2018 Annual Letter excerpt - Four-Step Pattern and CAM investing frameworks

2/15/2019

I. 2018 Annual Letter excerpt - Long Game Financial’s (“LGF”) Four-Step Pattern and CAM investing frameworks:

We believe that it is important to make sure that clients understand the rationale for our portfolio decisions, especially during times of heightened market volatility. When it comes to the stock market, occasional price declines are the rule rather than the exception—and the best way to adapt to volatile market conditions, which are inevitable, is to go into them armed with knowledge and logic instead of (understandable but unproductive) emotion.

LGF endeavors to achieve superior risk-adjusted returns across market cycles for our clients. We seek to do this in specific by building and managing concentrated, long-term-biased equity portfolios. The portfolios we manage on behalf of our clients—while first and foremost subject to individual goals—tend to concentrate in stocks that we believe can appreciate meaningfully in value over a multi-year investment horizon.

Beginning with the basics, a share of stock means fractional ownership of an asset. For example, if a company has one hundred shares of stock outstanding and you own a single share, you own 1/100, or 1%, of that company. If that same company were then to repurchase five of its shares on the open market, you would then own 1/95, or 1.05% of that company. If that company were then to announce a 2:1 stock split, you would then own 2/190 shares—or, still, 1.05%.

Economically, a share of stock entitles its owner to a fractional share of what a company owns and earns. Because most companies are valuable primarily because of their ongoing earning power, LGF focuses primarily on what companies earn. Calculating earnings does require accounting knowledge but one can conceptualize earnings as what remains of sales after a company pays all of its other stakeholders (e.g., suppliers, employees, contractors, landlords, lenders, and governments).

For example, if we own a lemonade stand, our sales are cups of lemonade multiplied by price per cup. After we pay our suppliers (for lemons and cups), employees, contractors (to maintain our lemonade stand), landlord (let’s say we lease the land on which our lemonade stand sits), lenders (let’s say we financed the purchase of our lemonade stand), and, finally, taxes, we are left with earnings…perhaps positive, perhaps negative.

When we divide earnings by total shares outstanding we get “earnings per share”, or EPS—a key concept for LGF clients to internalize because if each share is a fractional claim on what a company owns and earns, EPS is the specific dollar value of each share’s claim on what a company earned or—more importantly—may earn in the future over a certain timeframe. The concept of EPS is also critical because multiplying an estimate of future EPS by a multiple is one of the most common ways to value a stock, though not always the ideal way.

To apply these concepts, we know that shareholders own stocks because they wish to earn a positive return over time—and under the “equity value per share=EPS*multiple” framework there are only three factors that can lead to a positive return: (1) EPS growth, (2) multiple expansion, and, as the quarters and years pass, (3) ongoing generation of earnings and cash flow.

Though all three factors are important, LGF generally seeks share price appreciation that results from EPS growth rather than the other two factors. This is because EPS has the ability to increase much more, and much more predictably, over a multi-year period than an EPS multiple (multiples tend to be relatively bounded over time) and also because stocks with low multiples (i.e., multiples low enough such that ongoing earnings generation alone might hypothetically generate a meaningful return for shareholders) often come with serious potential downside risks.

So, we like EPS growth-driven total shareholder return profiles—but we are not yet finished because there also happen to be three main ways to increase EPS and they are not created equally. The three main ways a company can increase its EPS are (1) sales growth (e.g., by selling more units, raising price per unit, or introducing new products), (2) profit margin expansion (e.g., by selling proportionally more high-profit margin products or decreasing payments to other stakeholders), and (3) sharecount reduction.

Here, LGF prefers sales growth-driven EPS growth over the alternatives. This is because sales growth has the potential to far-and-away be the highest magnitude driver of return for shareholders over longer timeframes. It is possible for a company’s sales to grow by even multiple orders of magnitude. On the other hand, there are real business limitations to cutting operating and capital expenses, and the opportunity cost of repurchasing shares is less funding for other priorities like growing the business, developing new products, and others.

As an illustration of the latter two points consider the example of McDonald’s, which requires employees and equipment to make and sell burgers. If all McDonald’s locations were to lay-off employees and spend less on equipment, expenses would decline—but doing so might also negatively affect the customer experience and depress sales. Separately, if McDonald’s corporate were to allocate cash to share repurchases instead of opening new locations, its lower sharecount might indeed increase EPS—but the opportunity cost of that decision would be forgoing incremental profits from new locations. Because resources are always finite, decisions unavoidably involve opportunity costs and trade-offs.

