Do you have an Investment Framework??

While my investment principles are the high-level guide for my stock picks and portfolio management, I use my Investment framework to grade companies at a detailed level.

While my investment principles are a high-level guide to run through every decision, I have a step by step investment framework to grade companies at a detailed level. My investment framework includes 4 steps, in order of importance — the exception being for valuation which although being the last is very important:

1. Timing & Market
2. Management
3. Vision & Business Model
4. Financials & Valuation

I will be going into detail below:

1- Timing & Market

I believe the timing is the most critical factor for a business and, therefore, an investment. I’m not talking about the trading sense of the word, but more if the right conditions exist for the business to grow. The idea and management can be excellent, but it won’t be worth investing in if there isn’t customer, government, and ecosystem support. The company won’t be able to scale effectively. For example, there was mp3.com and Napster before Spotify — only Spotify had the required mix of govt support and computer & internet bandwidth penetration to get its music streaming model to scale to millions of users.

Ironically, I believe the essential 1st step in choosing a winning company might not be the company itself but whether the market is ready for prime time. Key questions to ask:

1. How big is the TAM?
2. How fast is the TAM growing?
3. Are the conditions ripe for scale?

Timing can also guide the allocation in your portfolio. Potentially, there are multiple promising companies and the deciding factor can be a more scalable and more extensive market.

2- Management

Management is super important and often the source of optionality in the company. Good management can spot new adjacent markets and expand the TAM. Good management can also be the catalyst for a turnaround in a declining company. Having good management is like having a free call option on the business embedded in the stock. Is the CEO an engineer and can see what is physically possible with technology? Or is the CEO design-centric and able to serve more of the customer’s needs in the future?

It is commonly good to see founder-led management teams as they have a vested interest in making the company succeed compared to career CEOs or caretaker CEOs.

Other than the CEO, how are the rest of the executive team? What is the culture of the company? Do people want to work there? Is the CFO good at controlling costs & keeping the balance sheet healthy? For example, issuing stock when the stock price is high is a sign of a great financier.

Good management can sometimes even out-execute timing and lousy business models. Uber vs Lyft management is an excellent example of this. During the recent pandemic, Uber launched Uber Eats, which saved Uber despite having an undefendable ride-hailing business (against Lyft). On the other hand, Lyft didn’t pursue this and languished during the pandemic. Even now I believe Uber’s business model still has little to no moat, which underscores what great management Uber has in isolation.

Lousy management constantly underlies and blames external events — supply chain, wars, recession etc — while great management continues to execute. While other car makers complained of supply shortages — Tesla still grew at 50% YoY.

3- Vision & Business Model

However, even a great market and management aren’t good enough as seen from the Uber example above. The business idea & model is equally important. Firstly, do customers love the product? Is there a “cult” following?

If many people rave about the product, it can be a starting ground for it as a great company. However, a great product does not mean it is a great company — Airlines, for example, offer excellent customer service; however, it is an operationally intensive & commodity industry. Even though these produce a lot of value, it doesn’t mean they can capture them. Google, for example, is more valuable than the whole airline industry. The business model is equally important.

How strong is the business model? What “moats” does it have? Moats is a term coined by Warren Buffet, and they are barriers to entry that make it hard for competitors to enter the same market. Namely, does the business possess any of the following characteristics:

1. Network effects — does the service/product improve with more people using them?
2. High Switching cost — is it challenging to switch the solution?
3. Economies of Scale & Low cost — Are there significant economies of scale, or can the business offer something for a lower price than the competition?
4. Intangible Assets — is the brand well known and well managed? Is it a verb? “Google” is a term, “Uber” a ride. Any special regulatory exemptions?
5. Embedding / Platform — this happens when there is more value in the ecosystem than the 1st party product/ service. Think — Windows, iOS, Android
6. Technology — Does it have patents or some technological edge to outperform the competition?
7. Capital — Does it have a lot of cash? Can it raise money quickly & easily?
8. Counter Positioning — Counter positioning is defined as developing a new, superior business model which incumbents do not mimic as it could damage their current business.
9. Cornered Resources — When a company gets preferential access to resources, they gain the power of cornered resources. The resources could be in the form of material, license, patent or talent.
10. Process Power — When an organization commits itself to a set of activities or a system which enables it to deliver superior and low-cost products/services, it can achieve process power.

The key is that we want to find monopolistic businesses before they become monopolies and subsequent appreciation of their stock.

Some other good things to see if possible:

1. A recurring subscription model — allows for a predictable income stream
2. Having float — where you pre-collect payments and only have to fulfil the service/ goods afterwards
3. Software / Intellectual Property — little or no production cost

These don’t have to be all present in the current business model, but perhaps 1 or 2 characteristics. Things are not set in stone and companies build moats after the fact. For example, Apple didn’t have a recurring subscription model until recently. Also, not all moats are created equal. There are stronger moats than others, but I will write about another time. Generally, a tell-tale sign of a robust business model is a high gross profit margin, as the business can charge a significant amount without losing many customers.

4- Financials & Valuation

In general, financials are not that important. Moreover, financials are backwards-facing and should be used to confirm the strength of the business. Look out for the typical stuff — like profits growth, revenue growth and cost growth. My favourite metric for unprofitable companies is checking for massive free cash flow (CFC), indicating that the business is on the edge of being profitable.

I use the financials to check are any red flags such as low cash and if the company is close to bankruptcy.

We first need to figure out if the business is a good one. However, figuring out if it is a good price is another question entirely — this depends on the final & arguably most important step — which is valuation. Valuation is a whole other article. So I will just mention the key metrics I use to evaluate companies.

Valuation Using the following is common

And of course, a DCF to generate the intrinsic value of the business.

Conclusion

Before investing in stock — do evaluate the timing, management and business model to determine if it’s a good business. Only after which, use financials to back it up and also perform a valuation to decide if it’s worth the money.

Other then this investing framework — I also detail the Investing Principles that run through every decision I make :

Sources:

Stronger Companies, Deeper Moats: A Summary of 7 Powers

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Originally published at https://www.melvinfoo.com on June 4, 2022.