Our Modern Value Investing Framework

Introduction

Our framework focuses on the idea of understanding the story of a company. If at any point it is too hard to answer the questions, there is no shame in moving on to the next business on your list of potential suspects. As Charlie Munger said, most stocks should land on the ‘too hard’ pile.

We want to find great companies and ensure that we don’t pay more than what we think they are worth, ideally we want to pay less. The key factor here is valuation. However, no valuation is ever perfect since it relies on an ‘educated guess’ about the future. To even be able to make the slightest guess, we have to truly understand a business and it’s dynamics.

Generally speaking, the more predictable, the better. A predictable business must have some underlying economics to continue to be strong and also have a moat that protects it’s earning power.

In short, we want to guess how much a business can return to us as shareholders and then determine how certain we are about our assumptions and what might stop us from receiving these returns.

The below framework gives an idea on how we approach a business from the ground up. We want to understand its economics and the position in the competitive landscape, then give judgement on what we think lies ahead for it and evaluate how management tackles it. In most cases we don’t feel confident to have just a glimpse of an idea, but if we do, we like to add a margin of safety to our conservative valuation and wait for Mr Market (aka volatility) to serve us a price at which we’re willing to bet big.

This sounds like a boring task, and most of you will say it is, but we cannot justify owning any company that we don’t feel confident about nor even understand it. 

1. Business Overview

When analyzing a business (the word stock can be used synonymously) we need to understand what the business is actually doing. There are a few main questions here:

• How does the business generate revenue?

• How cyclical is the business?

• What do revenues depend on?

• How are earnings generated?

If we feel the business is something we can properly understand, we move on to dive deeper:

2. Revenue/Operations Split

To truly understand the way a business makes money, we have to take a closer look into its distribution. In which regions are revenues generated and through which product or service? Every market has their own dynamics, and we find it important to understand the key drivers of business success before moving on.

3. Moat & Profitability

This is the point where we get rid of most businesses already. We like to look at businesses with existing cash flows and very healthy margins. In simple words: A business has to sell products or services for significantly more than it costs it to make. Remember, we look for predictability, so we really want to see stability and a proven track record here.

Now, any business can have a good year or a few, but predictability only comes from having a moat. A moat is a competitive advantage that protects the castle (business) from threats & future competitors that might enter over time. Although we try to identify major threats, there will be competitors and hurdles which we can’t foresee yet. This just underlines the importance of an outstanding defense, any business with healthy margins will face someone trying to use their margin as a way to undercut sales prices and gain market share.

A moat can come in many ways, but if you find it hard to identify, it is likely that there is not a strong enough moat to make it a great fit for our long term approach.

4. Balance Sheet & Capital (Returns, Efficiency & Structure)

We don’t necessarily look for high growth. As Buffett said, growth is simply part of the value equation. Instead, we like a business that can defend itself well, and therefore we look for conservative capital structure with serviceable debt. I’m not saying debt itself is bad, I just like to point out that interest should be easily covered even if there will be a couple tough years ahead.

The balance sheet gives us an insight into past performance of a business, as it accumulates over the entire lifetime. There are a few red flags that will make us worry:

• High amounts of leverage and other long term liabilities

• Continuous dilution of shareholders through issuance of new shares

• Unreasonable amounts of goodwill and intangible assets

If we find the capital structure to be reasonable and management ideally buying back shares in times of low valuation, it’s worth it to dive deeper.

The key to a good long term investment is finding a business that produces a lot of cash, which it can then reinvest into itself at great rates of return. There are multiples measures we like to look closely at: Return on Equity (ROE), Return on Capital (ROC) and Return on Capital Employed (ROCE). They all share some similarity, we want to see them at least above our desired rate of return (+15% annualized in our case).

If a business is unable to reinvest its profits at a high rate of return, we can’t expect the stock to deliver great returns over time. The return on a stock investment is derived from 2 parts: increase in valuation and increase in intrinsic value. We can earn some good returns by ‘buying low and selling high’ but we look for a combination of both. The longer our time horizon, the more important the latter becomes. Simply put, if we find a business that reinvests profit at a high rate of return, we can sit back and relax instead of constantly having to find new opportunities.

Now we have to revisit some of the qualitative metrics and ask why returns on capital are high. If this is only the case through reduction in the denominator instead of numerator growth, we might have to be a little more careful. 

This is where the moat becomes important again. If high margins are protected and likely to continue, so will returns on capital. They have to be defended just as well as they will be a main driver of intrinsic value growth. Remember, investing is about the future, not the past.

5. Management, Insiders & Shareholder Treatment

By now, we should have a good understanding of the underlying economics of a business and identify its drivers. Now it's time to really dig deep into past earnings calls, interviews and events to see how management behaves. Does management promise more than they deliver, or vice versa? We want to see their opinion on different drivers and opportunities and make sure their opinions align with ours. You will quickly get a feeling if management aims to treat shareholders well or doesn’t care about them much. 

