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The Science of Hitting
The Science of Hitting
Articles (690) 

Security Analysis: Getting Your Feet Wet

Some thoughts on how to analyze businesses for a novice investor

September 19, 2020 | About:

I recently joined Michael Roberson of the "Strategy Chain" podcast for a discussion about the pros and cons of traditional value (cigar butt) investing versus a focus on higher-quality businesses, my thoughts on active versus passive, and other investment topics. In our conversation, Michael also asked me to walk through my research process. In particular, he wanted to know how I thought about idea generation, along with how I analyze a business once I've found a company to focus on.

First, my idea generation process tends to be a bit sporadic. I do not use stock screens, largely because I question the value of the outputs. Most notably, as I've written about in the past, I think most screens put the cart before the horse, with an emphasis on securities that may appear cheap as opposed to spitting out the high-quality businesses that are in my wheelhouse.

I think Brian Bares of Bares Capital Management hit the nail on the head when he said the following in a discussion with Dave Sather's students at Texas Lutheran University:

"Most managers use price as an input to their process. What do I mean by that? 'Well, let's look for cheap stocks, and then let's convince ourselves of the quality of those names. Let's start with low P/E or low EV/EBITDA, and rank order our securities.' We think, especially with a concentrated portfolio, that's a huge mistake. And it has taken me a long time to harden this conclusion, and it's nonobvious. Price is the last thing we look at because we don't want to make a mistake on the business quality or the management quality because that is going to be the determinant of your success… If we're going to make a mistake, I want to make a mistake on the price, not on the quality. That's why we do the pricing last."

Instead of using stock screens, I tend rely upon a network of close friends for new ideas (and other investors that I hold in high regard who are required by the Securities and Exchange Commission to detail their holdings on a quarterly basis). I also read financial publications like Barron's and The Wall Street Journal, which are good for a new idea from time to time. Once you've found a company (or companies) to look at, you're closer to the task at hand: after you find one that piques your interests, then what do you do? What is the actual research process?

First, I approach the process through the lens of Peter Lynch and Warren Buffett (Trades, Portfolio): my primary consideration is truly understanding the business – which is easier to do when you work in the industry or frequently engage with the business as a customer, supplier, etc. In my opinion, you shouldn't even bother trying to analyze something like pharmaceutical companies if you're new to the game; instead, find something that's well within your circle of competence. For this reason, I often recommend that people start with an industry like retail, which is easy to understand in terms of unit economics (the financials for a single store).

From there, I would pick four or five companies that are similar. As an example, you might select Dollar Tree (NASDAQ:DLTR), Dollar General (NYSE:DG), Walmart (NYSE:WMT), Costco (NASDAQ:COST) and Kroger (KR). For each company, I would put together an Excel document with financial results for the past 15 to 20 years, tracking metrics like revenues, gross profits and gross margins, operating income and operating margins, returns on invested capital, asset turns, free cash flow, capital returns to shareholders and so on. The basic idea here is to try and understand the unit economics, along with the underlying drivers of growth over the past 15 to 20 years.

As you work through this exercise for each of the companies, some things should start to jump off the page at you. For example, here's a metric that stood out to me as I compared Costco's historic financial results with the numbers at Sam's Club (Walmart's warehouse club business).

The material outperformance of Costco warehouses relative to its closest competitor over the past 15 years suggests they have a sustainable competitive advantage. As an investor, this is exactly what I'm looking for; whether or not the price is right today, it indicates to me that it's the kind of business that I would like to own for the long run if I'm given a chance to do so at a reasonable price.

The question from here is obvious: why does that gap exist? And what explains its persistence?

That question – why? – is something that an intelligent investor is constantly asking themselves. Buffett and Charlie Munger (Trades, Portfolio) spoke about this idea at the 1999 Berkshire Hathaway shareholder meeting.

Buffett said:

"If you look at each [Value Line] page and what's happened in terms of return on equity, sales growth, all kinds of things. And then you say, 'Why did this happen? Who let it happen? What's that chart going to look the next 10 years?' That's what you're really trying to figure out, not the price chart, but the chart about business operation. You're trying to print the next 10 years of Value Line in your head. And there's some companies that you can do a reasonable job with, and there's others that are just too tough. But that's what the game is about. If you have some predilection toward it, it can be a lot of fun. I mean, the process is as much fun as the conclusion that you come to."