For these and other reasons we prize long-term, organic sales growth-driven EPS growth at LGF and our enthusiasm is both financial and academic: organic sales growth-driven EPS growth that persists sustainably over many years is the (accounting) driver of the largest corporate wealth creation stories in history. This is to some extent tautological because it is hard to be a valuable company without significant sales, but stay with us…because we think that there is a critical investing observation here: we posit that the majority of the most valuable companies in the world today became what they are because they fit LGF’s Four-Step Pattern.

(a) LGF’s Four-Step Pattern:

Step #1) Start with a company whose sales opportunity is large relative to its current sales and also large in absolute terms.

Investing is always about the future rather than the past—and future corporate giants tend to begin life in one of the following situations:
- Small market share in an existing large market (e.g., McDonald’s and food or Priceline and travel)
- Large market share in a new, small market that becomes large (e.g., Apple and smartphones or Monster and energy drinks)

Step #2) In order to scale into its opportunity, our plucky company must offer a sustainably competitively-advantaged product that customers love—or, at least, a product that customers feel economically compelled to pay for because of a characteristic like limited alternatives (e.g., Comcast) or high switching costs (e.g., Oracle…or also Comcast).

LGF defines a competitively-advantaged product as one that offers customers value that is either:
- Sustainably greater than the value offered by competitive products (e.g., Google search), or…
- Similar to the value offered by competitive products but at a sustainably lower cost (e.g., Walmart)

Step #3) In addition to a large sales opportunity and competitive advantages, our company’s process of scaling into its opportunity must be economical. That is, in financial terms its process of fulfilling its potential must occur at an attractive return on incremental invested capital.

“Attractive return on incremental invested capital” sounds complicated—but all it refers to is incremental earnings per incremental dollar of investment.
- If a company can sustainably increase what it earns on its incremental investments, it can sustainably grow its earnings at a higher rate.
- The most valuable companies are those than can grow earnings swiftly while also generating more cash flow than they can profitably reinvest. As such companies grow, their excess cash flow can be put to other potentially value-enhancing uses like acquisitions, share repurchases, debt reduction, and dividends.
- Lofty returns do not mean infinitely fast growth. The earnings growth of companies with superior returns on incremental invested capital (e.g., VISA), if not limited by investment dollars, will be limited by some other factor, such as customer adoption or market size.

Step #4) Last, once our company in question reaches its maximum potential, we would prefer for its sales and profits to then be sustainable into the foreseeable future--rather than see it all retreat back to the primordial goo from whence it came.

In other words, we want investments that lead to significant capital gains over time and then we want to keep those capital gains.
For this reason we prefer companies with sustainable competitive positions in sustainable industries (e.g., Boeing) to companies whose competitive positions or markets have the potential to shrink due to forces like technological innovation (e.g., Exxon Mobil) or a change in consumer preferences (e.g., Coca Cola).

McDonald’s and Walmart are historical examples of LGF’s Four-Step Pattern in action. Both began as small companies competing in vast markets (food and retail, respectively), both offered competitively-advantaged products (fast, cheap, and predictable food and a wide assortment of low cost goods, respectively), both scaled at attractive returns on invested capital, and we argue that both companies have largely defensible competitive positions in markets that are here to stay. (This is not to say that there are never challenges for these firms, of course—no company can take its customers for granted.)

As a result, McDonald’s and Walmart realized astounding sales (and earnings) growth. McDonald’s’ system-wide sales in 2017 were $96 billion—a 96-fold increase from its $1 billion of system-wide sales in 1972. Walmart, in its fiscal year that ended in January 2018, generated $500 billion of global sales on a store-base of approximately 11k locations globally—i.e., a 6,410-fold increase from its $78 million of sales in 1972 (and, by way of comparison, Walmart ended 1972 with a grand total of 51 stores). If the Four-Step Pattern conditions exist and one then adds the necessary ingredient of time, a corporate titan can emerge.

