Introduction
Welcome to Clayton Capital Insights. I am creating this newsletter to analyze value investments and share my thoughts on investing. I have now been investing and writing about stocks for over 10 years and have learned a quite a few important things along the way. The first book I read when I was 18 was Robert Hagstrom’s The Warren Buffett Way. I found the book in my parent’s library which mostly included books on business success and investing. My parents were successful entrepreneurs that created and sold a digital advertising company in the automotive industry, so I learned how to read financial statements when I was fairly young. I also took accounting and corporate finance classes at college which helped refine the knowledge I had gained working in the family business. Reading the Warren Buffet Way led me to create my first discounted cash flow model in Excel to try to come up with an intrinsic value for each stock I was looking at. I spent hundreds of hours when I was younger valuing stocks using discounted cash flow models. Then began my quest to learn everything I could about stock investing. I read everything from the Intelligent Investor and Security Analysis by Ben Graham to Buffett’s Partnership letters to Value Investing: From Graham to Buffett and Beyond by Bruce Greenwald. I thought investing and beating the market could not be that hard. I would just find undervalued companies, buy them and wait for the price to go up. I found out that knowing academic investment theory and successfully investing actual money are two very different things. It is the latter that all of us aspire to, but it can be much harder to try to outperform the markets when investing our real, hard-earned money. I had all the knowledge of sound value investing principles but executing it was much more difficult than I had imagined. After all, why is it that so few professional money managers can consistently beat the market? Something like 90 – 95% of professional money managers fail to beat the indexes over the long-term. A major hindrance to successful investing is the fact that our biases and emotions usually get in the way of sound decision making. I know mine did. I tried investing in cheap stocks in industries I did not really understand. That did not work. I then tried analyzing “quality” large cap companies, thinking I had some unique insight that the other 30 analysts covering the stock did not have. That really did not work either. Thus, after years of trial and error, I came up with my own personal checklist for stock investing.
10 Step Checklist for Stock Selection
#1 – Easy to Understand Business Model
This seems simple in theory but too often investors (me included) have tried looking for the cheapest stock or highest returns without first really understanding how the business makes money. Investing legends such as Warren Buffett, Charlie Munger, and Peter Lynch have often touted the benefits of staying within your “circle of competence.” By buying stocks in companies that you are familiar with, you will have more conviction to hold larger positions and be less likely to sell (or have more conviction to buy) when the stock goes down. Thus, the shrewd investor can formulate a sound investment strategy because they know the long-term value drivers of the business.
#2 – Consistent Track Record of Profitability
How often have you gotten excited and bought stock because it was trading at 4x price to earnings, or the sales growth last year was a record high? I have seen many stocks like this where the stock looked cheap only to find out that the company had one-time “non-recurring” income, or some other one-off event and the earnings were really a mirage. I like to look back over a 10-year period to see the “normalized” financial picture of a business. I like to assess the true “owner earnings” of a business (as Warren Buffett talked about in his 1986 letter to Berkshire Hathaway shareholders.
“If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N's items (1) and (4) less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.”
-Warren Buffett, 1986 Letter to Berkshire Hathaway shareholders
The financial statements won’t tell you everything about a business, but they can tell you a lot. Typically, a business with consistent margins and earnings through multiple economic cycles has some sort of competitive advantage and financial results often have tendency to revert to the mean for an enterprise with a long-term track record. Barring some major operational change, financial results in the future will often mirror results from the past. There are exceptions for sure, however, I like to be conservative in my investment analysis and not speculate on high future growth rates.
#3 – Non-Cyclical
Obviously, the best investments are in businesses that can make money in any market environment. Think Coca-Cola or Costco. The problem with well-known “consumer defensive” stocks like Coke and Costco is they are often expensive and so the long-term investment returns are likely to be average. Costco may be a great hedge against a potential recession, however, buying it at its current 50x price to earnings multiple is not likely to lead to stellar long-term investment returns. My goal is to find value investments in stocks where customers will use their product no matter what the economy is doing. They are out there; you just have to look hard to find them.
#4 – Competitive Moat with Few Competitors
I know what some of you may be thinking. How can you find a stock with a competitive moat selling for a value type multiple? I agree that most of the stocks with strong competitive advantages are well-known household names and it is hard to find stocks with “wide moats” trading at bargain valuations. Value stocks with few competitors and strong competitive advantages are hard to find but they are out there. My two largest positions are in stocks that have the largest market shares in their respective industries. They operate in niche industries but have been consistently profitable for years. My largest position is currently selling for less than 7x free cash flow and at 61% of book value. My second largest position is in a company with no meaningful competition and currently trades for about 9x price to normalized earnings.
#5 – Quantitatively Cheap
I like to find investments where the price to “owner’s earnings” (aka free cash flow) is less than 10x and the projected annual rate of return or IRR is at least 15% with very conservative growth estimates. For instance, with my largest stock holding I have projected a 19% annualized rate of return (including dividends) assuming only 2% revenue growth, which is roughly the long-term average growth rate for the consumer price index (CPI). The current earnings yield on my largest position is about 14% and with share repurchases and dividends, the long-term IRR is 19%. Moreover, I purchased the stock at a 60% discount to my conservatively estimated intrinsic value calculation. Obviously, this doesn’t guarantee a successful investment outcome but by buying at a low price to “owner’s earnings”, I am buying with a margin of safety. Check out chapter 20 of the Intelligent Investor for more information on margin of safety as the central concept of investment.
