Chuck Akre is one of the modern-day investing greats. His Akre Focus Fund has easily outpaced the S&P500. Here are some lessons I learnt from him.
Chuck Akre is fast-becoming one of the investing greats of this generation. His Akre Focus Fund (the retail class) has achieved an annualised return of 16.72% since its inception in August 2009. The fund’s return easily outpaces the 14.14% annual gain of the S&P 500 over the same time frame.
As its name suggests, the Akre Focus Fund focuses its investments on only a small number of high-quality businesses (as of the fourth quarter of 2019, the fund only had 19 holdings). These are companies that meet Chuck Akre’s high standards related to (1) the quality of their businesses, (2) the people who manage them, and (3) their ability to reinvest capital at high returns. The Akre Focus Fund holds these companies for the long-term, allowing them to compound over time. Based on his fund’s results, this relatively straightforward strategy has worked tremendously well for Akre and his investors.
With that in mind, I want to highlight five things I learnt from Chuck Akre’s interviews and writings.
He doesn’t predict where the market is going
Unlike other investors, Akre does not scrutinise or make predictions about where the stock market is going. Instead, he focuses his efforts on finding great companies that trade at reasonable prices.
“It’s not that we don’t care what the market is going to do. It’s that there is nothing in our record that suggests we have any skill in making those predictions, so we don’t bother. We just focus on what it is that we do well. That has been successful for a long period, and we do that because we think it is logical, repeatable, simple and straightforward.”
Owning good businesses is more important than simply buying and holding
It is no secret that buy-and-hold investors have outperformed those that trade frequently. However, this is only one piece of the jigsaw.
The difficult part is actually finding stocks that are worth buying and holding. From my personal experience, buying and holding a mediocre business will, as you may have guessed, produce only mediocre returns. Akre says:
“Buy and hold is not our philosophy. What we want to do is own businesses that are exceptional until they are no longer exceptional. It’s a nuance on the notion of buy and hold.”
He also emphasises the point that investors should not hold a stock simply because they prescribe in the buy and hold strategy. If an investment thesis is flawed or the company has lost its competitive edge, it may be time to let go. He explains:
“We’re not afraid to sell, but we want to know that the company really isn’t exceptional anymore, because it has often taken me a long time to understand just how good the really good ones are. And once you own them, you shouldn’t get rid of them easily, or just because something has changed right now.”
He believes indexing is a perfectly good strategy for average investors
Despite running an actively managed fund, Akre still believes owning an index fund is a decent strategy for the retail investor.
Not only has indexing produced a decent return over the long term, but it is also difficult to find good active managers who can outperform the index over time. Akre explains:
“I think it is very difficult to understand who the good managers are and what makes them good. I think about this a lot as it relates to my partners and people in other firms. It’s hard, and people need help, and the idea of using index funds is perfectly reasonable for getting an experience that is the market experience.”
He doesn’t focus on the short-term fluctuations in his portfolio
Akre’s core investing principle is to focus on long-term returns. The stock market may fluctuate wildly in the short-term. Although this can create near-term upsized returns or steep drawdowns, we should not read too much into it. Instead, we need to focus on the long-term potential of our investments.
“You might say, ‘No one can predict stock returns even on a single day. So how can you possibly focus on long-term returns?’ The answer is we do not focus on stocks. We focus on businesses. We earn a majority of returns as portfolio businesses improve and grow, year by year. Is it so crazy to think that if we find a thriving business with strong competitive advantages and buy it at a reasonable price, it might provide us with better-than-average long-term returns?”
He believes the market’s focus on short-term goals creates investing opportunities
It is well-documented that stocks tend to be the most volatile around earnings season. An earnings miss or earnings surprise can cause a stock price to rise or fall disproportionately to its true long-term value.
This is where Akre believes long-term investors can gain the upper hand. Simply by using this price-value mismatch to pick up shares at a discount, long-term investors stand to gain above-average long-term returns. In his discussion on his investing philosophy, Akre says:
“Wall Street’s obsession with what we describe as the “beat by a penny, miss by a penny” syndrome frequently gives us opportunities to make investments at attractive valuations. We keep our focus squarely on growth in the underlying economic value per share – often defined as book value per share – over the course of time. Our timetable is five and ten years ahead, and quarterly “misses” often create opportunities for the capital we manage.”
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
I recently read the book The Behavioural Investor by Daniel Crosby. he brought to light some reasons why investors tend to make bad decision.
I recently read the book The Behavioural Investorby Daniel Crosby. Crosby is a psychologist who specialises in behavioural finance. Through his years of research, he found that humans tend to make bad investing decisions simply because of the way our brains are wired.
But it doesn’t have to be that way. We can learn to overcome some of our behavioural tendencies that cause poor investing decisions by learning and understanding the impact of human psychology.
Crosby explains:
“Understanding the impact of human physiology on investment decision-making is an underappreciated area of study that represents a unique source of advantage for the thoughtful investor.”
With that said, here are some things I learnt from his book.
Our brains were not designed for investing
It may seem strange, but our brains are not really designed to make investing decisions. Homo Sapiens have been around for close to 200,000 years and yet our brains have barely grown since then. A 154,000 year old homo sapien skull found in Ethiopia is believed to have held a brain similar to the size of the average person living today.
Essentially, that means our brains have remained relatively unchanged – although the world around us has changed dramatically. This resulted in emotional centres that helped guide primitive behaviour now being involved in processing complex financial decisions. This has, in turn, led to poor decision making.
Crosby explains:
“Rapid, decisive action may save a squirrel from an owl, but it certainly doesn’t help investors. In fact, a large body of research suggests that investors profit most when they do the least.”
“Behavioral economist Meir Statman cites research from Sweden showing that the heaviest traders lose 4% of their account value each year to trading costs and poor timing and that these results are consistent across the globe. Across 19 major stock exchanges, investors who made frequent changes trailed buy and hold investors by 1.5 percentage points per year.”
Our brains are hardwired to be impatient
Our brains are also hard-wired to seek out immediate rewards. This can lead to impulsive behaviour and poor investing decisions.
