The Proper Analysis of an Investment

In this post I would like to summarize my thoughts on how one goes about analyzing an investment. I will focus on the situation where one is analyzing a potential 'good business' which is expected to compound value over time and which you can hold for the long run.

In my experience, one understands a business, its competitive advantage, and potential for future growth rather quickly or not at all. It is seldom the case when I begin with little understanding of a company's products/industry and end my research feeling that I have a solid understanding of the future of the company or its industry. This is mainly because the companies that I cannot initially understand would require too much time for me to feel comfortable with- I could use many examples such as industrial companies with highly technical products that are sold to other companies, pharmaceutical companies which sell drugs I cannot pronounce and fix ailments I have never heard of, certain software developers, and companies which manufacture certain highly technological products.

To become comfortable investing in such industries would take years of study at a minimum. Although there are a number of companies in these industries who sell products I can fully understand, they exist in rapidly changing industries and it is quite difficult to predict the future 5 or 10 years out. This of course, makes it nearly impossible to value a company and determine how much I should be willing to pay for it. 

The prudent investor who understands the limits of her/his own knowledge will rule out a significant number of public firms (likely the vast majority) as a result. This does not mean they are any worse off. To determine the suitability of a company for investment, one must understand its products, its industry, its position within the industry, and the future of both the industry and the company's position within the industry into the future. Of course, after those considerations the firm must be selling at a reasonable price or the stock will produce mediocre returns to its owners even if it is a truly extraordinary business. Thinking about an industry 5, 10 or 20 years from now is no simple task and requires one to focus on certain industries in which they are truly competent and can understand in their entirety. 

So as stated, at the start of one's research it should become clear quite quickly whether the firm in question can be understood within a reasonable period of time and whether it has potential to compound value into the future. As the research continues, the investor forms an understanding of the industry structure, and then develops the basis for the firm's current advantage and how the firm will retain that advantage in the future. 

Something I personally do once I reach this stage and believe the firm is in a very enviable position for the long-term is think about all my potential biases and whether my perception of the firm could be in any way skewed, if I could be acting on emotion in any way or if this is the result of truly logical reasoning.

After considering all potential biases, I invert my thinking and consider all of the things that could possibly harm this business and its position in the future. Which factors could reduce demand for this firm's product/service? There are a nearly countless number of potential factors to consider for any business, including current competition, potential new entrants, a new technology which revolutionizes or destroys the industry in any manner, any substitute product in a separate industry which could affect demand for this firm's products, and many more. Further, which factors would make it so that the firm doesn't do as well as I believe it will? For any industry there will be a large list of potential risks and influences to consider. It is important for the investor to determine which are benign and which could seriously harm the firm's performance.

It is my opinion that in many cases, the harm will come from that which you don't know you don't know. This is particularly the case in highly volatile and rapidly changing industries. Attempt to consider all material things and you will be better prepared to value the business and its future prospects accurately.

After this analysis has been done, and the investor has a rational basis on which to believe the firm will continue to do well in the future, the company must be purchased at a fair price. There are many books on valuation and I don't want to bore my readers to death, but it is always important to note that the price you pay (even for a compounder) can have a big impact on your returns- see here for more on that

It is both an investment and mathematical certainty that if you purchase a company for less than what it is worth you will do well, no matter the quality of the business (one caveat- the business has to be worth something). Of course, you must be able to accurately determine what the company is worth. Business values however, are never certain, and even if one has a great understanding of a business only a range of fair value can be produced at best- it is impossible to say with certainty that a company is worth some exact value. 

My point here is that the investor's entire analysis of the firm was done in an effort to properly value the company. The value of a company includes all future cash flows until the year infinity, so the better that understanding, the more accurate the valuation will be. If the investor is wrong on any material point, the value of the business could be much less than what she/he originally thought, and therefore the price paid could then be too high. It is always a matter of price paid versus intrinsic value.

To summarize:

1. Understand the business and its competitive advantage

2. Ensure the business will retain that advantage in the future

3. Understand how quickly the business will grow over time

4. Make sure you buy the company at a fair price

When an investor has finished this process, she/he will be able to concisely describe the firm and its potential in a logical manner. It should be simple to understand and explain to others in a few sentences.

