I started my investing journey around 14 years ago, after reading Rich Dad, Poor Dad. The idea of acquiring income-producing assets resonated with me and I have since been consuming numerous books and resources on the web regarding investing. Today, I focus mainly on growing companies with a wide moat and great management in place.
Looking back on my investing journey, I first started out using a mix of fundamental and technical analysis. I was thrilled when I saw gains of 30% to 50% within a short time frame of six to 12 months. It got me to dive deeper into the subject and I subsequently learned about deep value investing—buying companies so cheap that I could make 30% to 50% even if the company was liquidated.
However, those were one-off returns and I was lucky that some of my early investments turned out okay.
Technical analysis paints a nice story as to why the share price moved up, moved down, or consolidated (sideways). It is impossible to be consistently right on the patterns and I found myself questioning, “What does historical price movement have to do with the future and is it reflective of business fundamentals?”
Deep value investing, otherwise also known as cigar-butt style investing is as its name sounds, gives you one last puff. Once the stock revalues upwards, it will be sold off and we will have to hunt for the next idea. Deep value stocks are often cheap for a very good reason. Usually, they are either facing structural decline or they are in a cyclical industry—both of which could be adverse to your wallet. And nobody knows when the stock will revalue, so waiting for the stock revaluation is like watching the paint dry.
In order for me to build up wealth, I switched my approach to looking for companies with wide moats who can continuously reinvest their earnings at a high clip. The book 100 Baggers by Chris Mayer illustrate this approach the best, quality companies that have a long runway are able to continuously reinvest for growth.
This brings me to the two basic rules of compounding:
The longer you let it work, the bigger its impact – time, not rate of return, is the most important factor in the compounding formula
If you lose big money even a few times in your compounding journey, you will not receive its benefits, even in the long run (Google Long-Term Capital Management for example.)
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”
With that in mind, the following are the list of filters I learnt and applied over the years to steadily compound my wealth:
1. Do I understand the Business?
Value investing requires us to be able to reasonably assess the intrinsic value of a company. Companies with complicated business models or accounts would go straight into the “too hard” pile. As Warren Buffett puts it, “I don’t look to jump over 7-foot bars: I look around for 1-foot bars I can step over.”
There are plenty of companies with simple business models which have generated above-market returns over the years. Names like Starbucks, Google, and Monster Beverage should be familiar to many and easily understood.
2. Does the Company Have a Wide Moat?
Moats are what protects the company’s profits from its competitors and wide moats enable a company to generate a high return on capital. A company’s moat is either widening or narrowing. Here I am looking for companies who are continuously investing to widen the moat and focusing on the long term outlook of the company.
Companies such as Amazon and Monster Beverage have delivered more than 100x returns for their shareholders as they were willing to sacrifice short-term results and focus on widening their moat.
3. Is the Company Able to Reinvest at High Returns?
I prefer companies that do not issue dividends and are able to sustainably reinvest their earnings at above 15% returns. For compounding to work its magic, the company should have a long runway for growth. I look for companies whose revenue is small relative to the potential market.
For example, Facebook currently captures approximately 20% of the global digital advertising market and the digital market is expected to grow 12% per annum over the next five years.
4. Does the Company Generate High Free Cash Flow?
Not all earnings are created equal. Charlie Munger once joked about his friend John Anderson’s construction equipment business at Berkshire’s AGM. The company makes 12% return on capital yearly, shows a profit every year but there is never any cash. The profits are all the metals sitting in the yard. In order to keep going, the cash is constantly ploughed back into the business and there’s neither growth nor cash for the shareholders.
I look for companies that are able to generate high Return on Tangible Assets (ROTA) of at least 20%. A company that shows high ROTA is able to bring in income with relatively little assets.
In Warren Buffet’s 2019 shareholder letter, he highlighted that the companies Berkshire owns typically earn more than 20% on the net tangible equity required to run their businesses without employing excessive levels of debt.
5. Competent and Shareholder-Friendly Management
“Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you. You think about it; it’s true. If you hire somebody without [integrity], you really want them to be dumb and lazy.”
Here I am looking for management who are great capital allocators, open communicators and preferably with significant skin in the game. Judging management is really more of an art than science, here are some key indicators I look out for:
Ownership – Do the executives & directors have a stake? For this I look at the portion of net worth the management has that is tied up to the company’s stock. The classic example is Warren Buffett with more than 90% of his net worth in Berkshire Hathaway!
Insider Trading – As Peter Lynch says, insiders buy only if they feel that the stock price is going to increase!
Remuneration – Is there an agency problem? Is management excessively remunerated compared to net income of the company and is it exorbitant compared to competitors? I will also look at their remuneration structure, are they compensated for long-term capital allocation skills or short term results (e.g. next year’s EPS growth)?
Capital Allocation – Based on their past records, have they generated at least a dollar for every dollar retained in the business?
Related Party Transactions – This is a red flag that warrants further investigation if it’s a significant percentage.
Shareholder Letters – Are they frank in their annual letter to shareholders, highlighting both successes and failures? I regard Warren Buffett from Berkshire and Ronnie Chan from Hang Lung as the gold standard in this area.
As minority shareholders, we are passive in deciding how a company is managed and run. Here, we must select competent management with a demonstrated interest for shareholders to generate positive returns for us as shareholders.
While not perfect, this investment framework has helped me pick up high quality companies over the years that will compound my wealth steadily. As Peter Lynch says, “In this business, if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.”
P.S. Below is an advert on the Wall Street Journal posted by Warren Buffett back in 1986 which outlines his filter for investments. Enjoy!