Crosby cited research from Ben McClure and colleagues who measure the brain activity of participants who made decisions based on immediate or delayed monetary rewards. According to the study, when the choices involved immediate rewards, the ventral stratum, medial orbitofrontal cortex, and medial prefrontal cortex were used. These are parts of the brain linked with impulsive behaviour.
On the other hand, the choices involving delayed rewards used the prefrontal and parietal cortex, parts of the brain that are associated with more careful consideration.
The experiment showed that our brains made more impulsive and greedy decisions when it comes to immediate reward.
Crosby explains:
“Your brain is primed for action, which is great news if you are in a war and awful news if you are an investor, fighting to save for your retirement.”
Our brain makes assumptions
Our brains have been hardwired to make quick decisions. This involves making assumptions, extrapolating patterns, and relying on cognitive shortcuts. As you can imagine, this can be a beautiful thing when it comes to saving energy for other functions of the body.
Unfortunately, making quick decisions based on cognitive shortcuts is by no means ideal when it comes to investing. These cognitive shortcuts can lead to poor decisions, cognitive biases and, ultimately poor returns.
A great example of cognitive shortcuts is the irrational primacy effect. This is the tendency to give greater weight to information that comes earlier in a list or a sentence.
The Good Investors’ Conclusion
The Behavioral Investor brings to light some of the more common human tendencies and why the human brain is not built to make sound investing decisions. But don’t let that deter you from investing.
We can overcome these behavioural tendencies simply through an awareness of what drives unhealthy behaviour and build processes to guard against poor investing decisions.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Uber is trading some 30% below its IPO price. I took a look at its business fundamentals to see if it is worth picking up shares now.
Uber Technologies, Inc (NYSE: UBER) was once the most anticipated public listing of 2019. But since its initial public offering (IPO) last April, the ride-hailing giant has been a major letdown, with shares trading some 30% below its IPO price.
With that in mind, I decided to do a quick analysis of Uber using my blogging partner Ser Jing’s six-point investment framework.
1. Is Uber’s revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market?
Uber is a great example of a company that is dominant in its industry but still relatively small compared to its total addressable market. According to Uber’s IPO prospectus, the global personal mobility market consists of 11.9 trillion miles per year – or a US$5.7 trillion market opportunity in 175 countries.
Despite Uber’s dominance in the ride-sharing space, it “only” recorded US$12 billion in ride gross bookings in the three months ended September 2019. That translates to gross bookings of just US$48 billion annually, a drop in the ocean compared to its US$5.7 trillion total addressable market. Uber also owns minority stakes in affiliates with similar businesses, such as Didi and Grab, which serve markets that have an estimated size of US$0.5 trillion.
Besides personal mobility, Uber is also in the food delivery and freight business. Uber believes its UberEats business addresses a market opportunity of US$795 billion. The freight trucking market is estimated to be around US$3.8 trillion in 2017, which Uber believes represents its total addressable market as it will address an increasing portion of the freight trucking market.
UberEats and Uber Freight’s gross bookings of US$3.6 billion and US$223 million, respectively, are less than 1% of Uber’s total addressable opportunity for these markets.
Let’s not forget that Uber is also spending heavily on autonomous vehicles and other technologies such as Uber Elevate (aerial ridesharing). These could potentially open other avenues of growth for the company.
2. Does Uber have a strong balance sheet with minimal or a reasonable amount of debt?
Uber ticks this box too. It is widely publicised that Uber has been burning cash at an alarming rate. However, the company managed to buy some time by raising US$8.1 billion through its IPO.
As of 30 September 2019, Uber had US$12.6 billion in cash and US$5.7 billion in debt, giving it around US$7 billion in net cash.
3. Does Uber’s management team have integrity, capability, and an innovative mindset?
I want the companies that I invest in to be led by capable and honest people.
Uber’s CEO Dara Khosrowshahi was appointed to lead the company in April 2017. Before that, he was the CEO of online travel outfit Expedia. Khosrowshahi brings with him a wealth of experience. His track record at Expedia – he quadrupled the company’s gross bookings – speaks for itself.
Khosrowshahi has also been able to clean up Uber’s corporate culture, promising to instill integrity and trust among stakeholders. Before he arrived, Uber’s corporate culture was said to be hostile and sexist under founder and then-leader Travis Kalanick.
I would also like to point out that a large portion of the compensation of Uber’s executives is in the form of stock-related awards. In 2018, 88% of Khosrowshahi’s compensation was in stock awards. Khosrowshahi also bought around US$6.7 million in Uber shares in November 2019, bringing his total number of shares up to 1.53 million, worth around US$48.9 million.
His large personal stake in the company, along with his compensation package, should mean that Khosrowshahi’s interests are aligned with shareholders.
That said, Khosrowshahi has only been in charge of Uber for slightly over two years, and the company has only been listed for less than a year. As such, I think it is worth keeping an eye on management’s decisions and the company’s performance over the next few years before we can truly judge the capabilities of Uber’s leaders.
4. Are Uber’s revenue streams recurring in nature?
Recurring revenue is a beautiful thing for any company to have. A company that has recurring revenue can spend less effort and money to retain existing customers and focus on expanding its business.
In my view, Uber has recurring revenue due to repetitive customer behaviour. Uber’s customers who have experienced the efficacy of ride-sharing end up consistently using the company’s services, along with those of other ride-sharing platforms.
On top of that, Uber has built a large network of drivers and regular clients that is difficult to replicate. More drivers, in turn, leads to faster pickups, better service, and more consumers, creating a virtuous cycle.
Uber has thrown large amounts of cash at drivers to attract them to its platform in a bid to improve its ride-sharing platform and decrease the wait-time for commuters. As the network matures, Uber can theoretically start to profit by raising prices.
That said, Lyft still remains a fierce competitor in the US and has also built its own huge network of riders. While the US market is potentially big enough for two players to co-exist, if Lyft decides to try to eat into Uber’s market share, both companies may suffer.
5. Does Uber have a proven ability to grow?
From Uber’s IPO prospectus, we can see that it has indeed been growing at a decent clip. Adjusted net revenue for ride-sharing, which removes excess driver incentives, tripled from US$3 billion in 2016 to US$9 billion to 2018. Uber Eats’ adjusted revenue went from just US$17 million in 2016 to US$757 million in 2018.
Uber is still growing fast. Its total revenue for the first nine months of 2019 increased by 21% from a year ago.
