing, innovation and product development and the duration of an asset is an important factor in calculating long term real returns.
Tangible assets are reflected on a company's balance sheet, involving cash expenditure, liability assumption through debt, and subsequent placement of assets on the balance sheet. Only the depreciation charge, if applicable, affects the profit and loss account, potentially having no impact on cash flow post-purchase.
In contrast, intangible assets are predominantly created through expenditures reflected in both the profit and loss account and the cash flow statement.
This nuance results in intangible heavy businesses showing lower reported earnings (yielding higher earnings multiples), especially when compared to companies with substantial tangible asset bases. You can’t compare apples to oranges using these kinds of metrics, so don’t try.
Sometimes high earnings multiples are justified, just look at the track record of Amazon which continued to deliver shareholder returns despite analysts constantly claiming that its shares were overpriced.
Growth
Many investors make the mistake of pursuing growth at all costs.
Growth is only beneficial where the company is able to reinvest at least a portion of its excess cash flow back into the business while maintaining a high return on that reinvested cash. Over time, this should compound shareholders’ wealth by generating more than a dollar of stock market value for each dollar reinvested (the Warren Buffett test).
If increasing the capital in the business results in increased margins, perhaps due to a larger market share or economies of scale, then that is the kind of growth to invest in.
In all other circumstances growth is not necessarily a good thing.
First, if the incremental return on investment is less than the cost of capital being reinvested then growth erodes shareholder value. Many executives are bad at capital allocation and do just this. It should be a huge red flag for an investor. If these circumstances exist, constraining growth and focusing on enhancing returns augmented by a mitigation of costs must be the priority. But this is anathema to many, particularly in the tech sector where capital burn is eye-watering as they chase growth, literally at any cost.
Second, be aware of the source of growth. If it is coming from external factors such as enhanced revenue due to increasing prices in the market, then this may encourage more competition into the market which maybe detrimental in the long term. Consider the production of photo-voltaic cells when solar power arrived. The market became so saturated that there was insufficient meat on the bone to feed so many mouths. Short term growth became long term misery and the failure of many businesses.
Third, a company could double the number of its shareholders and use that capital injection to double its revenues to double its earnings without any additional benefit accruing to each share. As an investor, all else being equal, the company has created no additional shareholder value.
In summary, only if the cost of capital is less than the return on capital should the focus be on growth even if the cost of that growth results in negative short term earnings. Gaining a competitive advantage through scale is value accretive.
Resilience
A product like Coca Cola has been popular for over a century and may still be popular one hundred years from now. This has made it a great investment, particularly when its value comes from an intangible asset (the Coca Cola recipe) that requires no maintenance costs in terms of R&D. Having chosen not to patent the recipe, it remains a well guarded secret today which means that it will continue to produce value for years to come.
Innovation is often sought after by investors, and sometimes brings big rewards, Apple being a case in point, but many times it disappoints. Airlines have been a poor investment ever since the Wright brothers’ inaugural flight in 1903, having consumed way more capital than it has ever created. But many who witnessed the dawn of a new era threw money into aviation and lost it.
As Steve Jobs said, don’t focus on what will change in the next 10 years, invest in what is unlikely to change in the next decade.
Value
A good company at the wrong price is a bad investment. Those that invested in Microsoft at the turn of the century overpaid for its stock at the height of the dot-com boom. Despite constant growth in the years that followed, the share price under-performed the market because it had run too far ahead of the intrinsic value and so fifteen years of consolidation and shareholder misery followed.
I’ve covered this in much detail in the past, see: Price Matters
Free Cash Flow
Estimate the free cash flow of every company after tax and interest, but before dividends and other distributions, and after adding back any discretionary capital expenditure which is not needed to maintain the business. Otherwise we would penalize companies which invest in order to grow.
Invest only when free cash flow yield is high relative to long term interest rates and when compared with the free cash flow yields of other investment candidates both within and outside your portfolio. Your goal is to buy securities that you believe will grow and compound in value, which bonds cannot, at yields that are similar to or better than what you would pay for a bond.
Conclusion
While there is no definitive formula for identifying exceptional businesses, the correct process is the opposite to that deployed by most people. Instead of seeking a screener that highlights promising investment opportunities (no such thing exists), the key lies in identifying a screener that filters out subpar investments based on specified criteria. By effectively screening out 95% of listed companies, the remaining few emerge as worthy candidates deserving careful consideration for potential inclusion in your portfolio.
It’s all about deploying the better process.