“Getting inside the guts of a business and understanding how it works really isn’t that interesting or sexy. I remember sitting on an assembly line and watching three people add a small piece of felt on to a rubber ducky. I must have spent three hours watching this process. The workers did these thousands of time each week. When I asked about it, management told me they had recently fired the entire team and hired outside temporary laborers to complete the work. We ended up not investing in the company but I did notice about 6 months later they were engaged in a huge product recall dispute because the felt pieces weren’t applied correctly and several children had choked on them. Now I didn’t KNOW this was going to happen, but in our deep dive research of the business, I’d seen dozens of areas where new management were cutting corners and I thought it was only a matter of time before something blew up. That’s why we conduct fundamental business analysis.”
- Wes Leason, Jr.
Fundamental business analysis can either be the most exciting or most boring part of the investment process. As a former consultant, it is second nature for me to break down the major components of a company, create a business operations map, and then tie that to the broader markets, company financials, and direct competition. It’s a lot of work and I don’t know many other investors who complete a full business analysis. Some of this is due to the sheer number of stocks in the portfolio, others prefer to spend time focusing on ratios (price to earnings, price to book, price to sales) and some are focused on things like stock price momentum or macro-economic numbers.
Why Do It?
I’ve found that fundamental business analysis gives me a huge leg up on my competitors because it allows me to see my investment through the eyes of the business owner. I want to understand what the major drivers are of margins and free cash flow and what management can do to improve operations to maximize these. I’d like to understand what restrictions have been imposed on management’s capital allocation choices because of debt levels. Essentially I want to understand the operations and key drivers of what makes this company successful and profitable. Equally – if not more important – I want to know what types of events would impact or impair my business case. Through fundamental business analysis, I look to get three key insights into the business.
What Story Do the Financials Tell?
As a value investor, I have a tendency to look at corporate financials a little bit differently than most. I start with the Statement of Cash Flows, move to the Balance Sheet, then finish with the Income Statement. I place very little emphasis on earnings. I’ve found over time they are the easiest numbers to manipulate. I try to stay focused on free cash. On the balance sheet I look for no short or long-term debt. I also look for high amounts of goodwill. Don’t get me wrong, some goodwill is valuable – like Coca Cola’s brand. Others, not so much. After purchasing aQuantive for $6.3B in July 2012, Microsoft was forced to take a $6.2B write off less than 6 months later. That type of unforced error drives me crazy. I like to see goodwill represent less than 5% of total market cap. Finally, I love to find companies where cash and cash equivalents can pay off all liabilities without even touching operating income. On the statement of cash flows I look for companies that convert roughly 25% of every dollar into free cash.
In essence, the financials should show s company with strong competitive advantages achieved through high returns on capital, financial flexibility through no debt, and outstanding capital allocators in management. Inversely, the should tell you the areas of concern that might lead to real distress down the road.
How Exactly Was the Moat Built?
This question can only be answered by an extraordinary level of research where an investor really needs to roll up their sleeves and dig into the company, its markets, and its competition. Evaluating a moat is similar to 3-D chess. First, you must understand the dynamics of the moat (meaning its source: customer demand versus need, switching costs, brand strength, pricing power with vendors, etc.). Second, you must understand the market dynamics (key players and their relationships, product/service development, competitive players and their strategies, market niches, etc.). Last, you must be able to map out what you believe are the major trends and their outcomes for both your potential investment as well as the industry. This includes assigning a range of probabilities of these events happening.
A great measure of how well you have succeeded in this endeavor is not only the level of comfort you have talking with management of your potential investment but also a wide range of players including vendors, competitors, and industry knowledge thought leaders. If you find yourself comfortable asking and answering questions to this range of players you’ve accomplished your goal. As an example, I remember the first time talking to a pharmaceutical company and they kept discussing ambulatory versus hospitalists. The fact I had to look it up meant I wasn’t nearly ready to invest.
What are the Characteristics and Capabilities of Growth?
Perhaps the greatest problem for management is the ability to handle growth. We’ve all seen those UPS or FEDEX commercials telling companies to “let us handle the growth in your shipping needs”. They run these ads for the simple reason it’s true. Most companies can’t handle growth, and growth is the only way you are going to achieve long-term outperformance in your investment portfolio.
In a McKinsey article[1], the authors point out some great reasons why companies hit a wall and can’t grow anymore. They range from growing market share until there are no additional opportunities, management becomes complacent as they’ve reached a level of performance that assures high profits and steady revenue for the company, or organic growth is no longer an option and they begin to look at M&A as an option (I’ve written about the generally horrible returns from M&A before so watch this carefully). A great example of dealing with these issues was a company I owned from 2000 – 2015, Fastenal (FAST). As a company that sold replacement parts it seemed the company has tapped out its market by saturating areas with distribution centers. The company came up with the idea of micro-centers provided through on-site vending machines. Customers can purchase the highest requested product right on site with no delivery wait time. Fastenal achieved another decade of growth through this strategy. Now if only I was smart enough to see that coming.
Conclusions
Fundamental business analysis isn’t fun (unless you are odd like me) or sexy. The knowledge you gain from such research will pay you back in multiple ways going forward. Every time you begin the journey of learning about a potential investment and its industry, this knowledge builds on other companies and markets until you can weave that infamous “mental models” discussed by Charlie Munger. Understanding what happens in drug development can help you better understand the development of a software application. The more you learn the stronger the investor you will be. You can’t be unhappy about that.