6. Does Uber have a high likelihood of generating a strong and growing stream of free cash flow in the future?
So far we have seen that Uber ticks most of the right boxes. However, the last criterion is where Uber fails.
Uber has been unable to record a profit since its founding, and has also been burning cash at an alarming rate.
The company had operating cash outflow of US$2.9 billion, US$1.4 billion, and US$1.5 billion in 2016, 2017 and 2018 respectively. Worryingly, the cash burn has not slowed down. In the first nine months of 2019, Uber had a net cash burn of US$2.5 billion from operations.
One of the causes of Uber’s inability to generate profits or cash from operations is its relatively low gross margin of 50% for a tech service company.
Uber’s gross profit margin is low partly due to heavy insurance expenses required to operate its ride-sharing platform. This leaves the company with little room to spend on marketing expenses.
In addition, the potential for price wars could further squeeze Uber’s gross margins in the future. It remains to be seen when or if the company can eventually turn a profit and start generating cash consistently.
Other risks
A discussion on a company will not be complete without assessing the risks.
Besides the risk of competition driving down its profit margins, Uber also faces regulatory risk. Uber’s ride-sharing operations have already been blocked, capped, or suspended in certain jurisdictions, including Argentina, Japan, and London. These restrictions may prevent Uber from entering and growing into other markets, significantly reducing its total addressable market size.
Uber is also investing heavily in autonomous vehicles and Uber Elevate. Both these initiatives require a lot of money and have widened the company’s losses and cash burn rate. In the first nine months of 2019, Uber spent a whopping US$4.2 billion on research and development, which is more than 40% of its revenue. There is a chance that these investments may not pay off in the end.
Uber’s cash burn rate of more than US$1 billion a year is also worth watching. At this point in time, Uber’s strong balance sheet allows it to spend cash without overstretching its books. However, if the cash burn rate continues for an extended period, Uber may end up needing to raise more cash through an equity or bond issue that could potentially dilute shareholders.
UberEats also faces competition from startups such as GrubHub, Door Dash and Deliveroo. UberEats has been the biggest drag to the company’s profitability in recent quarters and a price war against these other food-delivery competitors could widen its losses.
The Good Investors’ Conclusion
There are certainly some reasons to be impressed by Uber. The ride-sharing giant has a long runway ahead of it and has set its sights on autonomous vehicles and air transportation. And with the move towards a car-lite society, ride-sharing will likely become increasingly more prominent.
However, there are also many uncertainties surrounding the company at this time. Ridesharing is effectively a commodity-like service and the presence of other big-name competitors such as Lyft may result in expensive price wars.
Another concern is Uber’s alarming cash burn rate and low gross profit margins.
Valuation-wise, Uber is also not necessarily cheap. At its current market cap of US$57.8 billion, it trades at around four times its annualised adjusted net revenue for 2019. That’s not cheap, especially for a company that has failed to consistently generate positive cash flow from operations and is unlikely to post operating profits anytime soon.
As such, despite Uber’s growth potential, the uncertainties surrounding Uber’s road to profitability, its ability to generate free cash flow, and the potentially painful price wars, make me think that Uber is still too risky an investment for my liking.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Autodesk shares climbed 44% in 2019. Its shift to a subscription model has reaped rewards but are its shares too expensive to buy now?
Software-as-a-service (SaaS) is fast-becoming the go-to business model for software companies. The SaaS model gives the service provider a predictable and recurring revenue stream, while clients enjoy hassle-free software updates, cloud storage, and the ability to access the software seamlessly on multiple devices.
One company that has quietly transitioned to the SaaS model is Autodesk (NASDAQ: ADSK). The 3D design and engineering software company is reaping the returns of this shift as recurring revenue streams have steadily increased.
The market has also appreciated the company’s shift toward the SaaS model. Autodesk’s stock climbed 44% in 2019, compared to a 29% gain for the S&P 500.
With all that said, I decided to do a quick review of Autodesk using my blogging partner Ser Jing’s six-point investment framework.
1. Is its revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market?
I think the answer to this is yes. Autodesk raked in US$715 million in revenue in the third quarter ended 31 October alone, and US$2.5 billion in its fiscal year 2019, which ended on 31 January.
On the surface that seems huge, but Autodesk’s revenue is still tiny compared to its total addressable market. Management expects that its market opportunity today is about US$48 billion. It sees that figure rising to US$59 billion by 2023.
To get a better grasp of Autodesk’s market opportunity, we need to understand what Autodesk really does. In short, the company provides a suite of different software-as-a-service, including computer-assisted design, construction management, and animation among others. It is the go-to software provider for the architecture and construction world.
Its Revit design software is one of the most commonly used among architects, which in turn leads to engineers and construction professionals using Autodesk services to collaborate with each other. Travis Hoium explained in an article for the Motley Fool:
“Once architects are hooked, then the waterfall of other available products begins. Engineering firms are more likely to use Navisworks (another one of Autodesk’s software) for model reviews of engineering and construction documents if an architect works in Revit. Building information modeling software like BIM360 also becomes more efficient in optimizing the construction process.”
The switch to a subscription model has also started paying off. Recurring revenue streams are growing, while the company’s painful transition years in 2016 and 2017 are already behind it. In the first three quarters of fiscal 2020, Autodesk generated a 57% increase in recurring subscription revenue and a 29% jump in total revenue.
More importantly, there is a group of customers who are still on the licensing model who could potentially transition to the subscription model in the future. As of July this year, Autodesk converted about 4.3 million customers to its SaaS model. But there are around 18 million active users of its software, which means that 14 million more users could potentially switch to the subscription model in the future. Autodesk’s very own user base represents a huge untapped addressable market.
The other big market opportunity is the move towards augmented reality and 3D models. While the technologies have not yet caught on, they could potentially be another avenue of growth.
2. Does Autodesk have a strong balance sheet with minimal or a reasonable amount of debt?
The next criterion in the framework is balance sheet strength. I typically want to invest in companies that have minimal or reasonable amounts of debt so that it can continue to sustain its operations should bad times arise.
Unfortunately, Autodesk fails in this regard. The software giant has been investing heavily in acquisitions and has suffered losses over the last few years. That has hurt its financials.
