Quality Investing: Owning the best companies for the long term – Lawrence A. Cunningham , Torkell T. Eide, Patrick Hargreaves

I recently read the absolutely wonderful book which is jam-packed with many insights and nuggets of wisdom on investing in quality companies. It definitely deserves a place on every serious investor’s bookshelf. It’s not that the concepts are groundbreaking but they are clearly articulated and weaved together in a manner that provides further food for thought. Reading the book provides a timely reminder of what it means to be picking exceptional companies.

However, I also recognise that buying great businesses that are clearly understood is insufficient. To make the big money, one has to find the businesses as they are building their moats rather than after, when their moats are fully established and mature. An example would be investing in Microsoft when Bill Gates was at the helm in the early years, rather than when the competitive strengths are well recognised after Steve Ballmer took over. It is of course easier said than done. That is precisely why I think the book is essential reading to help recognise the type of companies a portfolio should hold while the underlying businesses compound their way nirvana.

In this entry, I’ll highlight 7 key points in the book which I thought stood out the most for me.

On 3 key factors necessary for a business to generate great returns
“In our view, three characteristics indicate quality. These are strong, predictable cash generation; sustainably high returns on capital; and attractive growth opportunities. Each of these financial traits is attractive in its own right, but combined, they are particularly powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can be reinvested again.” (pg 2)

High ROCs by themselves will not generate great returns for long
“It is relatively easy to identify a company that generates high returns on capital or which has delivered strong historical growth — there are plenty of screening tools which make this possible. The more challenging analytical endeavor is assessing the characteristics that combine to enable and sustain these appealing financial outputs.” (pg 3)

Clues of competitive advantage from analysing gross margins
“Gross profit margin demonstrates competitive advantage: it is the purest expression of customer valuation of a product, clearly implying the premium buyers assign to a seller for having fashioned raw materials into a finished item and branding it… Gross profit margin demonstrates competitive advantage: it is the purest expression of customer valuation of a product, clearly implying the premium buyers assign to a seller for having fashioned raw materials into a finished item and branding it.” (pg 21)

Presence of older players signs of a less competitive industry
“Observing many older players in the industry is also encouraging – it’s a sign that long-term survival is possible.” (pg 39)

Companies selling products that go into the mouth or skin may be potential gold mines
“Intangible benefits often matter more to customers the more intimate the products are. Products that go in the mouth or on the skin carry more intangible potential than those that sit on a table or go into a machine, explaining why most people give the cost of their preferred toothpaste less thought than the price and brand of dishwasher detergent. This is one of the reasons why certain consumer products companies, from edibles to cosmetics, have proven to be such strong businesses over time.” (pg 45)

Why businesses aiming to sell to customers’ capex requirements are more vulnerable
“A business that is solely linked to customers’ capital expenditure makes for a much more complicated investment than one linked to their operating costs. In most cyclical industries, capital equipment is purchased amid periods of capacity expansion… On the other hand, for a company whose profits tie to customers’ operating costs, cyclicality poses less risk of disruption and remains relatively predictable.” (pg 28)

Learning from our own and others’ mistakes
“If smart people learn from their own mistakes while wise people learn from the mistakes of others, the goal is to be both smart and wise. The best thing to do after making or observing a mistake is to acknowledge it and absorb the relevant lessons to avoid repeating it.” (pg 158)

Progress of watchlist

The reconstruction of the watchlist in its new iteration should be pretty near completion. It is likely to be ready in a week plus. I have been spending about an hour each day to tweak the spreadsheet to automate it as much as possible, in a bid to mitigate the risks of the same fatigue and difficulties in referencing cells when I had to make changes in the past. These issues of unwieldiness and the sheer number of variables I had to enter in the past led the old watchlists to flounder after some time. The new watchlist tab will look fairly simple. It’s just the formulae that goes into the tab’s cells and other sheets that will go into longer lines.

In this version, even after reducing the variables, I hope to reduce it even further so that just the essential metrics are required. After all, the watchlist should serve as a quick reference panel to check for updates on whether a previously researched company is ripe for taking a position, rather than the watchlist being a full blown financial model.

