My investment process

Idea generation

I generate new investing ideas mostly through reading investment write-ups online, talking to other investors, occasionally going through screens of companies that meet some high-level criteria I look for, and general learning (like reading books and news) that sometimes leads to an idea. I like getting ideas from others (via investing websites, blogs, and friends of mine) because it’s a quick way to get an overview of the business and industry. Thus, my research doesn’t have to start from scratch. Between investing websites and blogs that I follow, I look at several hundred investment write-ups per year.

Depending on how well I know the industry, my research for a new company generally takes anywhere from a few weeks to several months. Thus, in an entire year I only have time to get to know a handful of companies really well. This forces me to be very picky on what companies I spend time researching. I want to know a small number of high-quality companies very well, as opposed to knowing less about hundreds or thousands of companies.

Because of the above, my goal is to pass on a company as quickly as possible—many passes are instant just from reading the business description. In general, the following types of companies get an immediate pass: oil and gas, commodities, minerals, restaurants, auto manufacturers, auto suppliers, traditional retail, banks, biotech, insurance, utilities, pharmaceuticals, and probably others that I can’t think of. These types of businesses are un-investable for me at any price.

When I first glance at a company, I’m trying to quickly figure out if this is a business that a) I already understand or it appears to be the type of business that I can come to understand, b) already has, or has the potential to develop, a durable competitive position, and c) is the type of business that I can imagine still being successful in ten or twenty years (are the major trends of the world a tailwind or a headwind?).

If the business passes that first glance, the next thing I look at is management. Ideally, the company is led by its founder. Either way, I check to see if the CEO seems to be shareholder friendly via things like insider ownership, salary, and annual option grants.

If the business appears attractive and management is aligned with me and doesn’t seem to be taking advantage of shareholders, I move into deeper research.

Research

Reading the most recent annual report is one of the first things I do when researching a new company. I find annual reports to be enormously helpful in getting an overview of the business, industry, financials, and potential risks. By the time I finish an annual report, I will inevitably have a bunch of notes and unanswered questions. These questions are what guides the next portion of my research, which is different for every company. I may delve into broad industry research, specific competitors, understanding the political landscape (if it’s not based in the US), or a variety of other topics. Research always involves the public company data (10-K, 10-Q, proxy, conference calls, presentations, etc), but usually involves some sort of scuttlebutt as well (talking to customers, buying and using the product, visiting their locations, etc).

Throughout my research, my focus is on how that industry may evolve over the next 5-10+ years and if the company’s competitive advantage can expand within that evolution. My goal here is to identify the handful of key factors that will determine a company’s long-term success or failure. It’s impossible to know everything about an investment, but if I’m right about the two or three main drivers of the company and industry, I’ll probably be right about the investment.

My top priority is finding durable businesses that should still be around ten and twenty years from now. To be confident in that long-term durability, a company needs to have some type of competitive advantage that will allow them to survive that long. In my opinion, durable businesses do not have major headwinds facing their industry (like oil and gas or traditional retail). They also don’t have a lot of debt or major customer concentration that could wipe them out if things go south. Finally, profitable businesses that can sustain themselves are more durable than ones that haven’t reached profitability yet.

In addition to the above, I spend a lot of time researching and/or getting to know the CEO. If the company is larger and/or has been public for a long time, there’s usually enough public data available via annual letters, conference calls, interviews, past pay and option grants, and past M&A to get a good idea of how shareholder friendly the CEO is.

The smaller the company, the more emphasis I put on personally getting to know the CEO by talking to them and visiting the company if I can. The founder of a 50-person micro-cap company is often the #1 salesperson, sole capital allocator, and is responsible for everyone and everything in the company. Thus, trusting this person is paramount. There is never one thing that makes me say “this is a trustworthy CEO who I can invest in”—it’s more about picking up on a lot of small things over several conversations.