As for Munger, he said:

"What he's saying there, when he talks about 'why' - that's the most important question of all. And it doesn't apply just to investment. It applies to the whole human experience. If you want to get smart, the question you've got to keep asking is: 'Why?' 'Why?' 'Why?' 'Why?' And you have to relate the answers to a structure of deep theory. And you've got to know the main theories. And it's mildly laborious, but it's also a lot of fun."

Reading through Costco's annual report, you immediately get the sense that management has a very clear sense on the "why." It understands the core value proposition that drives growing volumes and a high renewal rate among a growing base of cardholders, as well as the merchandising strategies that enable it to offer great values. In addition, you get a sense for how the company has methodically built its unit count to nearly 800 warehouses over the past 37 years, with an opportunity to meaningfully increase the number of warehouses outside the U.S. over the coming decades, along with the ability to continually improve the unit economics of the base.

For investors who are getting their feet wet, I think this is a useful way to approach the research process. Before you start worrying about how to value a business, you need to build the tool kit that will help you look at a handful of companies within a given industry and tease out which ones have a unique business model that will enable them to create long-term value for shareholders - the businesses, in my opinion, that you should desire to own.

Disclosure: None.

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

Praveen Chawla
Praveen Chawla premium member - 1 month ago

Thoughtful article. Do you wait for "weakness" in price before taking a position in these compounders? Lately, everyone and their uncles have been pursuing compounders and quality, so much so that some of the prices do not make any sense. Costco for example has a P/E of 40 while KR at only 11, yet overall EBITDA growth over the last 10 years have been similar.

johnbarber
Johnbarber premium member - 1 month ago

Walmart had incredible growth previously. Perhaps an equally important question is why did their growth slow? I read that they had huge margins goi g into small towns where there was little competition and they had an economy of scales advantage. Did it slow because they went into every small town and now they can only expand I to areas where there is more competition and therefore lower margins? WHat would stop Costco abnormal profits?

The Science of Hitting
The Science of Hitting - 1 month ago    Report SPAM

Praveen - Yes, I tend to try and wait for weakness, at least before I do anything meaningful (I might add 1% - 2% at a price I don't love). Now, with that said, I'm also of the belief that continuing to own something at "x", if you plan to do so for the long-term, is indistinguishable from buying at "x" today (whether that means buying for the first time, adding to an exisiting position, whatever). So, I try my best to avoid this sort of endowment bias. To your example, I do find it difficult to pay up for something like Costco today, even though I can make the math work if I truly think 10, 20, or 30 years into the future (and especially if I assume long-term rates will remain in the low-single digits for a long time). Even then, my preference is to wait patiently for those rare chances to buy at a good price - and to act aggressively when given the chance to do so. Admittedly, that can mean waiting years between meaningful decisions. Personally, I'm okay with that. Thanks for the comment!

The Science of Hitting
The Science of Hitting - 1 month ago    Report SPAM

Johnbarber - I think that's an important point; as part of the research process, you need to break out the contributors to growth. Is this is a comp story? New units? If the latter, in a market where they've shown an ability to win (like the U.S. for Walmart) or a new region where their business is unproven? Those are all important questions that you need to answer if you're going to make estimates 5, 10, or 15 years into the future. As I think about those questions for Costco, I'm quite confident in saying that the business will be meaningfully larger 5, 10, and 15 years from now (with profits moving higher with the top line). Thanks for the comment!

jacktickle2498
Jacktickle2498 - 1 month ago    Report SPAM

Thanks for the interesting read. What other blogs do you read frequently? I LOVE this blog and wondered if you know of any similar ones? Plus how I can I turn on email notifications for this blog (if you know possibly)? I think an interesting stock you may like could be Greggs, which is a UK fast food company. It recently was very cheap compared to its historical price. It was also growing great in the pre covid years. I wrote about it on my blog TheUpAndComingCapitalist (Building Wealth: One Pasty At A Time the article is called).

The Science of Hitting
The Science of Hitting - 1 month ago    Report SPAM

Jack - Glad you enjoyed the article! And I'm not familiar with Greggs (or the UK fast food market), but I'll check out the article.

If you follow me, I think it will turn on email notifications, but I'm sure someone from Guru can confirm or deny that. Thanks for the comment!

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