During the course of the exercise, I had to make use of a number of spreadsheet functions I haven’t used in some time such as INDEX, MATCH, INDIRECT, TRIM, LEN. New ones such as CODE, CHAR, CONCATENATE and Array Formula had to be utilised. I’ve never been much of a hard core Excel monkey but it was still fun to revisit and build a fully functioning spreadsheet.

Once the watchlist that is built on Google Spreadsheet is able to see the light of day, I’ll likely be ‘publishing’ it as a page on the journal. This will serve as an easy reference for myself wherever I am.

Picks and shovels in Virtual Reality (VR) and other industries

Just the other day, I was at a friend’s place trying out his new big-boy-toy, the HTC Vive. For the uninitiated, it’s one of the hottest gadgets in the market currently to get the VR experience. I’ve tried the Samsung Gear which I thought was pretty cool. But the HTC Vive, a collaboration between the Valve – the gaming giant – and HTC – an ailing mobile phone maker – is unlike anything I have experienced before.

Blown away by VR
I shan’t go into the details of how the gaming experience on the device blew my mind. There are plenty of online videos and reviews for that. What I can say is that experience set me thinking about how VR seems likely to be the next big thing and can truly be transformative in terms of how we communicate with each other through games, videos, etc. More importantly and in direct relation to investing, is whether there are any potential investment opportunities in identifying which VR gear maker is going to come out on top. There are plenty of competition in the market. We have Oculus, HTC, Sony, Microsoft and plenty of others vying for a slice of the pie. Trying to pin down exactly which company is ultimately going to be the winner in the race to reign supreme in VR is tough, especially since the technology evolves very quickly. This almost guarantees obsolescence for those who are one step behind.

Asking the correct question
While in the midst of going through HTC’s financials (not exactly pretty given that revenue is in freefall) and cracking my head trying to solve the puzzle, I had a realisation that I was asking the wrong question. It wasn’t about who was going to win the VR gear race.

The correct question was – who is going to win no matter who wins the VR gear race? The inspiration came from the old investing story of the San Francisco gold rush of the mid-1800s. While a handful found fame and fortune, most miners failed had to head home with nothing more than rocks after failing in the quest to find gold. The ones that truly and consistently made money by the buckets were those who sold ‘picks and shovels’. In other words, those who sold tools to help others chase their pot of gold (pun intended) were the ones who ended up rich. Levi’s, the eponymous jeans maker, was one of the vestiges of the era. By selling rugged and durable jeans that were able to withstand the tough environment to gold miners, Levi’s made its own pot of gold.

Finding value in value chains
By the same token and in modern parlance, analysing the value chain of an industry can be a fruitful exercise, even though the economics of the main industry itself is in the dumps. In the field of VR, I came to the conclusion that the business selling modern-day picks and shovels were the graphic card makers. In this case, the largest maker is none other than Nvidia. VR gears require the vast processing power of a dedicated graphics card and the gear is required to be hooked up onto a rig which has the graphics card. Between Nvidia and it’s main rival, ATI, Nvidia had a much larger market share, greater economies of scale and a greater brand that people are willing to pay a premium for, even if the specifications of an Nvidia and ATI product are similar. It is pretty much like Intel vs AMD, in which Intel prevailed against AMD for a large part of their history in terms of well, everything. A little tidbit – ATI is actually owned by AMD.

While I have more than a fair deal of faith in Nvidia’s future, role in its industry and more importantly, it’s profitability, as any investor knows, a good investment isn’t just about whether a business is great. It’s also about whether the valuations are right to initiate investments in the stock. For the record, Nvidia is listed on NASDAQ in the US.

This post isn’t about the valuation on Nvidia. That’s another story for another time. It is more about the importance of applying a framework to dig deeper into an industry, looking into the value chain and finding out where the real value lies. It is about not expending energy in trying to read the tea leaves when a simpler answer lies in front of us.

Bright spots even in the worst of industries
Even in the worst of industries, there are invariably sub sectors that are cash spinners with deep moats. As an example and to close this post off, the air travel industry is a well known capital black hole. Very few airlines make money consistently, with the exception of a handful such as Southwest Airlines and Ryanair.