The short version is that I’m looking for CEOs who view the company as their baby. Loving a business like it’s your own child doesn’t guarantee you’re a good CEO, but that obsession can make up for a lot of faults. And I’ve found that obsession far more often in founders than in hired CEOs. I think passion is the best predictor of success, so that’s what I’m trying to find in a CEO/founder.

I believe founder-led companies have intangibles that are almost impossible to replicate. I remember doing my first few discounted cash flows when I was learning to invest, and I was surprised at how much of a company’s value is determined by the very long-term. It’s not uncommon that a company’s terminal value is 70-80% of its value today. If how a company will perform in 10-20+ years is most of its worth today, then the most important factor when choosing companies to invest in is how durable their competitive position is over the long-term. And if the long-term is what truly matters to a company’s value, then a CEO who is motivated to grow the business in the right way over a multi-decade period is required. In general, I believe founders are more likely to care about the long-term health of the business.

In summary, my favorite companies have most (preferably all) of the following traits:

  • Founder-led (high insider ownership)
  • Durable competitive position (as defined above)
  • Long runway for growth
  • Industry tailwinds at their back
  • Profitable
  • Safe balance sheet (lots of cash, little debt)

Valuation

When looking at growing companies that aren’t mature yet, current earnings multiples are mostly meaningless. A company is worth its future cash flows discounted back to today and that’s it. Therefore, a stock is cheap if it’s selling for below a reasonable estimate at what its future cash flow discounted back to today is. A stock is expensive if it’s selling for above that estimate—a stock is not expensive just because it’s selling for 100x earnings (or any other financial metric shortcut). Every company is different, but in general I value these compounders in two ways: from a top down, industry perspective and then a traditional discounted cash flow.

Many of these long-term compounders are either in newer industries that aren’t mature, or they are disrupting mature industries. This means that looking at the current industry size, market share, and margins isn’t necessarily indicative of what the future industry will look like. Thus, I think about how the industry may evolve over the next 5-10 years, what the company’s market share can be, and what kind of margins they can earn at maturity. I then put a multiple on those future earnings and discount them back to today to get me an estimate of what the stock’s current fair value should be.

In addition to looking at the company from a top down, industry perspective, my second method of valuation is a more traditional discounted cash flow. Although discounted cash flows have a lot of shortcomings, I believe they are the only way to explicitly estimate future cash flows (as opposed to using multiples that implicitly make those same assumptions).

With that being said, the longer I use discounted cash flows, the simpler they get. The main drivers of a discounted cash flow are revenue, operating margin, and capital intensity. While I sometimes estimate each line on the income statement individually, my focus is on those three main drivers. If I get the direction of those three drivers correct, my numbers should turn out ok.

With any valuation method, there is a lot of guessing and estimating involved—especially discounted cash flows, which are very sensitive to the many inputs. It’s possible to make any company look attractive by making aggressive assumptions. This is most dangerous when those aggressive assumptions are made subconsciously as a way to confirm my desire for any company to be undervalued. I try to counter this by doing many top down and discounted cash flow analyses for every business I value—with each one having different assumptions, from conservative to aggressive. The goal here is to come up with a range of values that seem reasonably fair.

I don’t do one discounted cash flow and come to the conclusion that “Company A is worth $42.67.” I believe most companies have a relatively wide range of what their fair value could be. My thought process is more along the lines of “depending on what assumptions are made, I can imagine a reasonable person making an argument for fair value anywhere from $35 up to $50.” This is why I do many versions of my valuation methods—to come up with what I believe is a reasonable range of fair value. If everything checks out so far, my goal is to buy these companies at the lower end (or even below) of that fair value range.

Buy

I like every company I own. Some positions have risen to being in the ballpark of fairly valued, some are still cheap, but I have no reason to sell any of them. Being in this position creates a high hurdle rate for adding a new company to the portfolio. This is because I’d have to get rid of, or trim, a current holding that I like. Thus, to add a new company to the portfolio I have to like everything about it (competitive position, runway for growth, CEO, etc) and I have to think it has significantly less downside and/or more upside than anything I own. If I think a new company is more attractive than something I own, I don’t get too greedy on price. If the current market price is attractive, I’m a buyer and I don’t worry if the stock has moved a couple percent since my valuations.

