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What I'm looking for in a business
Why I buy the business, not the story
This week I wanted to go a bit more in depth as to the sort of things I’m looking for in a business, my investment philosophy and in particular the sorts of metrics that make me go “No thanks”.
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What type of investor am I
I’m involved in the dividend growth community, and throughout my investing “career” I’ve made it a point to purchase securities that pay out dividends.
Indeed, I don”t believe I have ever owned a share in a business which did not pay dividends.
In my quarterly and annual reports on the status of my portfolio I make sure to mention the dividends I received, and their growth, and i generally highlight those dividends as the primary indicators on the performance of my portfolio and how satisfied I am with it.
This has led some people to have the misconception that I am a “Dividend Investor” or perhaps a “Dividend Growth Investor”, but that is actually not accurate at all.
At my core I’m a value investor, with the dividends that I receive being the way I realize that value.
What this means is that while dividends are a key part of my portfolio and strategy, what I’m really looking for is undervalued securities, so that I can take advantage of the capital apreciation when they return back to fair value.
In a sense, dividends are merely a “safety blanket” intended to reduce my downside risk in case the companies never return back to fair value, or in case the fundamentals deteriorate more than I otherwise expected.
In short, the dividends are not an objective, they are just an alternative way for me to realize the value of the businesses that I own.
The core precepts
Knowing that we can outline a few key questions that I ask myself whenever I am researching new companies, either in depth, or by just running a few screeners.
Do I understand how the company makes money? Does it make sense?
Is the company consistently profitable? On a GAAP basis.
Is the company paying a dividend? Is it returning capital to shareholders?
Does the company “feel” cheap?
These initial questions are more or less binary “Yes or No” type questions, and if the answer to any of these questions is “No”, then I move on.
At the end of the day I don’t want to waste my time researching and looking in depth at a company which I know from the outset does not meet the minimum standards that I require in order to invest in a business.
If a company goes past that initial screening, then its time to go a bit further in depth, do some valuations and really dig deep into the business.
It’s at this point that I look at the companies annual reports, look at their 10-year financial statements history, and really dig deep into understand how the company makes money, what troubles it, what risks are involved, and do my valuation.
This usually ends up giving me answers to the following key metrics:
Is the company a cyclical business, and if so, where in the cycle is it?
Is the company shrinking, stable or growing? If so, how impactful is that trend?
What are the company’s profit margins? Over 10%? 15%? 20%?
What is the company’s cost structure?
How volatile is their revenue, and what happens to the cost structure as a result?
Do they have a lot of debt?
Do they have any debt cliffs?
Is this a turn around story, and if so what needs to change?
Whats the company’s fair value? At what price should I be willing to buy it?
Is it cheaper than the safe purchase price? Why?
Does the company need to grow in order to give me an adequate return?
How are they returning capital to me? And how much are they returning?
Is this an Asset play? And Income play? Turnaround? Return to the mean?
How am I going to get my returns?
What happens if the stock market closes tomorrow?
What risks are facing the company?
Are they in a politically sensitive industry?
How relevant is the management team for the business to do well?
Do they have some sort of durable competitive advantage?
Is there anything weird in their balance sheet?
Is there anything weird in their income statement?
Is there anything weird in their cash flow statement?
This is by no means an exhaustive list of all the things that I want to know when I read a company’s annual report, but it does give you an idea of the sort of things that I need to know.
At its core I’m trying to figure out “What are all the bad things about this company?” and use that to determine if those things are bad enough for me to decide not to invest.
These are not “Yes or No” questions, and indeed I’m not looking for specific answers as much as I’m looking for a clear understanding of what the business looks like and what I can expect from it.
When do I deviate
Of course I don”t always strictly follow my rules, even the initial “Yes or No” questions can be “bent” depending on the circumstances.
A clear example was “Orion Office REIT” ONL 0.00%↑ which I owned for a bit over a year. This is a company that when i first owned it had all but the first question with a "No" answer.
But I owned it anyway because it was a spin-off from a business which I owned, and I wanted to give it some time to build a track record so that I could properly answer those questions.
Earlier this year I decided that it had had enough time, and since I was not satisfied with the answers, I sold it.
What about you? How do you look at companies?
What sort of metrics are you searching for? Do you have strict “Never invest in a business like this” metrics?
Let me know down below!