Investment Checklist III - From the customer's perspective

This chapter in Shearn's book goes to the heart of the scuttlebutt approach that is so popular. Not all investors use this approach. But viewing the business through the customer's perspective can be very useful. It can expose some biases that we're falling prey to. Often we like to hear good news about the business under consideration. This positive feedback loop can actually be hugely detrimental to a sound investment thesis. The scuttlebutt approach finds answers from stakeholders who actually drive the demand for a business i.e. the customers.

This post also begins to focus on concepts for competitive advantage that were missing in the previous post. Okay onto Shearn's checklist then -

1. Who are the core customers of the company? - Sometimes a major share of the revenues can come from a small percentage of customers. Understanding why these customers will stick around at times of distress can be the differentiating factor for a company's success.
2. Is the customer base concentrated or diversified? - Without product differentiation, a company is better off with a diversified customer base.
   
   Unfortunately unlike US companies, Indian companies are not obligated to mention the names of customers that contribute the most to their revenues. But with a little search should generally reveal names.
3. Is it difficult to convince customers to buy the company's products? - A company having an aggressive sales strategies without other merits will not have a sustainable advantage.
   
   
4. What is the customer retention rate? - Brand loyalty can be the make/break thing for a company. It pays to hear from the horse's mouth why it will/will not drink the water.
   
   Companies which have subscription services might be susceptible to disruption. Tracking customer retention is crucial here. Even if there are newer customers, without returning customers a business cannot grow e.g. Why should Mahindra Holidays/Wonderla/Speciality Restaurants continue to increase profits if they don't have returning customers?
   
   It is informative to speak to sales people and see whether they receive commissions for customer retention. e.g. the insurance business is completely based on this.
   
   If a company is selective about its customers, it's usually a good thing. This shows that the company wants to work with long-term clients who'll provide sustainable business.
5. Is the company customer friendly? - A customer friendly business, especially where customer-company interaction is very frequent is likely to do better.
6. What pain does the company alleviate for the customer? - This is important to determine for service oriented companies.
7. To what extent are customers dependent on the company's product/service? - Discretionary customer spending is likely to drop in times of financial hardship. Products which are more "need to have" are unlikely to face pressure.
8. If the company disappeared tomorrow, what would its customers do? - This reinforces the need-to-have v/s nice-to-have thinking. e.g. most fixed income managers would be completely lost without ratings companies.

Investment Checklist II - Understanding the Business - the basics

Once a company catches your attention, the first thing to do is to study the business. How does the company make money? What products/services does the company sell? If you can't describe the core business in a couple of words, it definitely deserves a place in the 'too tough' bucket. With modest effort, if you can't understand the business, you should not proceed any further.

Even if you're able to describe the business, you may have no competence in evaluating the business. For example, I might have some inkling about the oil and gas industry (because I worked in it for three years), but I am no master. So before I write my investment thesis, I must pin answer some questions -

1. Do I want to spend time studying this business? - Two things may deter you to proceed with the company at hand. You might not be interested in the business or you might discover that the learning curve is too steep. In the former case, you should definitely give up the chase. A company which bores you initially is unlikely to keep become the bedrock of investment success. (Second level thinking would also apply here - some of the best investment bets come from companies ignored by Mr. Market in the short term for being too boring!) In the latter case, you can be a good judge of the opportunity cost of your time and make a rational choice. The time taken to develop an understanding of the underlying business can be immaterial to investment success. But the depth of knowledge is not. I now try to aim for an inch wide, a mile deep sort of understanding of the companies that I'm invested in.
   
2. How would you evaluate the business if you were the CEO? - If you've always worried about your investment as a minority shareholder, you're probably not a long term investor. Wealth creation in the long term comes from alignment of interests between management and shareholders. Think like Buffett and try to evaluate a business like you'll hold it forever. This allows you to think like the CEO of the company. Not only will you pay attention to understand the business in great detail, you will also be able to evaluate management decisions in line with the company's vision.
   
3. Can I describe business operations in my own words? - You've probably done the short version of this already. But this delves into more specifics. Write down your answers to these questions and other things you think are relevant to your company. Doing this will expose grey areas in your understanding.
• What does the business manufacture/deliver?
• What are the raw materials used? How are these procured?
• Who are the customers? How is delivery done?
  
4. How does the company make money? - When I was reading Shearn's work, I thought he was being repetitive here. But the example provided by him does good justice. At the onset of the financial crisis, few financial gurus would have understood the complexity of credit default swaps. It was definitely right to say then that AIG is in the insurance business. That answered our previous question. Easy enough, but was that sufficient? NO.
   
   When the business model becomes so arcane that it's difficult to predict the effect of esoteric events on product groups, it's probably best to not bet. Personally, and given the lack of experience in my investment career, I try to stick to businesses which sell a single product/service.
   
   
5. How has the business evolved over time? - Has the company evolved into developing competitive advantage over a prolonged period of time or was it just at the right place at the right time? For cyclical industries, a bull run can see many companies rise to historic highs. With the incoming tide, everything rises. Only by delving into the past we can separate the wheat from the chaff. Good place to start is the company's website. Then onto annual reports, forums and any other media articles.
   
