What is the Rational Process Investing?

We’ve mentioned thus far that you need to do your homework on the stocks you plan on investing in. How exactly are you supposed to do this? What are some of the things you need to look for when analyzing a company and its business? This module is going to introduce you to our process of analyzing a stock’s prospects.

The Warren Buffett Test

The Warren Buffett test isn’t a single criterion. The aim here is to follow the simple principles that Buffett talks about when he mentions his investment criteria. A regular statement he has often made is that he looks for companies that are run by great management teams.

This means that he values integrity and honesty in them, aside from competence. Adherence to expanding the company’s bottom line and giving shareholders the highest possible return for their investment needs to be their top priority (LaRoche, 2019). While he does aim to buy entire businesses, he’s perfectly happy to own a percentage of a good business as well.

This is because a good business is one of the best assets a person can own. A company that is regularly expanding its bottom-line earnings and is growing them at a certain rate like clockwork is hard to find. Therefore, selling it doesn’t make sense. Your aim should be the same.

These kinds of companies do not sell for cheap, though. The market is aware of how good they are, and as a result, you’re unlikely to find the stock selling for a 60% discount from its value. Buffett instead focuses on finding great companies and paying a fair price for them instead of finding average companies at great prices.

The average company will have to be sold at some point since its earnings are unlikely to grow forever (which is what makes it average after all). This means Buffett needs to find better investments and keep searching constantly. By buying a great business, he gets to work once and earn profits forever. This doesn’t mean he never sells. It’s just that his mindset upon entry is to ask whether he wants to hold onto the business forever.

By doing this, he automatically screens for great companies, not mediocre ones.

Understand the Business

We talked about briefly in module 3 regarding buying stocks in business you the products of. This is a great starting point for your research, but you need to truly understand the business before you invest in it.

If you decide to buy Walmart stock, make sure you understand the ins and outs of Walmart’s business. Can you explain what Walmart does in 30 words or less? Alternatively, could you explain your rationale to a 10 year-old so that she would understand? If not, you probably don’t understand it well enough.

For example, you might think you know all about a movie streaming company’s operations (like Netflix) simply because you have a Netflix account. But if you don’t know basic numbers like how many new subscribers they are adding per quarter, or what percentage of their revenue they need to reinvest into content creation, then you shouldn’t buy shares until you do know these numbers. The good news is, they’re easier to find than you think.

We’ve not saying Netflix is a good or bad investment at this time. But our point is that many Netflix investors don’t understand how the company works, and more importantly, where it plans to make its money in the next 5-10 years.

It’s also important to make distinctions between the surface level business the company is in, and their bottom line profits. For example, McDonald’s might be a “fast food company,” but the real money is made in its real estate business and franchise model. The fast food business is just a catalyst for this. While ensuring that food gets made quickly and on time is a priority, this is not what really drives the company’s profits.

McDonald’s owns the real estate on which all its restaurants are built. The company then turns around and leases them to its franchisees and charges them rent that is well above market price. They can do this because the McDonald’s brand is so strong, meaning franchisees are willing to pay a premium on rent. One estimate placed rental costs at 22% of gross profits per year from a franchisee’s perspective (Daszkowski, 2019). This gives the company a significant cushion to weather tough business conditions.

If sales do decline, the company still owns all of its locations, and it doesn’t have to worry about not paying rent. It can repurpose its locations with ease and create new revenue streams. This is a significant advantage in the fast food business.

Another example of a business that is in seemingly another line of business is Starbucks. On the surface, the company is a coffee chain, but really, it’s in the third space business. What Starbucks is selling is not coffee, instead, it’s a place you can spend time that isn’t your home or office. It is the place where people meet one another for informal meetings, to catch up, go on dates. It is a convenient place to work from as well given the rising number of remote workers. Sure, the coffee prices are high and this is something that detractors point out over and over. However, people still frequent the chain, and it clearly is not a detriment to the business. Many Starbucks naysayers will laugh at the idea of paying $5 for a cup of coffee, but if their customer base thought this way, they would have gone bankrupt in the 1980s.