More broadly, we observe that the wealthiest Americans in the Forbes 400—among them, Jeff Bezos (Amazon), Bill Gates (Microsoft), Warren Buffett (Berkshire Hathaway), Mark Zuckerberg (Facebook), Larry Ellison (Oracle), Larry Page and Sergey Brin (Google), and Sam Walton’s children (Walmart)—all find themselves on that list because they lived the Four-Step Pattern. Initially, each was a relatively unknown individual who owned a significant fraction of a small, competitively-advantaged asset (or potentially competitively-advantaged asset) that over time expanded to become what is now a colossal, competitively-advantaged asset.

We would be remiss if we did not note the conspicuous number of technology billionaires on that list and suggest that their wealth is primarily a by-product of the particularly attractive Four-Step Pattern economics of successful software businesses. The software industry is large, heterogeneous, and sustainable (every company on planet Earth requires software), software generally exhibits high returns on incremental invested capital (e.g., it takes little additional investment to copy existing software and sell it to a new customer), and software often has network effects that lead to winner-take-most markets (circularly, in many cases customer adoption can make software more useful…and therefore increase customer adoption). There are more software billionaires than, say, mining billionaires, for a reason.

At the same time, software in the 1990s also boasted enviable economics but there were not nearly as many software billionaires then—so what happened? What happened is an exponential decline in the cost of computing that enabled the ascendance of the internet and the “cloud” despite a stock market head fake in the early 2000s. Over a two-decade timeframe software became far more useful and far cheaper and we experienced a Cambrian explosion of software firms and software applications for businesses and consumers alike. If you began your programming career in the 1990s your timing was impeccable.

Warren Buffett makes for an instructive case study as well. Although Buffett-the-grandfatherly-character-who-made-Tony-Soprano-loans-to-banks-during-the-Financial-Crisis may not initially appear to fit LGF’s Four-Step Pattern, many of Berkshire Hathaway’s (that’s Buffett’s holding company) most notable winners over the decades have been long-term market share gainers competing in sustainably large markets, including GEICO (which benefited from a long-term market share-shift from agent-written auto insurance to cheaper, direct-written auto insurance), Wells Fargo (a long-time retail banking consolidator), and Coca Cola (which benefited from a shift in beverage consumption to soft drinks domestically and then globally).

Another crucial contributor to Berkshire Hathaway’s success has been its low-cost liability structure. Berkshire partially finances its investments with monies—to be precise, the modest sum of $170 billion as of year-end 2017—from two cheap, permanent sources: (1) Berkshire’s insurance subsidiaries in the form of premiums received from policyholders but not yet paid out as claims (i.e., “float”) and (2) governments in the form of deferred taxes (i.e., the taxes Berkshire would pay if it were to liquidate its investments). Mr. Buffett’s liability structure means that he, to his credit, plays a different game than investors who 100% equity-finance their portfolios…or, in other words, almost everyone else, although LGF does endeavor to harness capital gains deferral as a source of value for clients.

To add data to our anecdotes, we note a 2016 Boston Consulting Group (BCG) study finding that revenue growth—not changes in profit margins, EPS multiples, or cash flow generation—was the primary driver of total shareholder return for top quartile-performing stocks between 1993 and 2013 over holding periods of three years or more. This means that if you were a longer-term investor over those two decades it made cents, puns always intended…to pay attention to revenue growth.

Speaking to the volatile nature of stock prices, that same study found that the dominant driver of total shareholder return for top quartile performers over one-year holding periods was changes in multiples rather than revenue growth. It bears emphasizing that changes in EPS multiples—while clearly capable of shifting any stock’s one-year performance quartile—in many (but not all) instances turn out to be ephemeral. Put differently, while changes in multiples obviously catch one’s attention they do not tend to be a persistent driver of long-term wealth. No billionaire in the Forbes 400 got there by speculating on multiples.

(b) LGF’s CAM investing framework:

For this to be a full-fledged investing framework, we must add valuation and management acumen to our initial criterion of sales growth-driven EPS growth (ideally accompanied by Four-Step Pattern characteristics). Valuation matters because no asset is so outstanding that one cannot overpay for it and management acumen matters because even a great business at a compelling valuation can be a poor investment if management make poor decisions (e.g., General Electric in recent years).

Enter CAM, LGF’s simplified framework for evaluating potential investments. CAM distills our three key criteria into an easy-to-recall acronym: (1) Competitively-advantaged, (2) Attractively-valued, and (3) Managerially-aligned. We walk through CAM on the LGF website here.