As of 31 October 2019, Autodesk had around US$1 billion in cash and marketable securities. However, it also sat on around US$1.75 billion of debt. On top of that, it was in the unenviable position of having negative shareholder equity. The company had US$5 billion in assets and US$5.2 billion in liabilities. That’s certainly a black mark in my books.
3. Does Autodesk’s management team have integrity, capability, and an innovative mindset?
I think Autodesk’s management team has proven itself to be innovative and capable in a few ways. Current CEO Andrew Anagnost has only had a short history as CEO, but he has already managed to transition the company to a subscription-based model fairly seamlessly.
For the three months ended 31 October, around 83% of the company’s total revenue was from recurring subscriptions. In fiscal 2019, Autodesk also managed to top its revenue generated in 2016, the year it started to make the transition to subscription.
Autodesk has also invested heavily in R&D. I believe its investments in expanding its product services, specifically into augmented reality, will pay off substantially when the market is eventually ready for it.
I also believe that the compensation structure for Anagnost and other executives is tied to that of Autodesk’s long-term shareholders. The performance metrics for the CEO and other senior executives included total annual recurring revenue, free cash flow per share, and total shareholder return over 1,2, and 3 years. While I prefer to see a larger focus on shareholder return over a longer time frame, I think that the performance indicators seem reasonable.
4. Are its revenue streams recurring in nature?
Recurring revenue is an underappreciated but beautiful thing for a company to have. Not only does it mean reliable revenue streams year after year, but the company can also spend less time and money on past sales and focus on other aspects of its business.
Autodesk ticks this box easily. Its transition to a subscription-based model means that its revenue is likely going to be recurring year after year.
Its net revenue retention range is also consistent between management’s target of 110% to 120%, which means existing customers are increasing their net spend on its products by 10% to 20% each year.
Autodesk provides free software training in a bid to grow its user base and to let students as young as grade school get familiar with its software. But the high lifetime value of each customer makes these customer acquisition efforts extremely worthwhile over the long-term.
On top of that, the fact it has about 4 million subscriptions to its services means there is very little customer concentration risk.
5. Does Autodesk have a proven ability to grow?
Autodesk is one of the early movers in software. It was founded nearly 40 years ago by John Walker who co-authored the first versions of AutoCAD. The software company has grown from focusing solely on computer-assisted design to one that has a whole suite of services.
Its revenue has also soared to around US$3 billion. In more recent years, the company’s top line has fluctuated due to the move towards subscriptions. But with the transition more or less complete, it is likely to have a smoother growth ride ahead. Analysts are also anticipating twenty-plus percent annual revenue growth for 2020.
6. Does Autodesk have a high likelihood of generating a strong and growing stream of free cash flow in the future?
The true value of a company is not based on its profits but on its cash that it can generate in the future. That is why the sixth criterion of Ser Jing’s investment framework is so essential.
While Autodesk’s free cash flow generation has been lumpy for the last few years, the completion of the transition to subscriptions will likely mean better days ahead. This year, Autodesk showed signs that it has begun to reap the fruits of its work.
In the nine months ended 31 October 2019, the company generated US$677.7 million in free cash flow.
The company’s gross profit margin stands north of 80%, which means that as the company scales down other expenses, we can expect it to generate a healthy net profit margin, and in turn a higher free cash flow margin.
Risks
A discussion of a company will not be complete without addressing the potential risks.
As mentioned earlier, the main risk I see in Autodesk is its weak balance sheet. The company has net negative shareholder equity and is sitting on a pile of debt. That said, it has started to generate a decent amount of free cash flow. This should enable it to pay off its interest expenses and to reduce some of its debt load.
The company also paid its executives nearly US$250 million in share-based compensation in the year ended 31 January 2019. While stock-based compensation does not factor into the company’s cash flow statement, it does have a meaningful impact. It reduces earnings per share and results in heavy dilution of shareholder interest. For a company that is generating around US$3 billion in revenue, stock-based compensation of US$250 billion does seem excessive.
Competition is another major risk. Autodesk operates in a highly competitive environment that is subject to change. That said, Autodesk has been investing heavily in research and technology to update its software and provide new services. I also believe its customer base who have familiarised themselves with Autodesk will be unwilling to swap products so easily.
Valuation
What is a good price to pay for Autodesk? As with any company, this requires a reasonable amount of judgment and estimation.
Autodesk is anticipated to generate an annualised revenue of around US$3.2 billion in its current fiscal year. The company’s customer count can increase as more of its existing customers switch to subscription models. Revenue will also likely grow organically as existing customers pay more in revenue each year. This can happen by increasing the number of services they buy or through price hikes.
In 10 years’ time, I estimate that around a quarter of Autodesk’s 14 million existing clients who are currently not on subscription plans will eventually switch over. That will bring the total number of customers subscribing to Autodesk’s services to eight million (from four million now). In addition, if the net revenue retention rate continues at 110% per year for 10 years, revenue could eventually reach US$16 billion.
It is difficult to estimate Autodesk’s mature-state profit margin, but considering its 80%-plus percent gross margin, it could easily reach a 10% net profit margin. That translates to US$1.6 billion in net profit.
Attaching a 30 times multiple to the projected net profit, the software giant’s market cap could potentially scale to US$48 billion.
Based on my estimate and the current market cap of the stock of around US$40 billion, the future market cap translates to 20% upside.
However, a 20% upside for a 10-year holding period is too low for my liking.
The Good Investors’ conclusion
There are certainly many things to like about Autodesk. Its transition into a subscription-based model gives it a more predictable recurring revenue stream. The addressable market opportunity for the company is also immense compared to its current revenue.
But having said all that, from a valuation standpoint, the company seems expensive. At its current market cap of US$40 billion, Autodesk sports a 12.5 price-to-sales (PS) ratio. It also only provides a 20% upside to my 10-year valuation projection.
Admittedly, my projection is very rough and conservative, but Autodesk’s high valuation leaves very little room for execution risk. In addition, if its relatively high stock-compensation scheme continues to rise, it might leave shareholders grasping at straws because of dilution, even if the company generates more free cash flow in the future.
As such, even though Autodesk seems like a solid growth company, it still remains only on my watchlist.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Short term trading may look enticing but it is actually extremely difficult to be a consistently successful short-term trader.