Move along the value chain and you start to realise there are some interesting sub sectors such as the engine makers (GE, Rolls Royce and Pratt & Whitney) which by the way, make pretty good money from their servicing contracts. Move further along and you find engine part makers. They make the parts that wear out real fast since engines burn at a high temperature and are utilised intensely. These parts form a small component of the overall cost of maintaining a plane but the parts are mission critical. A loose part may mean the certain deaths of a full load of passengers, not to mention the loss of an aircraft worth hundreds of millions and a huge dent to the airline’s reputation. In other words, if a new aircraft engine part upstart comes along and cut prices by 50%, you can be sure the airlines and engine makers aren’t about to make a snap decision to change engine part suppliers given the repercussions that may result from moving away from an established and reliable status quo.

In a similar way, engine part makers are also the modern day pick and shovel sellers, only that the industry in question is the airline industry. An additional investment tidbit – it is probably because of the dynamics of the sector and industry as discussed above that Warren Buffett, in his largest acquisition ever, bought Precision Castparts – the very producer of the said parts – for US$32 billion in 2015.

While the history of another San Francisco gold rush surely will not repeat, it does and will rhyme.

Advancer Global IPO

Penning down some quick scribbles on thoughts of an IPO in Singapore which will be listed at 9am this morning – Advancer Global. It’s business segments consist of Employment Services,  Cleaning and Stewarding, and Security Services.

I typically avoid IPOs and the only one that I have ever bought on the first day of its trading ended in tears.

The business is most interesting from a numbers perspective. It churns out a copious amount of operating cash flow that is accompanied by relatively low capex. In FY2015, it made S$4.3 million in operating cash flow and for FY2014, it made S$3.5 million. As for capex, it amounted to S$0.2 million for FY2015 and FY2014. To be conservative I’ll average the 2 years’ free cash flow performance to get a quick and dirty ‘normalised’ free cash flow, to adjust for business fluctuations and fluctuations in working capital. A point to note here is that the business was also provided with government grants and insurance refunds that should be considered non-recurring. These  amounted to S$2.3 million in total over the 2 years. Taking all these into account, the average adjusted free cash flow thus amounts to S$2.6 million.

Being service oriented, the business operates using low amounts invested capital. Its invested capital was about S$1.6 million and S$0.5 million for FY2015 and FY2014 respectively. That means in each year, the company generated at least high double digits in adjusted ROIC (2 year average ROIC in excess of 100%), leaving plenty of funds available for reinvestment purposes. The challenge is of course avenues for the business to redeploy the money profitably. So far, at least in the last 3 years of financial data provided in the Offer Document, it appears that they didn’t need much cash to grow the business, judging from the above 10% revenue growth achieved each year over the last 3 years.

Valuations wise, it appears very acceptable. With an expected market cap of S$38.1 million, cash holding of S$4.1 million as at 30 April 2016, after which, it will grow to S$12.5 million from the IPO proceeds, and debt of S$1.3 million, we are looking at an enterprise value of S$24.3 million. On an adjusted free cash flow to enterprise value basis, it’s about an 11% yield which doesn’t appear too bad excessive. Of course they will need to utilise the cash for expansion and the cash pile will almost certainly head downwards in the months and years to come.

As a quick final note on the risks and quality of the business from a numbers perspective, it doesn’t appear to be as good as the issuer may want us to believe. The gross margins for each individual business segment fluctuates fairly widely and revenue figures fluctuate as well. One way and the most obvious way for revenue to grow is to raise the pricing of their services which they have been doing so. The question is how sustainable will this be going forward? Raise it enough and your customers will flee by the droves.

Will continue keep tabs on this company.

Error of omission – Pandora A/S case study (Part 1)

With the benefit of hindsight, we can always find plenty of investment fishes that got away. Rather than wallow in self-pity by simply listing missed opportunities and whining about the unfairness of life, I want to explore in this, and subsequent posts, some lessons learnt from a near-commission opportunity some years ago. By doing so, I hope to better recognise my folly and avoid similar errors of omission in the future.

The company in question is Pandora. Not the music streaming business but Pandora A/S – the mass luxury jewellery business with its namesake stores that has been a retail phenomenon across the world.

