"The Pulse"--#56 / Components of a Good Investment

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Market Update:

Components of a Good Investment

This piece is a little different from our standard market update as we are going to dive into the components of a good investment—a frequent question for any buyside role (PE, HF, PC, VC, etc).

I like to think about it through 6 check boxes:

1. Does it screen?

2. Is the business aptly profitable and/or does it have great growth potential?

3. What is the business model? Do you understand it?

4. What does the competitive landscape look like?

5. Is the management team strong and well-incentivized?

6. Other

I’ll get to the ‘Other’ part towards the end.

-Now, does it screen? 

The nexus of this criteria is to discover if the price is right. If price isn’t right (the investment is too expensive), then you simply can’t execute. Regardless of how good the business is. See: "The Pulse"--#52 / CLOs (beehiiv.com) for the tenets of a good business.

If I pay too much, my returns are going to be terrible.

If I’m screening public companies, a few multiples I look for are LTM P/E, NTM P/E, LTM EV/EBITDA, NTM EV/EBITDA, P/B, leverage, and dividend yield as a bonus metric. Capital IQ is a great tool to use here.

By doing this, I can quickly assess how a business shapes up to its peers and benchmark indices solely on the basis of quick valuation. The goal here is to see whether or not the investment is too expensive at this exact moment.

If I have an infinite hold period, then my screening requirement may get moved to the fourth check box with the other items sliding up a notch.

-Profitability / Growth

The second tenet of a good investment, outside the price you pay, is to determine how you’re going to get repaid.

Repayment comes in two ways a). dividends or income paid to shareholders (profitability) and b). capital gains (growth).

Ideally, you want to find a business with strong profitability by looking at metrics like EBITDA, EBITA, EBIT, Net Income, and Free Cash Flow. Pairing these alongside competitors or an industry index is also very helpful. Strong profitability = the ability to pay dividends.

Bonus here for negative net working capital and obvious revenue synergies being explored vs. cost synergies which help preserve long-term profitability

On the growth side, look at industry CAGR, sales growth, and most importantly, the ‘investability’ of the business going forward. The question to ask here is, will someone else invest tomorrow?

We reposted an article on LinkedIn that goes into this concept: https://www.linkedin.com/feed/update/urn:li:activity:7188884172101365760 

-Business Model

Prior to screening and assessing profitability/growth, you obviously need to have commercial awareness of the business and the industry it operates in. However, after screening for price and profitability/growth you need to become an expert on the operations of this company in this industry. 

This is where you dive deep into the 10-Ks, earnings presentations, news articles of the company, customer attestations, and even scheduled diligence calls. 

This investigation is critical to discover if the business model is durable, the customer view on the brand vs. the execution, and the practicality of the business.

Regarding brand vs. execution, think about UPS. Nobody really gives a shit about the person/entity delivering the package. All anyone cares about is that the package is brought from point A to point B. In the case of UPS, people care about their business model, but not the brand of business. Polar opposite consideration to a company like Coca-Cola.

The average person has no idea how a biotech company works…so it is in your best interest to steer clear from things you don’t understand. Leave biotech to the PHDs and MDs (doctors of medicine lol). This is why there are so many job opportunities in the consumer, DI, and tech verticals—the average person can understand the business.

-Competitive Landscape

At this stage of the checklist, you’re looking to assess the business’ ability to fend off competitors. After all, if the business is so great why wouldn’t everyone try to imitate it?

Some key factors to look at here are: the market share of the company, it’s competitive mote, and even regulatory threats which I’d consider bake into the competitive landscape since bad regulation can shut down a business.

A mote comes in many forms, but capital intensity isn’t one of them. Capital intensity is like a 2-foot stream. Sure, it’s a barrier and people usually don’t try to step directly into the water, but it is a barrier that can be crossed since the average person won’t drown in 2-feet of water.

-Management 

Highly slept on criteria of a good investment. However, management is responsible for the future decisions of the business. 

You can buy into a cheap company, with great profitability, a critical business model, and a deep hold in its industry, but all of that is futile if the management team is composed of a bunch of individuals conducting reckless, dilutive M&A activity.

This is one of the hardest components to justify because it really comes down to a judgement call. For me, the best way to quantifiably assess the future actions of management is through the amount of leverage on the business. Leverage = debt= covenants =likely preventative language to deter management from being reckless or lazy. 

Obviously leverage has a limit. Too much leverage will kill a company.

Wrapped into the management piece is the consideration of management compensation. You want your management’s compensation to be tied heavily to the performance of the business to align their agency with yours.

-Other

As mentioned, my other category is loose and very open to adaptation. At the moment, key considerations in my other category are related to stock issuances and repurchases. Accretion and dilution. 

If the company is a large issuer, my position will be diluted which hurts my return and decision-making capabilities.

If the company is a large repurchaser, this will be accretive for my position, but also might mean the company has no good ideas of where to invest capital.

That is all for today, apologies in advance for the lengthy piece. Please be sure to let me know some investment tenets you have on your checklist!

Disclosure: Nothing written here is financial advice or should be used for investment decisions.

How to be the Best Analyst

So you just started training, soak it up while you can but the 4-6 weeks of dicking around end quickly. Immediately after, you hit the ground running…for the next 40-50 years.

Building off of our points regarding best practices of a summer analyst: "The Pulse" --#53 / Interview w Unstructured Capital (beehiiv.com)

Today, we are going to look at the best practices of a FT Analyst:

1. Form a view

• As a FT analyst, you’re expected to be a contributing member of the team across most processes. That includes forming a view on the given company, project, deal, etc. Is the company good? Unlike an intern, you can’t just hide and wait to be told what to do

• The best analyst will look to take ownership early and manage processes top to bottom. Mark Rowan (CEO of Apollo) was once known as DBL as the ‘Managing Analyst’ for his ability to run a deal

2. Legal Docs

• In case you weren’t aware, a big part of the job is being familiar with legal jargon. In fact, most deals get shot down over some random legal shit. So, being well-versed in legalese is incredibly helpful for your ability to take a stab at looking through the docs and communicating your analysis to the team

• After all, no one wants to be on the wrong side of the next Serta or Chewy process

3. Understand Transaction Incentives

• How is everyone being compensated? Why does X firm want to use X bank to execute? Why does X firm need X credit facility? These are all good questions to ask yourself to determine the motivation behind any given deal or project. These things don’t just happen without some incentive

4. Survey Preferences of Seniors

• Quickly learn how a certain senior likes data to be presented. Some seniors prefer lengthy decks with a lot of detail. Others prefer short decks with mostly visuals. Take notes of their comments to learn how they like data to be presented or spoken about

5. Take the Model Line by Line

• You might see some crazy ass financial engineering in these excel models. The best analysts own the model and understand how it works line by line. This helps you a). spot errors, b). prep for buyside job interviews where you may model from scratch, and c). not get fired because you’re the only guy who knows how a given model works

6. Manage Processes

• It can take a few deals to get caught up to speed, but you should learn how to manage more processes end-end as specified in point 1. Essentially, you’re taking the workload off of the hands of your associate or VP which WILL be recognized

7. Own the Social Events

• Can’t speak to every team here, but if your team frequently goes out for happy hour then you should lead the charge picking locations/times/invites. As the youngest member of the team, and likely most socially active, a great way to hold the pen on something is to run all social processes. Don’t force it if your team hates it or has someone insistent on running the social calendar

As mentioned, please reference "The Pulse" --#53 / Interview w Unstructured Capital (beehiiv.com) for an extensive list of best practices for summer analysts which is also applicable to the full-time gig. Pair these lists together and you have a recipe for success!

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“The Pulse” #56