The Tenets of Business-Driven Investing

A framework for evaluating investment opportunities

One has to choose between being a business owner or a speculator. Most investors spend too much time analyzing the stock market and forecasting the economy. They construct a broadly diversified, non-correlated portfolio or buy and sell individual stocks to attempt to outperform the market.

When investing, it is paramount to view oneself as a business analyst — not as an economic analyst, or even as an equity analyst. First and foremost, investors must look at companies from a business person's perspective. Companies must be studied holistically, examining quantitative and qualitative aspects of the business model, the management, the financial position, and the purchase price.

Below are a few timeless tenets to consider when purchasing wholly-owned companies or common shares in the stock market.

Business Must Be Understandable

Business owners should avoid complex business models and any company that has changed their business model because their previous plans were unsuccessful. The best returns are achieved by companies producing the same products and services for several years. Undergoing significant business changes increases the likelihood of committing major business errors. Investors tend to be attracted to fast-changing industries and companies that are in the midst of corporate reorganization. However, severe change and exceptional returns seldom mix.

Investing in companies you believe will be successful and profitable in the long term is far wiser than whatever is popular at any given moment. Predicting the future is never foolproof, but a steady track record is generally a reliable performance indicator. If a company has demonstrated consistent results with the same products or services year after year, assuming those results will continue is not unreasonable.

Favorable Long-Term Prospects

The business market can be divided into two unequal parts: a small group of great businesses and a much larger group of mediocre businesses, most of which are not worth purchasing. A great business can be referred to as a franchise. A franchise is a company providing a product or service that is

(1) needed or desired,

(2) has no close substitute, and

(3) is not regulated.

These traits enable the company to hold its prices and occasionally raise them without fear of losing market share or unit volume. Pricing flexibility is one of the defining characteristics of a great business, as it enables the company to earn above-market returns on capital.

Franchise businesses create a moat that gives the company a clear advantage over others and protects it against incursion from competition. The larger the moat, the more sustainable the profits will be. Conversely, a mediocre business that offers products or services virtually indistinguishable from competitors is a commodity business. Commodity businesses can only compete on the basis of price, which cuts into profit margins. The only way to turn a commodity business profitable is to become the low-cost provider, and low-cost providers only profit during periods of tight supply. A great company is one that will continue to be great for 25 years or more in all economic conditions.

Rational Management

The most important management act is allocating capital—reinvesting in the business or returning money to shareholders. The allocation of capital over time determines shareholder value.

Capital allocation is linked to the company's business life cycle; as companies move through the economic life cycle, their growth rates, sales, earnings, cash flows, and returns on capital change. In the development phase, a company loses money as it develops products and establishes markets. During the growth phase, the company is profitable and must retain all its earnings to grow. In the last phase, the terminal phase, the company is experiencing declining sales and earnings but continues to generate excess cash.

A company in the terminal phase has three options:

(1) Reinvest excess cash in an attempt to produce an above-average return on equity,

(2) Buy growth, or

(3) Return excess cash to shareholders.

Management must decide how to allocate excess capital rationally in the final phase.

Most managers believe their managerial prowess can achieve an above-average rate of return on excess cash. However, a company with declining economic returns, excess cash, and a low stock price attracts corporate raiders, who will inevitably fire the current management. To protect themselves, executives frequently purchase growth by acquiring another company. The announcement of acquisitions raises the stock price and dissuades the corporate raiders.

One should always be skeptical of companies that need to buy growth. Growth commonly comes at an overvalued price. Additionally, the company must integrate and manage the newly acquired business, which is ripe for costly mistakes for the shareholders.

The responsible course of action for companies with growing excess cash that cannot be reinvested at above-average rates of return is to return the money to the shareholders. Two methods are available:

(1) Initiate or raise a dividend, and

(2) Buy back shares.

With the cash from dividends, shareholders can look elsewhere for higher returns. However, the reward from a buyback is twofold. If a stock trades below intrinsic value, when management buys back stock, it's acquiring twice the intrinsic value for every dollar spent. A buyback signals to investors that management has their best interests at heart, attracting more investors, raising the stock price, and thus rewarding the shareholders twice.

Candid Management

Managers are responsible for reporting their company's financial performance fully and genuinely, admitting mistakes, and sharing successes. Respectable managers can communicate their company's performance without hiding behind generally accepted accounting principles (GAAP).

What needs to be reported is data that helps the financially literate investors answer three questions:

(1) Approximately how much is the company worth?

(2) How likely can the company meet its future debt obligations?

(3) Given the economic circumstances, how good of a job are the managers doing?

Management should be encouraged to discuss failure openly. Every company makes mistakes over time, both significant and inconsequential. Many managers report with excess optimism rather than candid explanations, serving perhaps their own interests in the short term but no one's interests in the long term. The CEO who misleads others in public will eventually mislead themself in private. The key is to avoid failures of omission.