Do you have the mindset of a trader? That’s the advertising catchphrase for an online broker that is marketing aggressively around Raffles Place.
The advertisement makes short-term trading sound like a lucrative and exciting proposition. But in reality, short-term trading is an extremely risky sport. Many factors are working against traders that they more often end up losing money instead.
With the aggressive marketing campaign in the heart of CBD, I thought it would be important to highlight some of the dangers of short-term trading before more people get burnt.
Trading costs
Day traders who trade frequently end up paying much more in commissions than long-term buy and hold investors. These commissions add up over time, especially when short-term traders tend to take profit after only a small percentage gain.
While online trading fees are generally falling, fees can still add up over time. Right from the get-go, traders are already trying to claw back what they lost in fees, making their task of earning money all the more difficult. The difference in the bid and ask further complicates the issue.
Buy and hold investors, on the other hand, pay less in fees and each investment they make can end up becoming multi-baggers, making brokerage fees negligible in the long run.
The use of margin
Typically, day traders use margin to increase the size of their trade. Margin allows traders to earn a higher return on their capital outlay but it also increases the size of a loss.
On top of that, margin calls make trades even riskier. Should the trade position go against the trader and fall below their available funds, the margin call will immediately close their position, realising the loss.
It’s a zero-sum game
Short-term trading is effectively a zero-sum game. For there to be winners in short-term trading, there must also be losers.
In addition, short-term traders are playing the game against professionals, who may have an informational advantage.
This is very different from long-term investing, where a rising stock market creates the opportunity for all investors to make a profit together.
It’s time-consuming
A successful day trader also needs to factor in the time taken to make frequent trades.
Short-term trading requires the constant monitoring of charts, news, and technical indicators. The time and effort to make successful trades may not be dissimilar to that of a full-time job.
The Good Investors’ conclusion
Don’t get taken in by the aggressive marketing campaign to be a short-term trader. While it may seem enticing, short-term traders bear the huge risk of loss. There are so many factors working against short-term trading, that only a small percentage of them are able to make consistent profits.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
2019 has been one of change and challenges. But it has also been a year that has taught me the power of human generosity and to shoot for the moon.
In both my personal and career life, 2019 was one of the more challenging but rewarding years.
The Motley Fool Singapore – what I believe was an excellent portal for investor education in Singapore, and a platform that I had been contributing to – unexpectedly closed down (for commercial reasons); Ser Jing – my fellow Good Investor – and I subsequently decided to launch a fund; we started our blog to share our investing thoughts; we joined a company with an eye on helping the less fortunate in Cambodia; and I finally got engaged!
It was indeed one heck of a year.
With that said, I decided to pen down a few things I learnt along the way.
Don’t underestimate human generosity
The cynic in me used to believe that the majority of people want to see others fail. There’s even a word for it in Germany: Schadenfreude.
But this year I learnt that while there are people who are generally self-serving, many are not. My personal encounters with generous people – people who were willing to share, teach, and help – have made me believe in the innate generosity of human beings.
Setting up a fund is not an easy task, a task which Ser Jing and I could not have imagined doing on our own. Thankfully, throughout the year, we encountered countless people who were willing to take time off from their busy schedules to help in whatever way they could.
Meeting people who didn’t even know us well but who were willing to share insights, give advice, and encourage us, was a truly humbling experience.
Be open to new experiences
I knew that setting up fund was not going to be easy. Compliance needs, regulatory requirements, gaining the trust of investors, legal fees, etc, are all challenges we have to overcome.
But a fund would also be an avenue for Ser Jing and I to help more people prepare for retirement, provide us with a platform for investor education, and to be a guiding light on how funds should charge clients. It could also be a great way to give back to society (as Ser Jing and I have pledged to give back at least 10% of our personal profits from the fund to charity).
Taking a step in the dark can be daunting. But it can also be hugely rewarding.
Even if the fund does not achieve all our goals, there are still many invaluable lessons from what we have done so far.
The friends made, the knowledge gained, and the chance to make a meaningful impact make it all worthwhile.
Surround yourself with the right people
This is a cliche but it is one worth repeating. This year could not have been so fulfilling or rewarding if not for the people who have supported and helped us.
My family not only provided the encouragement to take the leap of faith but also the support that all entrepreneurs really need.
I am also thankful for friends who have placed their trust in Ser Jing and me and have been willing to support our venture so far.
This year has indeed been a messy one; one of change, challenges, and uncertainty, but it has also been one that taught me to treasure my close circle, shoot for the moon, and not to underestimate the generosity of humans. I certainly wouldn’t have had it any other way.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Haidilao is one of the top-performing stocks of 2019. Its surge has propelled its founder to the top of Singapore’s rich list. But is it a good stock to buy?
Haidilao has been one of the top-performing stocks in Hong Kong this year. The premium hot pot restaurant brand’s share price has climbed 79.4% this year, compared to a 10.8% gain for the Hang Seng Index.
But historical share price performance is not necessarily an indicator of future success. With that said, I decided to do a quick analysis of Haidilao’s business. I will use Ser Jing’s six-criteria investment framework to determine if the company is indeed worth buying.
1. Is its revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market?
This criterion is important because Ser Jing and I want to invest in companies that have the ability to grow. The size of the company’s addressable market, and the speed of the market’s growth, are important determinants of the company’s growth potential.
I think Haidilao ticks this box easily. The hotpot king’s revenues are still tiny compared to its overall addressable market size.
Haidilao, as of 30 June 2019, had a network of 593 restaurants around the world. On the surface that seems like plenty but if you dig deeper a different picture emerges.
First, Haidilao has room to grow in China. The company has 550 restaurants in mainland China. Given that China’s middle-class population (defined by the Chinese government as having an annual income of RMB 60,000 to RMB 500,000) numbers around 420 million people, that translates to just one restaurant for every 763,300 middle-income person in the country.
Comparatively, the largest casual dining chains in the US restaurant industry serve around 200,000 to 500,000 people (including the low-income population) per restaurant.
If we assume Haidilao can penetrate the market at the low end of that range, it can increase its store count by more than 30% just based on the current middle-income population.