My position sizing is based on Kelly calculations I’ve done, combined with what I personally feel comfortable with. The Kelly calculations I’ve done for what I consider realistic public market opportunities suggest position sizes from a minimum of 5% up to a maximum of 40%. Within that, I’ve found my comfort level is 7% minimum position sizes and 30% max. Below 7% results in me not caring about the position enough. Above 30% results in me caring too much about the position, over-analyzing every detail, and losing sleep over it. Most positions are started in the 7-10% range and potentially made larger as I get more comfortable with the company, management does what they said they would, and my thesis starts to play out. Averaging up after good performance is much preferred over averaging down.

Sell

Unless the facts change (and my thesis is proven wrong) or the founder dies or something like that, I view these long-term compounders as almost permanent investments (whether that ends up being a holding period of 5-10 years or forever, I don’t know). My focus is on the very long-term, so I’m not selling when numbers deteriorate over the short-term or the company has a bad quarter or two. If the founder is still there, he’s continued to be honest with shareholders, and the industry dynamics haven’t drastically changed, I want to continue to hold.

In addition, I generally don’t sell a position just because it reaches my estimate of fair value. With positions that are fairly valued, I still expect them to match or slightly beat the market going forward (maybe 8-12% expected returns per year). So, if I sell a fairly valued stock just to sit on cash, I’m costing myself an expected 8-12% per year on that position size.

Ideally, I would only sell a position when I am replacing it with a new company that is significantly more attractive.  This is the best reason to sell a company and it comes as a tough decision. I like every company I own, so it’s not easy for me to sell them. Nonetheless, there are of course exceptions.

Management that is aligned with me is paramount to my investing process, so if I stop trusting management then I can’t continue to sleep well owning that company. Thus, if I think management is lying or taking advantage of shareholders, a sell is in order. The founder leaving unexpectedly (death, health problems, early retirement) is another event that I worry about with long-term positions. Finally, an unexpected disruptor or new technology coming out that I think is notably better would make me question the long-term durability of the company’s competitive advantage.

9 thoughts on “My investment process

    • I’ve had several people tell me about Amber Road actually. I know I briefly looked at it a few months and if I remember correctly, I felt like it was outside my circle of competence. I added it back to my research list though, so I’ll circle back around (again!).

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  1. Great post but don’t you think you’re too picky on an industry level? Especially given the importance of the micro in your process.

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    • I’m curious about the industry avoidance as well. I understand some, though why avoid banks or insurance companies? Both are really nice businesses if run responsibly. Buffett has made almost all his money thanks to those two industries. Or how about Car manufacturers? A lot of them have been great investments and don’t necessarily have more disruption possibilities than anything else (BYD as an example)

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      • I agree banks and insurance aren’t total stay aways, but I do tend to avoid the larger more complex ones. Their value is often tied to opaque balance sheets, potentially full of tail risk. Very hard to appraise value in those situations.

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      • Thanks for the comments. That sentence about the industries I avoid does start with “In general” 🙂 so there are occasional exceptions. I own a pet insurance company, but normal insurers don’t interest me. A friend told me about a restaurant recently that I looked at because I respect his opinion, but it’s not a space I ever go looking in (I also owned Fogo de Chao for a while, but that was a pretty unique one in my opinion).

        Banks are kind of like insurance companies–for whatever reason they just bore me. I’ve tried on multiple occasions to learn more about banking and bring it within my circle of competence, but each time I start reading about the industry I get bored and give up. Maybe I’ll get there in the future! The only cool auto manufacturer in my opinion is Tesla, but that’s way outside my circle of competence (never even looked at their 10-K, I just like their cars and Elon).

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    • I don’t think there are any blogs or sites that consistently give me good ideas – I just follow as many as I can. My current portfolio is pretty mixed in terms of where the original idea was sourced from. Off the top of my head, John Huber’s blog is one of the highest quality investing blogs I’m aware of.

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