The Institutional Imperative

The institutional imperative is the tendency of corporate managers to imitate the behavior of others, no matter how irrational. The institutional imperative is responsible for several existential conditions within companies:

(1) The organization resists any change in its current condition;

(2) Just as work expands to fill available time, corporate projects or acquisitions will soak up available funds;

(3) The demands of the leader, will quickly be supported by their troops;

(4) The behavior of peer companies, whether they are expanding, acquiring, or setting executive compensation, will be mindlessly imitated.

Just because everyone else is doing something doesn’t make it right.

The institutional imperative is driven by human nature. Most managers are unwilling to look foolish in the short term, mainly when their company posts a quarterly loss when all others in the industry report gains. Management's inability to resist the institutional imperative is fundamentally driven by their inability to accept change.

There are a few explanations for management’s inability to overcome the institutional imperative:

(1) Most managers cannot control their lust for activity, and such hyperactivity finds its outlet in business takeovers;

(2) Most managers are constantly comparing their business's sales, earnings, and compensations with other managers within their industries and these comparisons invite hyperactivity;

(3) Most managers exaggerate their capabilities;

(4) The ability to execute a plan for radical change is often too daunting for most managers to accomplish. Hence, it’s tempting for management to buy a new company rather than face the financial dilemmas of their current situation.

Another common problem is poor allocation skills. CEOs often rise to their positions by excelling in one division of the company, such as administration, engineering, marketing, or production. With limited experience in allocating capital, they turn to board members, consultants, or investment bankers, and inevitably, the institutional imperative enters the decision-making process. The most desirable skill in a manager is capital allocation, and the most desirable trait in a manager is the ability to resist the institutional imperative.

The Measure of Management

Managers should be evaluated along the dimensions of rationality, candor, and independent thinking. Some believe the value of management is fully reflected in the company’s performance statistics, which include sales, profit margins, and return on equity; therefore, placing a value on management is a form of double accounting. Evaluating financial data can tell an investor what has transpired, but assessing the character of management can give insight into what will occur. Studying the strategies and words of management can yield clues to help measure the value of the company’s work long before it shows up on the financial reports or in the newspaper.

Investors should review annual reports from a few years back, paying particular attention to what management said about the strategies for the future. Compare those plans to today’s results; how fully were the plans realized? Also, compare the strategies of a few years ago to this year’s strategies and ideas; how has the thinking changed? It is also wise to compare the annual reports of industry competitors.

It is worth mentioning that it’s not wise to invest in people alone because there is a point where even the brightest and most capable managers cannot rescue a problematic business. When managers with a reputation for brilliance tackle a business with a reputation for poor fundamental economics, it is the reputation of the business that stays intact. It is more important to invest in brilliant business models than brilliant managers. However, the best combination is to own companies with attractive economics run by shareholder-oriented managers.

Return on Equity

Earnings per share (EPS) is a smoke screen. Most companies retain a portion of their cash from the previous year's earnings to increase their equity base. Suppose last year's earnings are not paid out in dividends. In that case, the growth in EPS can be attributed to an increase in working capital and not necessarily an improvement in underlying business value or the quality of management decisions. This phenomenon is called the retained earnings effect.

The preferred measure of a company’s annual performance is the return on equity, the ratio of operating earnings to shareholder equity. This ratio requires several adjustments. First, all marketable securities should be valued at cost and not market value. The stock market's overall performance can significantly influence a company's shareholder equity if securities are valued at market price. This can lead to distorted return on equity calculations that don't accurately reflect the company's operational performance. Second, capital gains, losses, and other extraordinary items must be removed from the calculation as they don't reflect the company's core operational performance. The goal is to isolate the precise annual performance of the business to understand how well management accomplished the task of generating a return on operations given the capital employed.

Great management should achieve excellent returns on equity while employing little or no debt. Highly leveraged companies are vulnerable during economic downturns. However, depending on their cash flows, different companies can manage various debt levels. Companies reliant on debt for returns on equity should be viewed with suspicion.

Owners Earnings

Not all earnings are created equal. Companies with high assets compared to profits tend to report distorted earnings. This is because inflation erodes asset-heavy businesses over time. Cash flow is not a perfect tool for measuring value and can often be misleading. Cash flow is the ideal variable for measuring businesses with significant investments during the development phase and minimal investments in the terminal phase. Examples include oil and gas, real estate development, and maritime shipping. Manufacturing companies requiring ongoing capital expenditures are not valued accurately using cash flow alone.

A company’s cash flow is its net income after taxes plus depreciation, depletion, amortization, and other noncash charges. Cash flow leaves out capital expenditures, which are the earnings that must be reinvested for new equipment, plant upgrades, and other improvements needed to maintain economic position and unit volume. Capital expenditures are just as critical as labor and utility costs. The overwhelming majority of businesses require capital expenditures roughly equal their depreciation rates.