On top of that, the middle income population in China is growing – and fast. Mckinsey estimates that the upper-middle-class population (defined by McKinsey as having an annual income of RMB 106,000 RMB to RMB 229,000) will account for 54% of urban households by 2022, up from just 14% in 2012. That loosely translates to a population of 750 million people. The new generation of upper-middle-class is more sophisticated, has more picky taste, and is more loyal to brands.
All of which is good news for Haidilao, which already has an established reputation for good food and impeccable service.
The Mainland China market is not the company’s only avenue for growth. Haidilao has successfully broken into other International markets such as Taiwan, Singapore, Japan, South Korea, Malaysia, Australia, the United Kingdom, Canada, and Vietnam. And it has barely scratched the surface of the International market scene. It only operates 43 restaurants outside of China, leaving it plenty of room for growth. The average spending per guest outside of China is also much higher at RMB 185 per customer, compared to its overall average spend of RMB 104.4 per customer.
The company’s recent financial results also point to its ability to grow. In the 12 months ending 30 June 2019, Haidilao increased its store count by 73.9%, or 252 stores. More importantly, the increase in store numbers had little impact on existing stores, signaling limited cannibalisation. Same-store sales increased by around 4.7% and the average same-store table turnover increased to 5.2 from 5.0.
2. Does Haidilao have a strong balance sheet with minimal or a reasonable amount of debt?
Haidilao is in a great position financially. As of 30 June 2019, the group reported a positive net cash balance of around RMB 2.57 billion. It also had another RMB 1.7 billion in deposits placed with financial institutions. The company generated RMB 1.9 billion in cash from operations in the first six months of 2019; it was more than sufficient to fund capital expenditures for the opening of new restaurants which amounted to RMB 1.7 billion.
It is good to see that Haidilao is using internally-generated cash to expand rather than tapping into its reserves.
3. Does Haidilao’s management team have integrity, capability, and an innovative mindset?
Haidilao has not had a long history as a listed company, but its management seems to be treating existing shareholders fairly for now.
Even though 38% of Haidilao’s suppliers are linked to CEO Zhang Yong and his family, the cost of goods has not increased unreasonably since Haidilao was listed. This is a sign that Zhang Yong is committed to treating Haidilao and its minority shareholders fairly. On top of that, Haidilao has also started to reward shareholders by paying a small dividend for 2018.
Zhang Yong has also proven himself to be a capable leader. Now Singapore’s richest man, Zhang Yong has maintained his commitment to improving the customer experience in his restaurants. He has also overseen the company’s adaptation numerous times, including its expansion into delivery, Haidilao-branded food products and the adoption of artificial intelligence in restaurant operations.
Haidilao is also one of the more innovative businesses in the traditional F&B industry:
The company was one of the first to provide unique manicure and free snack services for customers waiting for a seat.
This year, it deployed intelligent robotic arms and intelligent soup base preparation machines in 3 restaurants. It also introduced AI robot waiters in 179 restaurants.
It has expanded its offering and now offers milk tea under the Haidilao brand. In 2019 alone it introduced 187 new dishes.
It encourages restaurant-level managers to maintain customer service by sending at least 15 mystery diners each year to each restaurant to rate their experience. Their feedback is a key performance indicator for managers.
Restaurant managers are also compensated based on the profitability of the restaurants under their care.
Restaurant managers are encouraged to train mentees and they are then compensated based on the profitability of the restaurants that their mentees manage.
These unique initiatives have helped to create a culture of providing good service and have enabled the company to retain talent more effectively.
4. Are its revenue streams recurring in nature?
A recurring revenue stream is an underrated but beautiful thing to have. It means the company does not have to spend time and money to remake a past sale. This can be achieved through repetitive customer behaviour or long contracts with clients.
In Haidilao’s case, its strong brand and loyal customers make its revenue streams recurring and predictable.
Needless to say, more brand-conscious consumers are loyal to brands that they trust. Haidilao has a strong brand and sticky following with consumers. The long queues in its Singapore outlets are a testament to that.
The number of customers Haidilao serves is also obviously large. In 2018, it served more than 160 million customers! That means it has no customer concentration risk at all.
5. Does Haidilao have a proven ability to grow?
Haidilao was listed only in 2018, and so far, it has shown the ability to grow based on its financials released in its initial public offering prospectus and subsequent earnings updates.
Source: My compilation of data from annual and interim reports
Revenue has compounded by 43% per year from 2015 to 2018 and the growth rate accelerated to 59% in the first half of 2019. Profit has grown at an even faster pace, at a compounded rate of 82% per year from 2015 to 2018. In the first half of 2019, profit increased by 41%.
6. Does Haidilao have a high likelihood of generating a strong and growing stream of free cash flow in the future?
The true value of a company is not based on its profits but on all the cash that it can generate in the future. That is why the sixth criteria of the investment framework is so important.
Based on Haidilao’s recognisable brand, strong customer loyalty, and the management’s determination to keep customer-satisfaction high, I can see customers continuing to frequent the company’s restaurants well into the future.
Haidilao is not only well-positioned to grow its store count, but same-store sales are also growing at mid-single-digits.
Although capital expenditures remain high, likely due to the opening of stores, I foresee that Haidilao could start to generate copious amounts of free cash flow in the future.
Risks
A discussion of a company will not be complete without addressing the potential risks.
Keyman risk is an important concern I have with Haidilao. Zhang Yong is a visionary leader who reinvented the hotpot dining space, through innovative initiatives. He continues to adopt new technologies and has constantly implemented plans to improve his customers’ dining experience.
He is the key reason for the brand’s huge success so far. Zhang Yong is 45 now and I don’t foresee him stepping down anytime soon. Nevertheless, investors should watch this space.
Another risk is that Haidilao continues to source supplies from entities with related-party ownership. Even though these related-party suppliers have so far been fair to Haidilao, there remains a risk that things could change.
Lastly, execution risk is another concern. The company’s growth is dependent on it expanding the number of stores without affecting its existing business. Store-location choice is an important determinant of whether new restaurants succeed.
On top of that, while size improves economies of scale, it can also become increasingly difficult to maintain food quality, food safety, and the quality of the customer experience.
Valuation
What is a good price to pay for Haidilao? As with any company, I think this requires a reasonable amount of judgment and estimation.
