[I recently finished my first quarterly letter to my investors, who are some close family members and friends. Below is an excerpt from the investment process section, where I spent most of the time explaining my unique (at least I think) business analysis framework, which is a combination of Sun Tzu‘s Five Factors (based on the Art of War) & checklist method.]
Investment Approach – The Process
I will start with where I spend my resources and our capital to. It’s mainly 3 investment themes: special situations, distressed assets and great operations at reasonable price. The core idea of all three is “buy low sell high”, however the way of analysis for each is somewhat different.
- In special situations category, I look for entities undergoing some type of corporate event that might lead to a mismatch of value and price (e.g. depressed prices due to forced sells, or under-appreciated prospect that could increase the value). Examples of special situation investments include, but are not limited to, spinoffs, corporate restructurings, mergers, liquidations, and rights
- In distressed assets category, I look for asset that is priced well below its value due to unfavorable developments. a.k.a. “There is always a price to make a crappy business an attractive investment.” Since the risky nature of distressed assets, heavy analysis is performed on balance sheet and solvency side. It also is the most time consuming from tracking perspective as any new development and disclosure could significantly change the value evaluation outcome. I typically size ideas in this category conservatively. Examples of distressed assets investment include, but are not limited to, cigar butts, scandals and high yield corporate debts.
- In great operations at reasonable price category, I look for, as the name itself says, great operating businesses at reasonable price. This is what Buffett does for the late part of his career, and examples include well known Berkshire Hathaway’s holdings of Coca Cola, American Express and Wells Fargo, etc. The return of this category comes not from the price/value mismatch in current day per se, rather from the compounding growth of the value in future. Thus, my research spent on this category is mainly on the industry, business model and moat of the business, which drive the value compounding ability of an entity.
Next, I will talk about the process of how I approach analyzing an opportunity. I usually start with the business itself, trying to understand the business model, industry landscape & whether there is moat around the business. Then I will move on to balance sheet, to get an idea of what assets it has, last to its profitability (i.e. income statement). There are well documented metrics and valuation methods for analyzing the latter two, but the first (also the most important, in my opinion) item – business analysis – may worth more elaboration.
I use a self-developed “Sun Tzu’s 5 factors” method to analyze businesses. Sun Tzu’s classical military treatise, The Art of War, starts with the 5 most important factors affecting wars: Tao/Dao (道), Meteorology (天), Topography (地), Commander (将), System (法).
1. Tao/Dao, as a term, is very hard to interpret (even for Chinese) because Taoism thinks the essence of the universe is not describable, thus intentionally keep it as general as possible. It is commonly interpreted as “morality” in this context as Sun Tzu elaborates it in subsequent texts saying “Tao causes the people to be in complete accord with their ruler, so that they will follow him regardless of their lives, undismayed by any danger”. In my framework for business analysis, I extend it a bit to include more “spiritual” consideration of a company.
- Mission/Purpose – Does the company have a big mission/purpose? What societal problem is this business trying to address? How much is the business meaningful for the society?
- Morality – Does the company always adopt moral and prudent business practices?
- Sense of the Position in the Value Chain– Does the company understand the value it creates for the world? And only take fair return for the value it created? (This is a different angle asked for the same idea Buffett had about “having pricing power but not abusing it”.)
- Benefit to All Constituents – Does the business create value for all constituents (including suppliers, employees, customers and the society)? Does the business have support and belief from all the constituents?
- Societal Value – When the company has some unique process/practice, if significant proportion of the industry adopt the same process/practice as this company, would the society better or worse off? (In Credit Acceptance’s case, I believe yes; In Valeant’s case, I believe no.)
- Range of Vision – Does the company have a short-range or long-range outlook in regard to profits?
2. Meteorology literally means the weather, seasons etc. In business analysis, I look at all the influential forces that are NOT IN the company’s own control.
- Addressable markets – How large is the addressable markets of the company’s products/services? Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
- Industry Trends – What are the secular and cyclical trends affecting the business?
- Competition – Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competitions?
3. Topography literally means the likes of positions, distances & terrain. In business analysis, I look at all the influential forces that are IN the company’s own control, the most important of which is the moat (which coincidentally is a topographical term for ancient warfare itself!).
- Moats – Does the company have moat? Are they narrow or wide? Are they susceptible to disruption/erosion?
- Profitability – Does the company have a worthwhile profit margin? And what is the company doing to maintain or improve profit margins?
- Financial Strength – Does the company have relative strong/healthy financial position? Does the company use leverage prudently? Does the company need external financing to achieve its stated goals?
4. Commander probably needs the least explanation. It simply means the management in business analysis.
- Integrity – Does the company have a management of unquestionable integrity?
- Capital Allocation – Does the management have superior capital allocation skills?
- Determination – Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
- Transparency – Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointments occur? Are executives promotional?
5. System means laws and discipline in Sun Tzu’s context. I include all governance & incentive related items here. The most important one that I focus on is incentive systems (including both rewarding and punishing).
- Culture – Does the business have a good culture, cultivating prudent value creation?
- Interest Alignment – Does management/insiders have material ownership or material portion of equity in their comp package? How does the management’s incentive plan tie to the business’ profitability and shareholder value?
- Corporate Governance – How good are the company’s cost analysis, asset evaluation & accounting controls?
- Capital Structure/Dilution – In the foreseeable future will the growth of the company require sufficient equity financing so that the large number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?
Lastly, I want to touch on some miscellaneous items of my investing process. In terms of concentration, I typically hold 10 to 15 instruments, with each of the position consisting between 5-10% of the portfolio. From time to time, some highly convicted ideas in the great operations at reasonable prices category could have larger position up to 15% of the portfolio. My typical holding period is 1 to 3 years, with special situation and distressed ideas on the short side, and great operations ideas on the long side. The implication for you as an investor is that your capital may experience higher volatility (as measured by the change of market prices) due to the concentration, however that doesn’t mean it carries higher probability of permanent capital loss. Rather, the margin of safety (i.e. paying prices very conservative to estimated value) will ensure your hard-earned wealth, along with my own, to bear smaller risk.