Differentiating between sector and company

A common problem with new investors is they buy into the hype of shiny new industries. In the past few years, we’ve seen Marijuana, CBD, sports betting, biotech, 5G, and other “hot sectors” have their days in the sun and become the ‘cool’ industries to jump into. It’s not uncommon to meet a new investor with 60% of their portfolio or more in one of these sectors.

In the image on the next page, you’ll see a visual representation of how most investors think about new industries. They only take 1st order consequences into account. These are often already accounted for in a company’s share price. But if you can identify the 2nd and 3rd order consequences of any decision, then you will be able to find undervalued companies with huge potential.

It’s essential to make a distinction between sector growth and company growth. Just because 5G will be a big sector in the next 5-10 years, does not mean every company with 5G exposure will be a good investment.

A growing sector is a good place to start your research, but it’s not a good place to end it.

Like we’ve said previously, for many average investors, the best place for them to start is the sector or industry they work in. Even if the 5G or Marijuana industries appear sexier than the industry you work in, you probably don’t understand them nearly as well.

CEO/Founder Syndrome

Many companies that have their founders still in place as the CEO tend to be safer investments because founders understand their businesses a lot better than outside CEOs do.

The example of technology companies is a good case in point. Almost all of them are run by their founders and all of them operate in extremely competitive environments. While Apple has been an exception, the fate of Microsoft is an excellent example of how the lack of a founder at the helm leaves a company vulnerable in a changing and dynamic industry.

Even Apple would not have grown to its current size without the leadership of Steve Jobs. The company’s fate in the years when he was ousted (before his return) provides a good example of the dangers of externally hired CEOs running the company.

On the flip side, is there a point where the founder has outstayed his welcome. At the time of writing, there is a legitimate debate about whether the fate of Tesla would be better if Elon Musk stepped down as CEO. We saw a similar trend when WeWork was completing their IPO in late 2019. CEO and Co-Founder Adam Neumann was forced to resign after inappropriate behavior and an ongoing legal battle where he trademarked the word “We” and forced the company to repurchase it from him for a cool $5.9 million.

Intangible Assets

Also known as “what you won’t find on the balance sheet”. A company has two types of assets: Tangible and intangible. A building or a factory is a tangible asset, as are the goods that the company produces. Intangible assets are a bit trickier to nail down. For example, Coca-Cola has one of the biggest intangible assets in the world: Its trademark.

The phrase “Coca-Cola” is recognizable all around the world. If we were to pour Coca-Cola into another bottle and call it “Freeman Cola,” would you drink it? Even if it tastes the same as Coca-Cola, you’ll be unlikely to switch your preference to the new drink. This is the power of an intangible asset.

Ferrari is another company that has a similar pull. Swap the badge on a Ferrari with anything else, and people will suddenly want to pay far less for it, even if it is in the right shade of scarlet. The best companies have some form of intangible assets that work for them. This could be a brand name, a patent, or a process that gives them a competitive advantage in the marketplace.

Management quality is also a key intangible asset. For example, Apple under Steve Jobs had one of the biggest intangible assets that could not be quantified on their financial statement. Their asset was Jobs himself. Disney is another example of a company that has significant intangible assets in the form of intellectual property.

Management Quality

It isn’t easy to evaluate the quality of management. Most shareholders look at the stock price and then reverse engineer whether management is any good. This is a bit like looking at the quality of windows in a house and trying to figure out whether it’s a good investment. There’s a lot more to it than just that!

One of the biggest qualities you need to look for in management is its ability to adapt. For example, Kodak was one of the biggest companies in the photography space thanks to its development of the film. When the digital revolution came, it doubled down on film and is now just an afterthought.

The development of the smartphone, in turn, left many digital camera producing companies in the dust. Some pivoted successfully to making high-end cameras for professionals (Canon, GoPro) while others never quite made the leap (Vivitar). It often comes down to honesty.

Honesty in communications is one half of this. How willing is management to disclose the business conditions to shareholders in their reports? Are they willing to admit faults and mistakes? Do they frankly discuss the upcoming headwinds for the business? Another part of honesty is management’s ability to stop themselves from drinking their own Kool-Aid.

