Moat Investing – A KIP Process

Investigate

  • First, explore the stock as a business.
  • Then ask: Has it created economic value? Is it likely to continue creating this in the future?
  • Value creation in the past: Unpack 10-years of financial history. a) Did ROIC meaningfully exceed WACC? b) Did the ROIC-WACC spread apply to an increasing Capital base? (aka. Economic Value Added)
    Businesses that feature both are often compounders of owner’s wealth. Apply the Berkshire-Cow EVC Model to determine the magnitude of value creation.
  • Identify Economic Moats: Careful quantitative inquiry raises a host of questions about the business. Advance to investigating the qualitative features behind the numbers. Importantly, apply the Measuring the Moat* checklist to study the competitive edges.
  • Recognize Reinvestment Runways: Extraordinary businesses have the capacity to reinvest new capital profitably (high ROIC-minus-WACC spread) into the existing capital base. (see part ‘b)’ in the EVC section above). This produces a ‘flywheel effect’, and business value grows exponentially. Analyse the company, its industry and competitors to determine if a) there are opportunities for profitable growth for several years (reinvestment runways), and b) if the moat will allow high incremental returns on capital, and endure the inevitable onslaught of competition and unfavorable economic circumstances. Bear in mind the rarity of such businesses.
  • Judge Capital Allocation: Exponential wealth compounding can only occur through superior capital allocation. That is, managers in command who are commited to directing capital in ways that maximize intrinsic value per share for the owners. This step involves scrutinizing a manager’s track record, their compensation plan, and by direct communication to judge if their capability and motivation. Great capital allocators share some features.
    • Acknowledge that growth (organic, acquisition, M&A) is only valuable when additional EVA is produced. Concede that most acquisitions and M&As destroy value.
    • Are incentivized to always act in favor of the owners, not themselves or other stakeholders.
      Caveat: This goal must not extort employees, customers and the enviroment. Ethical businesses that produce win-win scenarios tend to prosper.
    • Appreciate that buybacks and dividends are both forms of returning cash to owners. Buybacks benefit only when the intrinsic value of the asset exceeds the price paid. Dividends benefit only when owners can employ their capital elsewhere more profitably than within the business.

Valuation

Although price is far from the only consideration when investing in great companies, it is a crucial one. Great businesses can make terrible investments when the price paid is absurd.

  • Use the Price-Implied Expectation (PIE) Model to determine the extent to which the price has already captured future potential for value creation. 
  • If expectations appear overzealous, put the business on a watchlist and await an opportunity. 
  • If the implied assumptions appear irrationally depressed, try to work out if there is an opportunity for correction. What may be the catalysts? How probable? How soon?
  • PIE analysis also reveals sensitivity of value drivers. Key drivers include sales growth, profitability and reinvestments.
  • If an opportunity comes into view, the fundamental moat analysis factors into high probability scenarios. The DCF model (among others) is then used to anticipate a range of fair values.

Decision

  • If anticipated revisions exceed market expectations, take a buy position. If not, consider pass, hold or sell.
  • Apply expected value analysis to reach a decision. 

Husain Kothari | Shabbar Kothari
Last revised: April 2019

 

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