Uncertainty dominates the U.S. investing landscape, including questions on economic growth, election outcomes, and the impact of civil unrest. To help navigate the uncertainty, it is important to remember the core of investing in stocks and bonds: individual businesses. Specifically, it is desirable to seek good businesses.
What is a good business? I define a good business as follows: they offer a product or service that is indispensable to their customers; they have the ability to grow; and they are run by good managers.
Having defined a good business, how can we tell if the business we are considering is a good one? Regarding the strength of their product or service, one key piece of evidence is the company’s ability to maintain or increase the price of their product.
For example, Amazon raised the price of its Prime product by 20% to $119 a year beginning in mid-2018. A subsequent third-party survey showed that 6% of Prime users cancelled their service versus 53% reporting that it would not have an impact and 24% responding that they were not aware of the price increase. Their customers clearly value Prime service as a worthwhile investment to help improve their life.
Another good example is Disney World, which saw an 8.3% average annual growth rate in ticket prices since its opening in 1971, when a ticket cost $3.50.
Alternatively, businesses with less differentiated products or services face pricing pressure or risk losing business. Companies in those situations must have an unusual advantage, such as lower costs compared with competitors, in order to remove some of this pressure.
The second quality of a good business, the ability grow, follows from the first quality of having a highly valued product or service. However, what if your product is already sold to the entire addressable market? You may be able to increase prices, but that will be the extent of your sales growth. Ideally, growth will come from both pricing power and gaining new customers. In some situations, like social media companies, the ability to increase advertising rates is aided by their ability to add new users.
A good team of managers is another important component for a good business. The first piece of evidence to look for is circular within our framework: have they positioned the company to have the first two qualities of a good business? Another critical quality is the handling of the balance sheet and of every dollar the business generates. Regarding the balance sheet, the business should have a reasonable amount of debt. A more conservative level of debt is helpful in allowing the company to weather downturns and take advantage of opportunities such as acquiring competitors (who may be struggling under too much debt).
As the business generates cash, the manager’s job is to decide where to put it. They can pay down debt, reinvest in the business, make acquisitions, repurchase shares, or pay a dividend. The right answer is determined by specific circumstances, such as repurchasing shares when the company’s share price is low and acquiring other companies when their prices are low.
The result of a solid capital allocation program can be staggering. In William N. Thorndike Jr.’s, “The Outsiders,” he chronicles eight CEOs who outperformed over their tenures the Standard & Poor’s 500 index by over 20 times on average, and over seven times their peers, by wisely allocating their company’s capital. For comparison, Jack Welch, the CEO of General Electric from 1981 to 2001 and believed by many to be a top-tier CEO, outperformed the S&P 500 by 3.3 times over his tenure.
It is also important to understand the incentives of the managers. The compensation structures for the executives of publicly traded companies are disclosed in their annual proxy statements, and performance-based compensation often dwarfs their base salaries. Therefore, one can get a good idea of where the managers will be focused for the next one to three years.
Some incentives are better than others for shareholders. For example, if they are incentivized to grow revenues, they may be tempted to make big acquisitions at the cost of profitability or balance sheet strength. Charlie Munger, the vice chairman of Berkshire Hathaway, has spoken about the power of incentives: “I think I’ve been in the top 5% of my age cohort in all my life in understanding the power of incentives, and all my life, I’ve underestimated it.”
The last piece of the investment picture is the price paid for the investment. We will not cover that in depth here, but knowing that you are dealing with a good business may raise the price at which you are willing to invest.
Investing uncertainty lies beyond buying and selling publicly traded companies. The good news is that a good business framework can be applied in many settings.
For example, imagine you are considering leaving your job to start a new business. There is not much more uncertainty than that, as you are potentially investing substantial time and money in a new enterprise. Thinking about your product or service and its importance to customers, your addressable market, your ability to allocate resources, and the incentives of your team, will help you get more comfortable with your endeavor, or perhaps lead you to rethink your strategy.
Christopher G. Malde, a chartered financial analyst, is the managing member of Spokane-based Malde Capital Management LLC. He can be reached at 509.789.0899.
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