Cash flow is a popular metric since it is commonly used to determine the multiple at which businesses are purchased in a leveraged buyout. Cash flow can be a misleading metric without subtracting necessary capital expenditures. This is why owner earnings— net income plus noncash charges of depreciation, depletion, and amortization, less the amount of capital expenditures and working capital — is a preferable metric. Owner earnings are not necessarily precise calculations since future expenditures can be tricky to estimate. Even so, adjusting for noncash charges and estimated capital expenditures is far better than relying on net income alone.

Profit Margins

Businesses are prone to making lousy investments if management cannot convert sales into profits. There is no big secret to profitability: It all comes down to controlling costs. Managers of high-cost operations tend to add to overhead, whereas managers of low-cost operations tend to find ways to cut expenses. The trick is to have little patience with management that allows costs to escalate. Management must understand that there is an appropriate staff size for every business operation and a proper amount of expenses for every dollar of sales.

Dollar-For-Dollar Premise

If a company employs retained earnings unproductively — generating a return below the cost of capital — over an extended period, the market will justifiably price the shares lower. Conversely, if a company has achieved above-average returns on reinvested earnings over time, the success will be reflected in an increased share price. The increase in value should, at the very least, match the amount of retained earnings dollar for dollar. An investor's job is to select businesses with economic characteristics that allow retention of retained earnings to be translated into a dollar-for-dollar market value.

Determine the Value

The value of any business, bond, or stock today is determined by the cash inflows and outflows — discounted at an appropriate interest rate — that can be expected to occur during the remaining life of the asset. Hence, determining a company’s value is relatively easy so long as the business is simple and understandable, it has operated with consistent earnings power, and an appropriate discount rate is applied. Otherwise, it's advisable not to value the company.

One may ask, what is an appropriate discount rate? The simple answer is the cost of capital. The cost of debt is the weighted average interest rate of its debt outstanding. However, determining the company's equity cost of capital requires additional thinking. In academia, the appropriate rate is the risk-free rate — the 10-year US Treasury Note — plus an equity risk premium to adjust for the uncertainty of a company's future cash flows.

The idea of price volatility as a measure of risk is nonsense. Business risk is reduced, if not eliminated, by focusing on companies with consistent and predictable earnings. Risk in investing comes from not knowing what you’re doing. In a good company, the predictability of future cash flow should take a coupon-like certainty found in bonds. Hence, an appropriate discount rate should reflect the opportunity cost of capital. Most investors expect to earn at least a 10 percent return, the historical return of stocks since the 1900s. Thus, an investor’s cost of capital for 'lending' their money in the market should be 10 percent. Therefore, a discount rate of 10 percent is appropriate for calculating the intrinsic value of a business or stock.

It is also important to note that the job of an investor is not to calculate the exact valueof a business. Instead, investors determine the intrinsic value of a business. In reality, a business’s returns can and do fluctuate. So, to factor for different outcomes of business returns, one must take the probability of loss times the possible loss from the probability of gain times the possible gain. The expected intrinsic value is the weighted average value for the distribution of possible outcomes. It’s better to be approximately right than precisely wrong.

Buy at Attractive Prices

Buying great businesses that are understandable, with enduring and attractive economics, run by shareholder-oriented managers is not enough to guarantee success. An investor must buy at sensible prices, and then the company must perform to the investor’s expectations. Mistakes in investing are usually because of (1) the price paid, (2) the management, or (3) the future economics of the business. Miscalculations of the third instance are the most common.

Investing aims to identify businesses that earn above-average economic returns and purchase them at prices below their current market value. The fundamental principle is to buy a business only when the difference between its price and value represents a margin of safety.

The margin of safety principle helps investors to protect them from downside price risk. Suppose a business's value is only slightly higher than its per-share price, and its intrinsic value declines slightly because of miscalculated future cash flows. In that case, the share price will likely drop below what the investor paid for it. However, if the margin of safety between price and intrinsic value is large enough, the risk of declining intrinsic value is less. Suppose a company is purchased at a 25 percent discount to intrinsic value and subsequently declines by 10 percent; the original purchase price will still yield an adequate 15 percent return.

The Intelligent Investor

The most distinguished trait of an investor is a clear understanding that by owning shares of stock, they own part of the business, not pieces of paper. The idea of buying a stock without an understanding of the company's economics, management, and prospects is unconscionable. Investors have a choice: They can conduct themselves like business owners or spend their time trading stocks like speculators. Speculators behave as if the market’s ever-changing price reflects a business's value more accurately than the business's balance sheet and income statement. They draw and discard stocks like playing cards.

Most investors begin by purchasing common stocks and then later buying entire companies. Few investors will own companies outright while investing in the stock market. Still, nothing prevents an investor who doesn't fully own a company from thinking and behaving like a business owner when investing in stocks.