What characteristics do you look for in a business? (Part I)

There is no ONE way to approach your investments. Lots of investing processes have been met with success and lots have been met with limited results. This post details how I generally target businesses for investment.

To be clear, this is Part I on a rigorous topic. If it were easy, everyone would do it and I honestly believe everyone can do it well with the right skills and determination. I will go further into my investment process in posts to follow.

Let me lay a foundation first: We are investing in businesses. This may sound simple, but is so often missed and that is why it is critical for me to start here. We are buying a business and we want that business to give us the most bang for our buck, to compound earnings in such a way that it pays us dividends, we make multiples of our money and the business never needs another dime from us… right? Well some people do not think that way in the market it seems, or at least it doesn’t look that way by what they buy.

We are not buying a stock in the market just because we think we can sell it higher. That’s like buying someone’s piece of art on the street and asking someone else to buy it for more than what you just paid. That is speculating not investing, so go back a read my post on that topic.

Should we start top down or bottoms up?

Should we find a good business then analyze the industry? Or find a great industry and find a good company? This one is up to you actually — there is no right answer — but from my experience, I tend to try to find great companies operating within their industry. Bottom line: I try not to write off an investment just because the industry may appeal uninteresting or unattractive.

It should be mentioned here that I don’t think I can call the macro well (or even at all). Count all the things you thought would happen any given year in the macro environment and count all of them that actually happened (interest rates are going up, the stock market can’t go up this year, oil will just keep rising, just to name a few). Howard Marks said it best:

 “We don’t know what lies ahead in terms of the macro future. Few people if any know more than the consensus about what’s going to happen to the economy, interest rates and market aggregates. Thus, the investor’s time is better spent trying to gain a knowledge advantage regarding ‘the knowable’: industries, companies and securities. The more micro your focus, the greater the likelihood you can learn things others don’t.” 

“We don’t know what lies ahead in terms of the macro future. Few people if any know more than the consensus about what’s going to happen to the economy, interest rates and market aggregates. Thus, the investor’s time is better spent trying to gain a knowledge advantage regarding ‘the knowable’: industries, companies and securities. The more micro your focus, the greater the likelihood you can learn things others don’t.”

Sometimes you can have a great company, a great industry, but a bad security (i.e. stock). Sometimes you can have a bad industry, a great company and a great security! And sometimes you can even have a bad industry and company, but great security (it is just too cheap to ignore). But all things being equal, I prefer to buy great companies at a discounted price.

That being said, ask yourself questions on the industry such as:

  • How cyclical is it?
  • Is it growing or shrinking?
  • How competitive? Monopolistic?

In investing, I want to target businesses with strong “Porter’s 5 forces” that is, businesses with good economic moats, pricing power, solid competitive position, etc. These businesses can generally ride out the economic cycle well and are able to compound earnings at a quicker rate than businesses that face intense competition with little moat. Warren Buffett said he views companies like he views a castle… surrounded by a moat where each day that moat can get wider or narrower due to competition. Much has been written on this topic, so I won’t belabor the point here.

Ask yourself if the company you’re looking at has a moat. Is it getting larger or narrower? Why? And do you think the market’s view of the moat is too optimistic or pessimistic?

Business Characteristics

Asset-light businesses are terrific. It is the number one thing I look for. And it of course points to businesses with good returns on capital.

Think about investing in a restaurant concept. You invest in the business and then capital is used to lease space, rent kitchen equipment, pay employees, acquire initial ingredients, fund advertising and start cooking up burgers. After some success, a second location can be opened or dividends could be paid, etc.

On the other hand, think about the franchise concept. I can invest in a franchise business instead, which lets the franchisee handle all of that capital and the franchisor just collects a fee. The limited capital requirements involved let franchisors invest in other high return projects, acquisitions, or return cash to shareholders.

Now, this is not a statement that all franchisors are great, and usually the concept must be established well beforehand, but it gets to one of the main things I look for: High conversion of earnings into actual free cash flow (and I define free cash flow as cash flow from operating activities from the cash flow statement less capital expenditures). Remember my post on Nexeo? I like distributors not because they are super high margin, but because they convert a lot of EBITDA into FCF due to their limited capital intensity.

For example of another company, take a look at B&G foods (ticker: BGS). This company is generally a low growth, consumer staples business. Boring business that you’d expect to grow 2-3% per year. But you can see below that EBITDA has expanded significantly. The company generates a significant amount of FCF due to its high margins / limited capex and therefore, management has used that capital for acquisitions. Due to its high FCF, it also can support more debt for these acquisitions, which generates a higher IRR for its shareholders. Finally, B&G also offers a 5.3% dividend yield today, so you can start to see why asset light business models are attractive for equity holders and why this is a good case study.

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Asset light businesses can weather economic cycles better

Have you ever heard of the best way to win at investing is by not losing? It almost sounds like a Yogi Berra quote, but it has some wisdom. Warren Buffett didn’t build his empire on one or even a couple high flying, successful stock picks. He picked a portfolio of good businesses bought at good prices.

I like asset light businesses as they usually are better insulated in downturns. Take a look at Company A below. It has 15% EBITDA margins and will likely perform OK in an expanding cycle. However, in a recession we can see the business becomes barely break-even since it cannot pull on its cost structure. Businesses like these include auto companies, airlines, steel producers, grocery stores, gyms, and so forth. And it makes intuitive sense – an auto company must maintain massive production facilities while also maintaining a global distribution platform in addition to its sales, marketing and other staff. It cannot cut some of these costs quickly enough and expect to revamp in time when the cycle does recover, so it eats the cost in the meantime. This just shows EBITDA, which of course is earnings before even interest and capex are taken out, which implies the business would likely burn cash (without cash flow from working capital).

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Now look at Company B with less fixed costs. It weathers the storm much better. We would also expect that it would have lower capex needs given low fixed costs so if I were to compare FCF of these 2 businesses (i.e. EBITDA – Capex – Interest – Taxes and change in working capital), it would advocate Company B even more.

I do want to caveat what I am saying here with what I said before about “bad industry, but great company or great stock” etc. Sometimes there I times I want businesses that are high fixed costs. That time is when we are at the depths of a business cycle. High fixed costs translate into higher operating leverage into a rebound as well. On the rebound, you can see how those fixed costs can translate into faster earnings growth and margin expansion on the way out. As such, I typically like to buy them when others think the cycle will be terrible for much longer and cast the businesses out right when things may inflect.

To again quote Howard Marks, always remember that although I am quickly detailing a couple things I like to look for in general, “high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them.”

That’s all for now.

-Diligent Dollar

One thought on “What characteristics do you look for in a business? (Part I)”

  1. Thanks for sharing! Makes sense. The moat thing, is kinda what Warren Buffet preaches. If the company has a wide enough moat, it’s really tough for new entrants to claim any sort of foothold. It almost creates a monopoly or oligopoly type situation where the giants slaughter or absorb any new-comers into the market. Especially from a supply chain standpoint. I think people forget how important that is in a business. If you can’t take your product to market in a very economical way, where the cost per widget is lower than all the competitors, and the access to the product is limited in the market place. It’s a real hard uphill climb.

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