Some Thoughts on Net-Net Stocks
Ideally, I like to focus on investments in non-cyclical industries with three exceptions. 1) The stock is very cheap. 2) I understand its business model and 3) the stock has low debt levels. This would make up most of the stocks trading for less that net current asset value. (“Net-nets.”) Even on net, net investments, I still want to see a prior track record of consistent profitability. I like to see a business that turned a profit at least 8 or 9 years out of the last 10. Net-net’s may be harder to find today than they were 50 years ago, but I promise you, they are still out there. I wrote up Hurco Companies (NASDAQ: HURC) last September and recently wrote up Jewett-Cameron Trading company (NASDAQ: JCTC). I will not typically allocate a large percentage of my portfolio to “net-nets”, since many times they are businesses in cyclical, declining industries. However, I think they can still offer great value when bought at large enough discount to net current asset value. In What has Worked in Investing, Tweedy Browne cited a study by Henry Oppenheimer which found that investing in a portfolio of stocks selling at 66% or less of their net current asset value produced a mean annual return of 29.4%. It should be noted that the minimum sample size of stocks in this study was 18 and the max was 89 so investors should diversify at least somewhat when buying “net net” stocks.
#6 – Pricing Power
This ties into rule number four because businesses with strong competitive advantages can usually raise their prices. While not necessarily a requirement of mine for an investment, a business that can continually raise prices should fare better in a down market.
#7 – Management is Aligned with Shareholders
Figuring out whether management is acting in the best interests of shareholders can be one of the more challenging things for an investor to determine. Without having inside information, it can be difficult to tell if the management team and board is acting in the best interest of the shareholders. I recently read the The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by William Thorndike. This is an excellent book that talks about the immense impact that management decisions can have on long-term shareholder returns. I like to look for managers that are buying stock or have a meaningful ownership stake in the business. Other good signs to look for are opportunistic share repurchases where the company is buying back stock when the stock is at a significant discount to its intrinsic value. I also like franchised business models when looking at restaurant stocks because franchisees are “owner-operators” that have skin in the game.
#8 – Asset Light/Low Capital Intensity
The ideal business is one that does not require high levels of capital spending to grow and sustain operations. Probably one of the worst types of businesses is one with high debt levels in a cyclical industry with high capital spending requirements. I try to avoid these types of stocks.
#9 – Business Model Insulated from Technological Shifts
I like to look at “boring businesses” when analyzing a stock for an investment. For example, artificial intelligence will not eliminate the need for waste management services or window cleaning. Autonomous garbage trucks may be coming but I think they are at least 20 - 30 years out! AI is also unlikely to stop people from drinking soda. Competitive destruction is alive and well and we do not know exactly what the next Blockbuster will be but suffice it to say that I like to avoid these types of stocks (unless it is a very cheap “net-net” stock with no debt and there is a significant margin of safety). For those who don’t know, Blockbuster was a large brick and mortar movie rental business that got wiped out by Netflix. Honestly, I avoid most technology stocks for this reason because I do not understand their business models well enough to be able to accurately analyze competitive threats. I like to look for stocks where there is a very high probability that their services will still be needed at least 20 or 30 years from now.
#10 – Strong Cash Conversion Cycle and Recurring Revenue Business Model
I like to look for stocks with strong cash conversion cycles. The cash conversion cycle measures the time it takes a company to turn its investments in inventory into cash from sales. A shorter operating cycle means the business gets paid faster, which is generally better for cash flow. One of the overlooked aspects of Amazon’s business model in the early days was its negative cash conversion cycle, meaning it got paid before having to deliver its goods and pay suppliers. This is one of the reasons Amazon was able to survive the dot-com crash at a time when many of its competitors were going out of business. A company with a negative cash conversion cycle is essentially being financed by its suppliers. It is similar to the “float” concept in insurance and is one of the reasons Warren Buffett likes insurance companies. I also like to look for companies with recurring revenue business models. Amazon and Costco are two of the most successful retailers in history and both have created strong “recurring-revenue” membership models. Stocks with some sort of “recurring-revenue" model are great to own for the long-term.
Takeaways
These are just my personal rules when thinking about a particular stock for a potential investment. If a stock does not meet all the criteria, it does not mean I won’t consider it for a potential investment. It’s just that I will have more conviction in an idea that meets most or all of these criteria. For instance, I may consider investing 20 – 30% of my portfolio in a stock that meets all 10 of these criteria. Rarely do I find these. They might come around once or twice every few years. Did I mention I believe in making concentrated investments in your best ideas? I believe my largest position meets all 10 of these criteria and it currently represents roughly 29% of my portfolio. Most often, I find deeply discounted stocks that meet 5 or 6 of the criteria (mainly they are statistically cheap) and I may allocate 1 – 5% of my portfolio to these types of stocks. My long-term goal is to generate at least 15% annualized returns in the stock market. While not easy, I believe it is doable for an enterprising investor that can stay disciplined and follow a sound investing framework.
Thanks for reading and stay tuned for future articles.