The Management’s Discussion and Analysis (MD&A) section of the company’s financial reports provides a good read on how honest management is. Reading prior reports and looking at how management evaluated the business environment at the time is a good way to get a handle on how they tend to communicate and view conditions. An excellent example of this was Jeff Bezos’ letters to shareholders when Amazon was still a fledging company. Bezos constantly reiterated his vision for the business and did not focus on minutia like whether they hit a Wall Street analyst’s earnings estimates. This is the kind of long-term thinking you want to see from management.

We saw a similar situation with Mark Zuckerberg’s actions around 2012. Zuck does get a lot of hate but an undeniable fact is that he knows his business inside and out. Following the release of the iPhone and mobile computing, Facebook remained buried in the desktop era and risked obsolescence. He didn’t mince words when he announced that Facebook needed to switch to mobile from desktop because the company was facing extinction (Wagner, 2019).

His foray into getting a Facebook phone manufactured failed, but his other efforts paid off, and Facebook is now firmly established as a giant.

On the flip side, we have examples of CEOs believing their own hype. While it wasn’t a public company, the saga of Theranos’ Elizabeth Holmes is instructive. While she has a considerable list of faults, almost all of her conduct stems from the fact that she was unable to be honest with herself about what the company could deliver in a reasonable timeline.

Sales and Marketing

These divisions of the company are the lifeblood of the organizations. Not all of us might like salespeople, but their efforts go a long way towards ensuring the company makes a profit. The organization of a company’s marketing efforts provides good insight into how careful the management is when it comes to deciding on the company’s future.

Consider the fact that Facebook still runs ads for itself, and Google still publishes direct mail pamphlets to get businesses to advertise with them. These efforts show that the management is not complacent despite occupying a premier position in their industries.

Coca-Cola is another example of this. They have one of the strongest intangible assets in the world and yet, they feel the need to advertise themselves. Looking at the turnover and quality of managers in charge of sales and marketing is a good way to gauge how much the company values this part of the business.

One important element of this principle is knowing which numbers matter the most to a company’s bottom line. For example, many Software-as-a-Service businesses have a tremendous amount of free users (who cost the business money in server fees). Still, they have a difficult time converting these free users into paying customers.

So when reading a company’s annual or quarterly report, focus on figures such as the number of paying customers or average customer purchase value. Rather than relying on misleading numbers like “total users” or “monthly average users.” These are often used by unprofitable companies to make their prospects look more attractive than they are.

Another essential element of this principle is that a company’s income is not reliant on a single factor. For example, if a semiconductor manufacturer relies on a contract with Apple for 80% of its revenue, then Apple ending that contract would plunge the economics of that business into disarray. This is exactly what happened with the UK firm Imagination Technologies. It had a contract with Apple to provide graphics processors for the iPhone. This single contract accounted for 45 percent of the company’s total revenue. After Apple ended the agreement, the stock took a huge hit and was down 71% from its peak.

As we explained in the previous module as to why diversification is important as an investor, the same applies to the businesses you invest in. Don’t buy businesses that are overexposed to a single economic factor.

Long Term Focus

You’re investing for the long term and therefore you want to invest in companies that align with that focus. It isn’t easy running a public corporation. There’s constant media pressure and analyst’s opinions that shift the focus from long term health to short term profits.

A typical scenario that often occurs with companies is this. The CEO decides to allocate capital towards a project that will ensure long term competitiveness. Doing this requires significant cash, and they increase the company’s short term debt burden. This has the effects of reducing earnings during that quarter.

Wall Street immediately reacts and begins questioning their motives. Will the long term project really work? Will the company be able to sustain the short term earnings projections? Earnings projections are figments of analysts’ imaginations that they expect companies to adhere to. If the company doesn’t meet this standard, a wave of selling begins, and the stock price gets depressed.

This, in turn, enrages shareholders who begin to think that the analysts were right after all. A good manager knows how to manage both sides of the equation. Short term projections need to be hit, and long term projects need to be prioritized as well.

Bill Gates was a good example of this back when he ran Microsoft in the 1990s. The company always magically hit analysts’ projections and still managed to drive competitors like Apple out of the market at that time.

It isn’t an easy job, but that’s why the CEO gets paid what they do. Someone obsessed with short term prospects and worried about the damage it will cause their reputation is unlikely to produce long term growth at the company.