As background, I started noticing the surge in popularity of the brand some time in 2011/2012 by observing friends and people on the street going gaga over Pandora charms. Only in November 2013 did I realise it is a listed company on the Copenhagen Stock Exchange (CSE). After an extensive search, I found the only brokerage in town that allowed the trading of stocks on CSE – Saxo Capital. I procrastinated for a few weeks and finally opened a brokerage account with them. Between the time I decided to purchase the stock and the time I could actually do so (after the usual administrative time lag needed to open an account) around Christmas 2013, after the account was opened, the stock price has surged by about 10%.

What I saw in Pandora then was probably the same as what most people have observed. Its charms were highly popular among youths, the queues outside its stores were long, stores were mushrooming everywhere, ads were plastered all over town.

In this post, I’ll explore the qualitative aspects of Pandora and what I believe made it successful. In the followup post(s), I’ll dive into the quantitative aspects.

What more should I have seen in Pandora then

Reinforcing buying behaviour using psychology

I have found that the best businesses successfully tap on deep-seated psychology of people in designing and/or selling their products. In Pandora, I found this to be true. While it may appear subtle, the way behaviours of consumers being harnessed by the nature of Pandora products is extremely ingenious.

Sunk cost fallacy

By selling for an exorbitant price, a bare and unappealing bracelet in which you string charms together, the sunk cost fallacy in the psyche is inevitably activated. Even if you made a mistake in purchasing the bracelet in the first place, it is psychologically hard to cast the the bracelet aside. My belief is that you will be subconsciously probed to make the best out of the situation by adding on more charms to fill up the bracelet in order to make it look pretty.

Step 1 of inducing consumers to buy additional charms fulfilled.

Competitive streak/conspicuous consumption

The element of competitiveness and the need to show off. Who walks around with an empty bracelet or strings the bracelet with just one single charm anyway? What would people think? What kind of stares would you elicit from the public? In order to outdo your friends, enemies and frenemies, you keep adding on one charm after another to keep up.

Notice how the charms are rather small? The naturally small size of trinkets means the activation of consumers’ urges to have to add more and more charms just to fill up every millimetre of the bracelet.

Step 2 of inducing consumers to buy additional charms fulfilled.

The advantage of being small

Ideally, great businesses should have products that take up little space, are non-perishable and has a fast inventory turnover. The nature of Pandora’s products comes pretty close in the sense that the charms are compact (takes up very little storage space) yet are high value items, are non perishable – not in the traditional sense anyway – and has sells pretty fast for a number of years (high inventory turnover). With that kind of economics, it’s no wonder Pandora is such a profitable business.

The other natural advantage of small products is the lack of need of large showrooms for selling the products. Notice how Pandora’s store sizes – probably more like booths than stores – are multiples smaller than retailers of say fast fashion or luxury goods? Smaller store sizes reduces rental expenses. When you are in the store with 6-10 other customers concurrently, it is not an exaggeration that you will practically have to squeeze your way around. From the outside of the store, this gives the impression to passerbys that the products are highly in demand. Imagine having just 6-10 people in a H&M or a Tiffany store. That’s probably more staff than customers. Granted, the business models of Pandora, H&M and Tiffany are different, each with a different set of value proposition, margins and inventory turnover. However, the point is that Pandora is able to sell relatively high value items and achieve a relatively high inventory turnover while keeping costs low both in terms of rent and manpower (usually just 2-3 sales persons per store) – a highly potent cocktail of factors that leads to a very profitable business.

Reinvestment opportunities – The golden goose that lays golden eggs that hatches

With the profits extracted from a single store, Pandora is able to redeploy the store’s earnings to open a new and equally compact store with the same great underlying economics. This new store then generates the same overwhelming returns to redeploy to the next store in a daisy-chain like fashion. Thus, this enables Pandora to practically become the proverbial golden goose that lays golden eggs over and over again, only in this case, the eggs hatch and out comes golden geese that lays even more eggs. In modern times and in the value investing field, it is known as the  compounding machine.

Quantitative case study

In part 2 of the ‘Error of omission – Pandora A/S case study’, I will look under the hood of Pandora and explore Pandora’s figures prior to 2013, during 2013 and post 2013, in an attempt to extract some insights on what a compounding machine looks like. More importantly, I hope to spot, from a numbers and figures perspective, the ways I could have prevented myself from freezing up during the last moments of December 2013 without pulling the trigger.