I will use two quick examples- firstly one which illustrates how one shouldn't think about a business, and secondly how to do this process well.

I must say that firstly, I have never seen an analysis or valuation from a Wall Street analyst that had any substance. I don't mean this as an insult, just as constructive criticism. I believe this is because they have different goals at heart, but it usually is the case in such analyses that a year in the future is considered the long-term and a price target as well as quarterly estimates over the next few months will be given without any regard to long-term business value. This is why I believe that investors can profitably exploit mispriced securities even if they are covered by many analysts- the wise investor considers long-term values and whether the business will compound over time; temporary issues and poor quarters are of little concern. Frankly, if you believe stock market volatility is a result of real changes in business values you are mistaken (more on this in future posts).

Last year, I was looking at a business that I believed was severely mispriced. I believed, and still do for good reason, that it would compound value over the long-run. Its stock had experienced a significant decline over a few months due to temporary concerns which I believed weren't material to the long-run. The company was covered by many analysts and I was able to read the research that one of them had published. The analysis focused mainly on the next 6 months, presented the current weakness of the company, and put a 'price target' on the firm, which is basically an estimate of where the stock will be priced within the next few months. That was essentially the entire analysis. No mention of potential future growth of the company, the firm's competitive position or the value it provides to consumers. If people were making investment decisions based on this information it became clear to me why analyst coverage and widespread knowledge of all current events of the firm weren't harming my ability to purchase the firm at a low price- they were all focused on the next 3-6 months while I was thinking about the next 10+ years.

Here on the other hand, is a great and concise analysis of Geico by Warren Buffett in 1951. The link will take you to another website and it may take you a few minutes to read, but I assure you it will be worth the time and you will quickly understand why I used it as an example.

1. He discusses that the firm has a major cost advantage due to the fact that it has no branch offices or agents, and as a result can charge much lower prices than its competitors. Since insurance is a near commodity and difficult to differentiate, those who can sell it at the lowest price will do extremely well. As a result of its low-cost structure, its underwriting results are far more profitable in comparison to premiums generated than other insurance firms.

2. He doesn't discuss whether any other firm could replicate Geico's low cost model, but it is clear that it would be difficult as all its competitors had higher cost structures and Geico has the advantage of loss-experience and brand over any new firms.

3. He discusses Geico's past results and why it will do well in the future. Note that it is not simply, "Geico has grown at such and such rate, so I assume it will continue to grow at this rate". It is a reasonable analysis of how many consumers would benefit from switching to Geico and notes that Geico was only doing business in 15 states until the current year. If the firm operates in a commodity industry, is by far the lowest-cost player, is only doing business in 15 of 50 states, and is rapidly growing, it is likely that it will continue to grow at high rates. 

4. The company was selling at only 8x current earnings. Price to Earnings (P/E) ratios are only a crude valuation tool but for those new to P/E ratios, a P/E of 10 would indicate approximately flat earnings forever. If a company is selling at 8x earnings, the market is pricing the firm as if it would have flat or reduced earnings indefinitely. That clearly was not an accurate assessment of Geico in 1951. Geico's earnings and future prospects were being discounted because it had experienced a drop in earnings compared to the prior year- this is very common in commodity-like industries and good insurers will usually decrease the number of policies they write in times where prices are abnormally low. A long-term investor would have understood that while earnings decreased, it was not an issue inherent to Geico but rather an industry-wide condition and there will be a time when premium prices rise once more.

Of course, we know what happens. Looking back 66 years later we can be truly amused at how inaccurate the market was. In 2016, 65 years after the market priced Geico as a permanently declining firm, Geico's premium volumes rose 12.5%. This was not the only time Geico was priced incorrectly either- at any period of premium price softening Buffett was able to load up on shares at cheap prices. Given that there are many such cycles on a regular basis in the insurance industry, you can be sure many investors suffered by selling their shares to Buffett at ridiculous prices. The difference between the parties on each side of the trade? Understanding competitive advantage and thinking about long-term business value.