At my current stage of life being a 30 year old as at 2016, the single objective’s essence is distilled into its simplest form – financial freedom by the age of 45. To get there and beyond to the next objective, since I started my investing journey in around 2005, I have found the gradual compounding of capital while mitigating the risk of permanent capital impairment via the Buffett/Graham school of investing to be the most suitable for my temperament.
Compounders using the QGV framework
Seek out compounders that generate high return on invested capital (Quality) with good reinvestment opportunities (Growth) at a reasonable price (Value).
3 legs of a compounder stool:
- Businesses must have well-defined moats that slows down, for an extended period of time, the erosion to its profit generating abilities
- The quantitative measure of such quality businesses should be a high returns on capital
- Growth is only profitable if the returns on investment exceeds cost of capital
- High returns on investment is particularly profitable if there are ample reinvestment opportunities
- Invest only when valuation is reasonable
Purchase only when an extreme mispricing opportunity is present from a balance sheet point of view. In the perfect situation, the equity should be trading below liquidation value with a balance sheet backed by plenty of cash and still generates normalised free cash flow into the foreseeable future.
The above scenario is almost as rare as unicorns but through some luck and constant turning over of rocks, they have been and will be found.
Checklist for QGV framework
- Any risk of accounting gimmicks? (Operating cash flow > net profit)
- Any risk of obsolescence or collectability? (Inventory and accounts receivables < Sales growth?)
- Does the business have ability to reinvest at high rates of return on capital? (examine incremental ROIC over last 5-10 years)
- Are high ROICs due to excessive debt? (Dupont analysis)
- How high is the pricing power? (Can it at least beat inflation?)
- Can rapidly changing technology damage the business significantly? (moat types and strength of it)
- Does management own a substantial stake in the business?
- What are the potential reasons the stock price may drop 50% tomorrow (pre-mortem)
- Have revenue and operating cash flow grown in 7 of last 10 years?
- Are there ample opportunities for the business to reinvest capital?
- Is EV / Maintenance FCF reasonable?
- Can I see the stock price doubling in the next 3 years?
- Are there any other positions in my portfolio that are more favourable on an overall basis than this?
- If the stock price drops 50% tomorrow, will I buy more?