The company recorded revenue of RMB 10.6 billion in China in the first half of 2019. Based on the addressable market size, I think the mainland Chinese market can easily absorb 1,500 Haidilao restaurants. That’s a three-fold increase.
The international market is a bit harder to estimate. But I do think Haidilao can easily increase its store count in geographies with large Chinese populations such as Taiwan, Singapore, Malaysia, Australia, United States, and Hong Kong. For simplicity’s sake, let’s assume it can increase its current international store count of 43 by three times to 129.
We will also leave out the growth in delivery sales for now.
Based on these assumptions, Haidilao can achieve an annual profit (assuming net profit margin remains the same) to shareholders of around RMB5.5 billion.
If we attach a multiple of 30 times to that figure, we can estimate a reasonable future market capitalisation. Based on this rough estimation, the company’s future market capitalisation should be around RMB 164 billion.
I think that Haidilao, at the current rate it is expanding its network, can realistically hit that level of profit in eight to 10 years.
If I want to achieve an annualised return of 10%, the most I would pay for the company would be RMB 76.5 billion.
At its current share price, it has a market capitalisation of RMB 154.8 billion, which is around 74 times trailing earnings. The company’s current market cap is twice the amount I would be willing to pay based on my calculations.
Although the numbers I used for my estimation may be conservative, the current market cap seems inflated and leaves investors exposed to huge risk should the company fail to achieve the anticipated growth.
The Good Investors’ conclusion
Haidilao ticks all six criteria of Ser Jing’s investment framework and is certainly a good business with great prospects. I think my estimates of the potential addressable market are fairly conservative, and the company could easily grow faster and bigger than I predicted. The addressable market could also grow much more as the Haidilao brand could penetrate the International market more deeply.
But despite all that, from a valuation perspective, the company’s share price is a little too expensive for my liking. It leaves very little room for execution error. Should Haidilao fail to deliver my projected growth, its stock might also risk valuation-compression.
As such, even though Haidilao is a solid growth company, it is only on my watchlist.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
The Mawer Global Equity Fund and Fundsmith Equity Fund have handsomely outperformed the market since their inception. Here’s how they did it.
If you thought that professional investors can easily beat an unmanaged basket of stocks, think again.
According to an article on CNBC, 64.49% of large-cap funds lagged the S&P 500 in 2018. It marked the ninth consecutive year that actively managed funds trailed the broad US-market index.
Over a 10-year period, 85% of large-cap funds underperformed the S&P 500. Over 15 years, that figure increases to 92%.
Given how such few funds consistently beat the market, I tend to take notice when one does.
Two funds, in particular, have caught my eye. They are the Fundsmith Equity Fund and the Mawer Global Equity Fund. Both funds have global investment mandates and have beaten their respective indexes by a wide margin.
Fundsmith has an impressive annualised return of 18.3% as of 31 October 2019 since its inception nine years ago. It is well ahead of the annualised 11.7% return of the global equities market.
The Mawer Global Equity Fund has also done really well since its inception in 2009. As of 30 September, it has a compounded annual return of 13.1%, compared to an 11.4% return from the global equity benchmark.
So what is the secret behind their success?
Low portfolio turnover
Needless to say, careful selection of high-quality stocks is one of the key ingredients to their success.
But another thing that stands out is that both Fundsmith and Mawer Global Equity Fund have extremely low portfolio turnover. Portfolio turnover is a way to measure the average holding period for a stock in a fund.
In 2018, Fundsmith and the Mawer Global Equity Fund had an annualised portfolio turnover of 13.4% and 16% respectively. In essence, that means the average holding period for stocks in their portfolios was more than 6 years each.
So why is this important? Terry Smith, founder and manager of Fundsmith, explained in his annual letter to shareholders that a low portfolio turnover “helps to minimise costs and minimising the costs of investment is vital contribution to achieving a satisfactory outcome as an investor.”
Besides reducing the costs of transactions, staying invested in high-quality stocks gives investors the opportunity to participate in the immense compounding effect of the stock market.
Morgan Housel, currently a partner in Collaborative Fund, wrote in one of his past columns for the Motley Fool:
“There have been 20,798 trading sessions between 1928 and today (2011). During that time, the Dow went from 240 to 12,500, or an average annual growth rate of 5% (this doesn’t include dividends). If you missed just 20 of the best days during that period, annual returns fall to 2.6%. In other words, half of the compounded gains took place during 0.09% of days.”
Hence, a low portfolio turnover not only reduces transaction fees but increases the chance that investors do not miss out on the best trading sessions, which form a large portion of the market’s returns.
Low management fees
Actively managed funds have been known to charge notoriously high fees. This is one of the reasons why active funds find it difficult to outperform their low-cost index-tracking counterparts.
However, both Fundsmith and Mawer Global Equity Fund buck this trend. Both funds have relatively low management fees and do not have a performance fee. Fundsmith’s management fee ranges from 0.9% to 1.5%, while Mawer Global Equity Fund has a management expense ratio of around 1.3%.
The Good Investors’ Conclusion
When Warren Buffett was the manager of the Buffett Partnership some 50 years ago, he noted that earning a few percentage points more than the market average per year can be hugely rewarding. He said:
“It is always startling to see how a relatively small difference in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.”
Actively-managed funds that can consistently outperform the market over a long time frame are a dime a dozen. But if you find one, it definitely pays to invest in it.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
I revisited some of the annual letters Warren Buffett wrote when he was a fund manager some 50 years ago. Buffett’s teachings then are still relevant today.
And his track record was, unsurprisingly, phenomenal.
According to his fund’s investor letter in 1969, his partnership produced an annual compounded return of 31.6%, compared to the Dow’s 9.1%.
Net of fees, limited partners (investors in the fund) gained a cumulative return of 1,403% in just 12 years, or 25.3% per year. Not bad.
Despite being written more than 50 years ago, Buffett’s teachings in his fund’s investor letters are still relevant today.
Here are five things I learnt from the great man’s writings.