6. In what foreign markets does the company operate and what are the underlying risks? - Many companies have revenue streams outside their home country. In the Indian context too, a number of domestic players are entering newer geographies to diversify their customer base. This growth-oriented strategy comes with its own share of risks and opportunities.
• Similar to the overall study of the company's history, it is important to study the history of a company in foreign countries. Each operation is an economic unit unto itself and can be expected to have unique customer preferences. 
• Unless the product/service being sold needs no differentiation in foreign markets, a company will have to spend significant resources on R&D and marketing to appeal to its new customers.
• Do foreign operations have their own management teams? - Strategies in developed/mature markets are unlikely to work in developing/nascent markets.
• Is revenue growth translating into profit growth? - Be cautious if the company does not break-up its profits between geographies. The company may be masking bad performance in some countries with better performance across others. Only with a proper break-up between revenues and profits amongst the geographies can we get a good sense of multiple streams of income. Generally when a company enters a new market, it has larger costs than in mature markets. This goes beyond fixed costs to set-up plant and equipment. To gain market share, a new entrant has to fight incumbents and can be expected to have larger advertising and marketing costs.
• What are the risks to the foreign currency earnings? - Earnings are most likely denominated in currency of the foreign country where subsidiary is located. These earnings are subject to country, political and currency risks. One must be cognizant of these before extrapolating past successes onto newer geographies.
• Country risks - Protectionism and tax inefficiency are some examples. Good places to get a flavour of macroeconomic conditions are World Bank's Doing Business Report and BMI's Country Risk Reports.
• Currency risks - Currency fluctuations will have an impact on the revenue reported in the home country. Most companies use forwards to hedge their revenues. This means setting an exchange rate in the future based on current rates. This gives greater clarity in terms of expected future income. Some companies export and import from the same countries. This serves as a natural hedge to their operations. Hedging policy can be found in annual reports and management disclosures to investors.

This post helps us evaluate businesses from the management's perspective. Nothing has been said so far about the competitive landscape in which the business operates. The focus has only been on what the business does and not on how it competes with other businesses. In the next post, we will view businesses from the customer's perspective. That will do more justice to questions on industry and competition.

Investment Checklist I.I - Filtering your ideas

Once you have a hunting ground for ideas, the next task is to filter them and put them in different buckets. Charlie Munger does this quite simply. He has only three buckets - in, out, too tough. But how to filter?

Circle of Competence

Working inside your circle of competence is crucial. It's not so much that you can never make money outside your circle of competence, but mistakes made here will take a toll on your portfolio and consequently your mental well-being. Also with investments failures outside your circle of competence, you are unlikely to learn anything from a post-mortem. 

Try to widen your circle of competence. Don't be despondent if you're unable to do so. You will find opportunities if you're patient enough. For example, till recently Buffett did not invest in technology stocks. He was ridiculed prior the tech bubble, but in hindsight his obstinacy saved him. 

Once you have identified that an idea is within your circle of competence, you may proceed to detailed questions based on past performance.

Criteria is a filter

Shaern points to a number of questions which can be used to filter investment ideas. More than anything else, I like to boil it down to some very basic things. Motivated from an interview with the Big Bull, I like to look for five things during my initial search - 

• Opportunity - This is a measure of how long the runway is for the industry and consequently the business. 
• Scalability - Is the business scalable? Can additional plants/manufacturing units be put up with increased return on incremental capital?
• Management integrity -  Probably the most important facet to avoid sour grapes in the Indian context. Does the management have a clear vision? Does it communicate this is a transparent way to stakeholders? Are minority shareholders given an equal opportunity to reap benefits from the underlying business?
• Competitive ability - This covers aspects related to Porter's five forces and moats.
• Valuation - "Price is what you pay; value is what you get" - always remember this. Without a reasonable estimate of value, you're only gambling.

Valuation is a criteria

There are numerous ways to arrive at valuations - DCF, relative or residual. Each has its own pros and cons. What one may use is highly dependent on the situation at hand. [post forthcoming]

For instance, Shearn quotes the example of Brad Leonard who uses enterprise value (EV) to EBITDA as a qualifying valuation criteria. In his words - 

"When you are paying one or two times EV to EBITDA, not much needs to go right. If the business survives, you win. As long as the business does not end, you don’t need to make a lot of great assumptions in your analysis. If instead I were paying a 5 percent earnings yield (earnings divided by market capitalization) on depressed earnings, it would not really be that cheap."

Valuation lies in the eye of the beholder. Subject to inherent assumptions, two people can come up with varied notions of intrinsic value. They may be both right (or wrong) at the start, but in the long run, the one to gain profitably from investing is likely the one who's honest and conservative in his assumptions and bets with good margin of safety.

Using a tracking sheet

A tracking sheet is a wonderful way to monitor businesses. More often than not, you'll encounter businesses which look strong fundamentally but do not offer any margin of safety. A tracking list gives you a number of advantages in making rational decisions:

• The sheet keeps our favourite businesses on the radar. An alert system can be incorporated to notify us about stocks that offer good price-value propositions in the future.
• Putting a business on the tracking sheet helps wear off the novelty of a new idea. We are conditioned to act impulsively and the sheet instills the discipline to think holistically before a buy decision.
• Ignoring other businesses in the sheet is the opportunity cost of making a new stock purchase. One is likely to make the best choices amongst a list of relatively good stocks. Over time, this is likely to deliver handsomely to the overall portfolio.

I've touched base with the most rudimentary ideas here - in further posts, I'll delve deeper into each of the matters listed here.