“Show me the incentive and I'll show you the outcome.” -Charlie Munger

Here comes the question about management incentives and their alignment with shareholder interests. Ideally, management and other insiders have substantial skin in the game by owning a good chunk of shares themselves. This tells us managers put their money where their mouth is.

Also, watch out for excessive stock based compensation, as this type of dilution is severely impacting shareholders.

6. Status Quo & Risks

Now that we understand the dynamics of a business, we have to look at the current state of it. We like to read through the news and recent reports, both from the company itself and other sources. What are the challenges it is facing right now? What does the media say? Is sentiment maybe overly positive or negative? Remember that analysts and media tend to look out for only a year or so ahead. We prefer to be in an overly pessimistic environment.

“The intelligent investor is a realist who sells to optimists and buys from pessimists.” -Benjamin Graham

This will give you an understanding of what the general crowd thinks of a business and its stock right now. You can’t outperform the market if you aren’t contrarian.

It is absolutely essential to understand the risks and opportunities a company is facing in the short term and view them on a long term perspective. We like to see temporary headwinds that drive down the share price but don’t harm the underlying economics.

7. Key Competitors & Industry Outlook

If we feel able to have a solid idea about the whole story of a business, we want to look out for competitors and their view on the status quo as well as dive deeper into the competitive position.

Before we try to quantify our feeling about a company through the valuation part, we want to narrow down the drivers as precisely as possible. Therefore, we like to use the idea of porters five forces, a framework which forces us to pinpoint the bargaining power across the value chain and the competitive landscape, paired with a SWOT analysis which gives us a snapshot of what to look out for in the future. With great companies, fundamentals won’t deteriorate quickly, but our investment thesis may still change. We want this part to be clear enough so we can revisit it anytime and make a judgement if the fundamental situation has ever changed.

8. History

The past is not a good indicator of the future, but it might just give us the hint we’re looking for. We like to look back on how the company has faced challenges in the past and how honest management was about them.

History can give us a good idea of how different stakeholders were treated. If we like the historical actions of management, we are more likely to believe in its future.

Every business has its own cycle, history can tell us how long it usually takes and to what extent the business changes throughout the cycle. A predictable business (which we look for) is likely not going to deviate much from the past.

9. Valuation

Here comes the hardest part. In order to make proper valuations, we should have a general idea of the 5-10 year and beyond state of the business. Assumptions will be wrong 100% of the time, but the question is how much they will differ from reality.

If we have a hard time coming up with an idea of how a business looks like in 10 years, we immediately move on and pass on the potential investment. However, if we have some confidence in the future we try to map it out as conservatively as possible.

If you own a business outright you can go ahead and discount all the future cash flows between now and judgement day (the end of your holding period). As stock investors, we can only account for returns which we actually receive. Returns are driven by the following:

• Direct cash flows in the form of dividends

• Indirect cash flows through share repurchases which increase our stake in the business

• Increase in value of the business

This might lead to the wrong conclusion that we look for businesses commonly referred to as ‘growth stocks’. As investors most of our return will most likely come from the third factor, increase in value (a fancy way of saying ‘the stock is going up’). However, this has two underlying drivers:

1. Increase in intrinsic value

2. Increase in valuation

Compounding really starts to happen if we manage to achieve both, meaning we buy at a low valuation and benefit from intrinsic value growth as well as increasing valuation. As the sheer growth in intrinsic value is closely tied to growth in earning power, we see growth as part of the value equation. 

Growth in earning power will be our most critical assumption for valuation. Therefore, we want to be very conservative in our growth projections. Additionally, we add a ‘Margin of Safety’ to our final outcome to further eliminate any error.

Lastly, we aim to test out a range of inputs to understand the consequences of our assumptions (in fancy words, this is called sensitivity analysis).

There is no one size fits all valuation model, it highly depends on the business we are looking at and its drivers, therefore we don’t believe in replicating the same core model over and over. There is no right or wrong in valuation, but our sincere advice is to keep in mind that no one knows the future.

Remember to keep it as simple as possible.

10. Verdict

Our core framework has come to an end and I could easily extend it to 100 pages. Keeping this in mind I would like to quote famous writer, Mark Twain:

“I didn’t have time to write you a short letter, so I wrote you a long one.”

I could list a bunch of criteria in this section to determine if you should buy the stock or not. If the decision doesn’t seem obvious at this point, I can only recommend that you step away from it and give it another shot at a different time. If you’re still not sure, stay away and move on. 

Most of the stocks we analyze end up never being bought, don’t feel disappointed if it looks like a time waste, since you most likely have learned something new every time.

Happy investing!
Josh

The information is provided for educational purposes only and does not constitute financial advice or recommendation and should not be considered as such. Do your own research.