DISCLOSURE: I do not own Fastenal in any of Nintai Investments LLC individual accounts or in the Hayashi Foundation portfolio.
[1] “Why The Biggest and Best Struggle to Grow”, Nicholas F. Lawler, Robert S. McNish, and Jean-Hugues J. Monier, McKinsey, Commentary, January 2004 https://mck.co/2ChUvpw
- Wes Leason, Jr.
Fundamental business analysis can either be the most exciting or most boring part of the investment process. As a former consultant, it is second nature for me to break down the major components of a company, create a business operations map, and then tie that to the broader markets, company financials, and direct competition. It’s a lot of work and I don’t know many other investors who complete a full business analysis. Some of this is due to the sheer number of stocks in the portfolio, others prefer to spend time focusing on ratios (price to earnings, price to book, price to sales) and some are focused on things like stock price momentum or macro-economic numbers.
Why Do It?
I’ve found that fundamental business analysis gives me a huge leg up on my competitors because it allows me to see my investment through the eyes of the business owner. I want to understand what the major drivers are of margins and free cash flow and what management can do to improve operations to maximize these. I’d like to understand what restrictions have been imposed on management’s capital allocation choices because of debt levels. Essentially I want to understand the operations and key drivers of what makes this company successful and profitable. Equally – if not more important – I want to know what types of events would impact or impair my business case. Through fundamental business analysis, I look to get three key insights into the business.
What Story Do the Financials Tell?
As a value investor, I have a tendency to look at corporate financials a little bit differently than most. I start with the Statement of Cash Flows, move to the Balance Sheet, then finish with the Income Statement. I place very little emphasis on earnings. I’ve found over time they are the easiest numbers to manipulate. I try to stay focused on free cash. On the balance sheet I look for no short or long-term debt. I also look for high amounts of goodwill. Don’t get me wrong, some goodwill is valuable – like Coca Cola’s brand. Others, not so much. After purchasing aQuantive for $6.3B in July 2012, Microsoft was forced to take a $6.2B write off less than 6 months later. That type of unforced error drives me crazy. I like to see goodwill represent less than 5% of total market cap. Finally, I love to find companies where cash and cash equivalents can pay off all liabilities without even touching operating income. On the statement of cash flows I look for companies that convert roughly 25% of every dollar into free cash.
In essence, the financials should show s company with strong competitive advantages achieved through high returns on capital, financial flexibility through no debt, and outstanding capital allocators in management. Inversely, the should tell you the areas of concern that might lead to real distress down the road.
How Exactly Was the Moat Built?
This question can only be answered by an extraordinary level of research where an investor really needs to roll up their sleeves and dig into the company, its markets, and its competition. Evaluating a moat is similar to 3-D chess. First, you must understand the dynamics of the moat (meaning its source: customer demand versus need, switching costs, brand strength, pricing power with vendors, etc.). Second, you must understand the market dynamics (key players and their relationships, product/service development, competitive players and their strategies, market niches, etc.). Last, you must be able to map out what you believe are the major trends and their outcomes for both your potential investment as well as the industry. This includes assigning a range of probabilities of these events happening.
A great measure of how well you have succeeded in this endeavor is not only the level of comfort you have talking with management of your potential investment but also a wide range of players including vendors, competitors, and industry knowledge thought leaders. If you find yourself comfortable asking and answering questions to this range of players you’ve accomplished your goal. As an example, I remember the first time talking to a pharmaceutical company and they kept discussing ambulatory versus hospitalists. The fact I had to look it up meant I wasn’t nearly ready to invest.
What are the Characteristics and Capabilities of Growth?
Perhaps the greatest problem for management is the ability to handle growth. We’ve all seen those UPS or FEDEX commercials telling companies to “let us handle the growth in your shipping needs”. They run these ads for the simple reason it’s true. Most companies can’t handle growth, and growth is the only way you are going to achieve long-term outperformance in your investment portfolio.
In a McKinsey article[1], the authors point out some great reasons why companies hit a wall and can’t grow anymore. They range from growing market share until there are no additional opportunities, management becomes complacent as they’ve reached a level of performance that assures high profits and steady revenue for the company, or organic growth is no longer an option and they begin to look at M&A as an option (I’ve written about the generally horrible returns from M&A before so watch this carefully). A great example of dealing with these issues was a company I owned from 2000 – 2015, Fastenal (FAST). As a company that sold replacement parts it seemed the company has tapped out its market by saturating areas with distribution centers. The company came up with the idea of micro-centers provided through on-site vending machines. Customers can purchase the highest requested product right on site with no delivery wait time. Fastenal achieved another decade of growth through this strategy. Now if only I was smart enough to see that coming.
Conclusions
Fundamental business analysis isn’t fun (unless you are odd like me) or sexy. The knowledge you gain from such research will pay you back in multiple ways going forward. Every time you begin the journey of learning about a potential investment and its industry, this knowledge builds on other companies and markets until you can weave that infamous “mental models” discussed by Charlie Munger. Understanding what happens in drug development can help you better understand the development of a software application. The more you learn the stronger the investor you will be. You can’t be unhappy about that.
DISCLOSURE: I do not own Fastenal in any of Nintai Investments LLC individual accounts or in the Hayashi Foundation portfolio.
[1] “Why The Biggest and Best Struggle to Grow”, Nicholas F. Lawler, Robert S. McNish, and Jean-Hugues J. Monier, McKinsey, Commentary, January 2004 https://mck.co/2ChUvpw
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