Economic Moat

This is a term Warren Buffett uses frequently when speaking of what he looks for in businesses to invest in. Internally, when one of our team brings up a new company to research, our first question is often, “where’s the moat?”.

An economic moat is some condition that gives a company a significant competitive advantage. It could be anything from size, to trademarks and patents, or a business process.

For example, Amazon’s size offers it a considerable economic moat. The company offers customers bargain-basement level prices, and it’s able to do this thanks to its sheer size. Its average cost per unit is far lower than what a smaller retailer can offer, and thus, Amazon can afford to earn a small percentage of profit, but it sells so much of it that the amount of profit it earns is high.

Coca-Cola has a strong economic moat through its brand name. Everyone recognizes it and everyone buys it because of that. Interestingly, both Amazon and Coca-Cola are owned by Berkshire Hathaway, Buffett’s investment vehicle.

Another factor that can create a moat is a large number of users. For example, Google and Facebook are popular thanks to the large number of users they have. This is an example of a moat caused by the network effect. This happens when companies build a significant userbase, which provides a better customer experience, which then leads to an even higher userbase.

Facebook is the perfect example of this. There comes a tipping point in many people’s lives where not being on Facebook is more detrimental to their quality of life than being on it. Take for example a woman in her early 60s. For a long time, she considered herself technophobic and avoided social media as a result. However, she has just become a grandmother for the first time, and her daughter has explained that the best way to get pictures of her new grandson is to use Facebook. She then realizes many of her friends are on the platform as well, so she encourages her other friends who don’t yet use the platform, to sign-up. All of this creates a better user experience for the people on the platform and fuels more growth. We see similar examples in the workspace communication space with companies like Slack and Zoom.

Customer acquisition processes can also create a moat. There is no end to what exactly can create an economic moat. All that matters is that the company has one.

One trap new investors full into is mistaking pioneering for a moat. What we mean is this: people assume that being first gives a company a significant competitive advantage. This really isn’t true. Does anyone remember Altavista or Orkut? You likely have no idea what those names are. Altavista was a popular search engine that existed before Yahoo search did (remember when Yahoo, not Google was the search king?) As for Orkut, this might shock you, but Google was one of the first companies to build a social media platform and it was years ahead of Facebook. However, the site was shut down in 2014 after it lost market share to other platforms.

You might point to Amazon as a counter-example of this, but even Jeff Bezos’ company was not a pioneer. Book Stacks Unlimited came a full three years before Amazon’s original avatar of an online bookseller. Our point is that pioneers are the ones that deal with all the obstacles and inefficiencies only for the newcomers to take advantage of the processes that have been built. This results in them growing faster and eventually obliterating the pioneer.

Weathering Storms

How robust is a company’s business model? Can it withstand a stress test? Stress tests are scenarios where analysts project profitability numbers based on the assumption of adverse conditions. For example, a hotel chain is unlikely to survive an 80% vacancy rate for too long before things get ugly. Airlines are also notorious for their inability to handle the slightest disruption to their business conditions.

For every business, a standard stress test is a reduction in sales. The higher the business’s ability to withstand this stress, the safer your investment will be. Another example of a stress test is multiple Acts of God in quick succession for the insurance industry.

This is why recessions destroy companies who are built solely on debt, whereas companies who maintain healthy cash reserves (like Berkshire Hathaway) can ride the wave through to the other side.

Read Books to Learn The Right Investment Mindset

A large part of successful investing is about Mindset. So I read many mindset books.

Recently, I read Rich Dad Poor Dad and found it quite interesting.

Through autobiography and personal experience, Rich Dad Poor Dad explores the steps to becoming financially independent and wealthy. 

The writing style and framework of this book are narratives. This book focuses primarily on anecdotes with nuggets of supposed wisdom, not technical insight or investment math.

He compares the lessons he learned from his biological father (an intelligent, but financially inept father) with the lessons that he learned from his friend’s father (an uneducated, but smart and wealthy father).

It weaves through Kiyosaki’s life as he learns from his rich father and rejects advice from his poor father (thereby eclipsing typical working-class mindsets).

Some of the concepts in this book are, however, questionable. Read my Rich Dad Poor Dad review to learn more about my insights about the book.

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