Don’t time the market
The market will swing in the short term. But over a long time frame, you can bet your last dollar that it will be up. Buffett wrote:
“I am certainly not going to predict what general business or the stock market are going to do in the next year or two since I don’t have the faintest idea. I think you can be quite sure that over the next ten years there are going to be a few years when the general market is plus 20% or 25%, a few years when it is minus on the same order, and a majority when it is in between. I haven’t any notion as to the sequence in which these will occur, nor do I think it is of any great importance for the long-term investor.”
Today, many hedge funds and financial advisors try to manage their clients’ money to reduce near-term volatility. But timing the market is a fool’s game.
Buffett’s right-hand man, Charlie Munger certainly agrees, saying, “Time in the market is more important than timing the market.”
It is notoriously difficult to beat the stock market index
When Buffett started his fund, he set the goal of beating the Dow Jones Industrial Average, which at that time was the most widely followed stock market index in the US.
If you thought this was easy to achieve, think again. In his 1961 annual letter, Buffett noted that out of 70 funds listed in Arthur Wiesenberger’s book with a continuous record since 1946, only seven outperformed the Dow. And those that did were superior by just a few percentage points.
Today the story is no different. Bob Pisani, wrote in an article on CNBC earlier this year that 64.49% of large-cap funds lagged the S&P 500 in 2018. It marked the ninth consecutive year that actively managed funds trailed the index.
Over a 10-year period, 85% of large-cap funds underperformed the S&P 500. Over 15 years, that figure increases to 92%.
The joys of compounding
A few percentage points can really add up when compounding. Buffett observed:
“It is always startling to see how relatively small difference in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.”
Buffett added the table below to show how much more you would make if you compounded a $100,000 investment at 15% instead of 10% or 5%. The results were indeed staggering, and also demonstrates that the difference in absolute returns mushrooms the longer the investment compounds.
Source: Buffett Partnership annual letter
Individual thinking is important
In his annual letter in 1962, Buffett warned that it is not safe to simply follow what others are doing. Individual thinking is essential. He wrote:
“You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you.
In many quarters the simultaneous occurrence of the two above factors is enough to make a course of actions meet the test of conservatism.”
He added:
“You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”
Making bigger bets on high-conviction stocks
While modern portfolio theory suggests ample diversification, Buffett had a somewhat less conventional style. His fund had the mandate to invest up to 40% of its assets in a single stock!
In his 1965 letter, Buffett reasoned:
“Frankly, there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation of achieving performances surpassing the Dow by, say, fifteen percentage points per annum.”
But he adds:
“It doesn’t work that way. We have to work extremely hard to find just a few attractive investment situations. Such a situation by definition is one where my expectation of performance is at least ten percentage points per annum superior to the Dow.”
Because of that, Buffett does not mind allocating a larger chunk of his portfolio to stocks that he expects to outperform the index and has a very low probability of loss.
Based on his track record, its clear this strategy has done really well for him.
The Good Investors’ Conclusion
Even at a young age (he was just 25 when he started), Warren Buffett was already a great investor. His performance as manager of the Buffett Partnership all those years ago speaks for itself.
More importantly, for investors today, his writings back then are still relevant today. If you want to read more of Buffett’s annual letters during his time at Buffett Partnership, you can head here.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Risk management is an essential component of investing. We can try to reduce the risk of permanent loss by investing in low-risk stocks.
Risk management is essential when building a stock portfolio. But it is impossible to remove risk completely. Instead, we should find ways to reduce risk in our investment portfolio, while maintaining a good chance for high returns.
With that in mind, here is a simple framework for picking low-risk stocks.
How to find low-risk businesses?
A low-risk business should have a strong balance sheet and an ability to consistently generate cash. Ideally, I look for companies with six qualities that should indicate it has a resilient business.
1. A manageable debt load and low-interest expenses
The company should be able to easily service its interest expense and to pay back its debts when they’re due. The company should have both a high-interest coverage ratio (how easily it can pay back its interest expenses using profits or free cash flow) and a low debt-to-equity ratio.
2. Consistent free cash flow generation
Cash is the lifeblood of a company. It is what the company needs to pay its creditors and suppliers. A company that is able to generate cash after paying off all its expenses and capital requirements (free cash flow to equity) is then able to reward shareholders through dividends, share buybacks, or reinvesting in the business.
3. Predictable and recurring sales
In order to generate cash consistently, a company needs recurring sales. A low-risk business should have recurring and fairly predictable revenue. This can come in the form of repetitive customer behaviour or long-term contracts.
4. Low customer concentration
The business should also have a varied pool of customers. A high customer concentration might cause wild fluctuations in sales and profits.
5. A diversified business
Similarly, the business should ideally not rely on a single revenue source. A business that has multiple revenue streams is more resistant to technological changes disrupting a single core focus.
6. A long track record
Finally, a low-risk business should have a reasonably long track record of all the above qualities. The track record should ideally span years, if not, decades. Businesses that have such an admirable track record demonstrate resilience and management’s adaptability to technological disruptions.
How to find stocks that will not suffer from valuation compression?
Besides investing in stocks that have resilient businesses, we should also consider the risk of valuation-compression.
A valuation compression occurs when a company’s market value declines permanently despite sustained earnings growth. This happens usually because the starting valuation is too high. If the purchase price is too steep, a good business may still end up becoming a bad investment.
The most common metrics that are used to value a stock are the earnings, cash flow, and book value.
Another metric that I like to use is the enterprise value to EBITDA (earnings before interest, tax, depreciation, and amortisation). The metric is also known conveniently as EV-to-EBITDA.
The enterprise value, or EV, strips out the company’s net cash from its market cap. Companies whose cash make up a large proportion of their market caps are prime acquisition targets. In addition, the net cash balance could also act as a support for which the company’s market cap will likely not fall under.
I also look for companies whose earnings are likely to grow faster or longer than the market expects. This requires a reasonable amount of judgment. But stocks that eventually exhibit such sustained growth are unlikely to see a compression in their valuation.
The Good Investors’ Conclusion
If you’ve been avoiding stocks because of the fear of the risk of loss, don’t.
Warren Buffett says that “risk comes from not knowing what you are doing.”
If we pick stocks wisely, the risk of permanent loss becomes small. On top of investing in stocks that exhibit low-risk qualities, investors should also consider diversifying their portfolio. Diversification reduces the risk that a single mistake or an unforeseen circumstance will be detrimental to our overall portfolio.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
