The best kind of investment...

Published on 05/26/21 | Saurav Sen | 927 Words

The BuyGist:

  • Something Buffett said in the latest Berkshire Hathaway meeting caught our attention. 
  • It's nothing new, but you'll be surprised how many investors ignore his observation.
  • We unpack his observation, and depict the kind of businesses we love as investors.

Dig into the cost structure

The best kind of investment is one that generates high returns with low risk. But you know that these are not easy to find. We try to find them by zooming in on the best kind of businesses – high return, low risk. High return businesses are usually High Growth businesses. But the problem is that they tend to be High Risk. The definition of Risk is important. In this case, Risk means that the company may not meet the ridiculously high revenue growth expectations baked into its stock price. Is it possible to find High Growth, Low Risk businesses then? Possible, but not easy. This is where we spend most of our time.

“We’ve known for a long time that the best kind of business is where you don’t have to put up a lot of capital…” That was Warren Buffett in the latest Berkshire Hathaway shareholder meeting. We’d like to unpack that statement a little bit. 

  1. Look for businesses with high revenue growth potential.
  2. Look for businesses with high gross margins and high fixed costs that are likely to be, well, reasonably fixed in the next few years.
  3. Costs come in 2 flavors: Operational & Capital
    • Operational Costs are either fixed or variable. Look for businesses with a low variable and high fixed cost mix. 
    • Capital Costs can also include fixed or variable types. Working Capital tends to be variable. But Capital Expenditure can be relatively fixed, depending on the business. 
    • Look for businesses with less working capital needs. 
    • Also, look for businesses that don’t need to reinvest most of their earnings to grow the business. If they do, then this Capital Expenditure amount should remain relatively fixed in the future. Here is where the ROIC (Return on Invested Capital) metric makes its grand entry. 
    • Look for high ROIC businesses – it means that management has done a good job of investing back in the business. The investments generated nice returns in terms of additional revenue and profits.
  4. The idea is that IF revenue grows the way we anticipate, then a lot of that revenue growth will probably flow down to free cash flow growth. 
  5. Ultimately, growing profitability – as measured by good old cash profits (which are different from accounting profits) – are the main driver of value.
  6. High Return, in this context, means High Revenue Growth. 
  7. Low Risk, in this context, comes from a fast accrual of Free Cash Flow from this high revenue growth, which happens if the cost structure of the business is right.

Why is that? Why does cost structure matter so much? Because most investors tend to overlook this scalability factor. For high growth businesses, they tend to underestimate how much of the revenue growth will filter down to Free Cash Flow.

So, given the cost structure of the firm, meaning how much of those extra sales are likely to flow down to the cash profit line item – what revenue growth is priced into the stock? In high growth businesses with fantastic cost structures, Mr. Market tends to underestimate how much the value of the business can grow. You’ll be surprised to know how many professional investors extrapolate the same cost structure into eternity to value a business and its stock. In that sense, sometimes the “Robinhood trader-bros” peg it more accurately – they tend to (implicitly) assume 100% of costs are fixed, and that 100% of additional revenues flow down to the cash profits! Obviously, both these analysts and trader-bros are incorrect. The truth is somewhere in the middle.

Low Risk comes from Mr. Market’s tendency to underestimate Free Cash Flow growth. That increases the probability of the stock price increasing, because every Free Cash Flow growth number will be a surprise. When we stumble upon a business (and its stock) that we think has low expectations built into it, it’s low risk. If we deliberately buy into a stock that has high expectations built into it, it’s high risk. If we buy a stock that has low expectations built into it for good reasons (low margin, competitive industry, no economic moat), that’s high risk too!

High Return, Low Risk = High Revenue Growth Potential, Fantastic Cost Structure!

Check out these 3 cash flow waterfalls of a model business. If we model out revenue growth and free cash flow growth, this is the type of picture we love to see!

That 853% number is what Mr. Market tends to underestimate. For example, do you believe Mr. Market got Esty's Free Cash Flow Growth right? 314,000%! If someone did, they must have looked deeply into their cost structure.

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