The very first stock market in the world was established in Amsterdam in the 1600s. A few hundred years have passed since, and a stock exchange today looks very different even from just 20 years ago. But one thing has remained constant: A stock market is still a place to buy and sell pieces of a business.
Having this basic but important understanding of the stock market leads to the next observation, that a stock’s price movement over the long run then depends on the performance of the underlying business. In this way, the stock market becomes something easy to grasp: A stock’s price will do well over time if the underlying business does well too. The next logical question then follows: Is there a way to find companies with businesses that could do well in the years ahead? From experience and logical reasoning, I believe the answer is “Yes!”
I’ve been investing for my family since October 2010, and over the past nine years, I’ve developed a framework for picking companies that have a good chance of growing at high rates for long periods of time. I focus on finding companies that meet all or most of the following six criteria.
My investment framework
1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market.
This criterion is important because I want companies that have the capacity to grow. Being stuck in a market that is shrinking – such as print-advertising for instance, which has shrunk by 2.3% per year from 2011 to 2018 – would mean that a company faces an uphill battle to grow.
An example of a company with smaller revenue in relation to a fast-growing market is, believe it or not, Facebook, a company I own shares of. Facebook’s revenue over the last 12 months is US$66.5 billion, of which most come from digital advertising. The company’s revenue, as large as it is, is still just a fraction of the global digital advertising market, which was US$283 billion in 2018 and expected to grow to US$518 billion in 2023. In turn, the global digital advertising market was less than half of the global advertising spend of US$617 billion in 2018. An example of a company that I own shares of with large revenues in relation to a fast-growing market is Intuitive Surgical, maker of robotic surgery systems. Intuitive Surgical’s revenue over the last 12 months is US$4.2 billion, while the worldwide robotic surgical market is forecast to jump from US$4.1 billion in 2015 to nearly US$10 billion by 2020. Intuitive Surgical’s systems handled 1.04 million surgical procedures in 2018, which seems like a large number, but only 5% or so of surgeries worldwide are done with robots today.
2. A strong balance sheet with minimal or a reasonable amount of debt.
A strong balance sheet enables a company to achieve three things: (a) Invest for growth, (b) withstand tough times, and (c) increase market share when its financially-weaker companies are struggling during periods of economic contraction. I typically want a company to have more cash than debt. If there are significant levels of debt, then I will want the debt to be a low multiple of free cash flow. If I’m looking at a bank, the level of cash and debt is inconsequential, so my attention will be on the leverage ratio, which is the ratio of the bank’s total assets to shareholders’ equity.
3. A management team with integrity, capability, and an innovative mindset.
A management team without capability is bad for self-explanatory reasons. Without an innovative mindset, a company can easily be overtaken by competitors. Meanwhile, a management team without integrity can fatten themselves at the expense of shareholders. There are a few things we can look at to understand how a company’s management team fares on these fronts.
On integrity:
- How has management’s pay changed over time relative to the company’s business performance? It’s not a good sign if management’s pay has increased or remained the same in periods when the company’s business isn’t doing well.
- How is management compensated? Ideally, we want management to be compensated based on metrics that make sense to us as a company’s shareholders. PayPal, another company I own shares of, excels in this regard, in my view. In 2018, the lion’s share of the compensation of PayPal’s key leaders came from the following: (a) Stock awards that vest over a three-year period; (b) restricted stock awards that depend on growth in the company’s revenue and free cash flow over a three-year period; and (c) which applies specifically for the CEO, stock awards that depend on the performance of PayPal’s share price over a five-year period.
- Are there high levels of related-party transactions (RTPs)? RTPs are business transactions made between a company and organisations that are linked to said company’s management. A good example will be the famous hotpot restaurant operator, Haidilao. In 2018, Haidilao’s top five suppliers accounted for 38.4% of the company’s total purchases of RMB 10 billion, and four of the top five suppliers were linked to management. The presence of high levels of RTPs in a company could mean that management is using said company to enrich entities that are linked to them – that’s not ideal for the company’s other shareholders. In the case of Haidilao, it appears that management has been treating shareholders fairly; the company’s net profit margin has been at a healthy level (for a restaurant operator) of at least 9% going back to 2016.
On capability:
- Does the company have a good culture? Some clues on a company’s culture can be found on Glassdoor, a website that allows a company’s employees to rate it anonymously. Unfortunately, Glassdoor’s coverage mostly extends to only US companies for now.
- Has the company managed to successfully grow its important business metrics over time? Going back to Intuitive Surgical, the number of surgical procedures worldwide performed with the company’s robots has increased significantly from 68,000 in 2007 to 1.04 million in 2018. Meanwhile, the installed base of Intuitive Surgical’s robotic surgery systems worldwide has jumped from 795 in 2007 to 5,406 today.
On innovation:
- It requires some judgement in assessing a management team’s ability to innovate. There are three companies that I think are great examples of having innovative management.
- First is US e-commerce and cloud computing giant Amazon, which I own shares of. Amazon started selling just books online when it was founded in 1994 but expanded its online retail business into an incredible variety of product-categories over time. In 2006, the company launched its cloud computing business, AWS (Amazon Web Services), which has since grown into the largest cloud computing service provider in the world.
- Second is the international video streaming provider Netflix, which I also own shares of. Netflix’s co-founder and CEO Reed Hastings said in 2007: “We named the company Netflix for a reason; we didn’t name it DVDs-by-mail. The opportunity for Netflix online arrives when we can deliver content to the TV without any intermediary device.” This shows that Netflix’s leaders were already thinking about building a video streaming business right from the very beginning, back when video streaming wasn’t even a widely used term.
- Third is MercadoLibre, another company that I have a stake in. MercadoLibre started life in the late 1990s operating online marketplaces in Latin America that connects buyers and sellers. In the early 2000s, MercadoLibre started an online payments service, MercadoPago, that now also includes online-to-offline (O2O) payments services. In addition, the service helps facilities online payments for merchants and consumers that are outside of the company’s online retail platform. In the third quarter of 2019, off-platform payment volume on MercadoPago exceeded on-platform payment volume in Brazil (the company’s largest market), for the first time ever. Then in 2013, MercadoLibre launched its shipping solution, MercadoEnvios. MercadoLibre’s service-innovations all help to drive further growth in the company’s marketplace business, and in some cases, even create new growth areas outside of the company’s main platform.
4. Revenue streams that are recurring in nature, either through contracts or customor-behaviour.
Having recurring business is a beautiful thing because it means a company need not spend its time and money looking to remake a past sale. Instead, past sales are recurring, and the company is free to find brand new avenues for growth.
A company in my portfolio, Adobe, provides subscription services for software used in many different areas including digital marketing and creation of digital content. The subscriptions provide recurring revenue for Adobe and accounted for 88% of the company’s US$9.0 billion in revenue in its fiscal year ended 30 November 2018.
Recurring revenue from customer behaviour is embodied by the digital payments company, Mastercard, another stock-holding of mine. Each time you swipe your Mastercard credit card, the company earns a fee; in 2018, Mastercard processed US$5.9 trillion in payments (that’s a lot of swiping!). Intuitive Surgical is also another good example of a company with high-levels of recurring revenue from customer behaviour due to its razor-and-blades business model. The company generates revenue from the one-time sale of its surgical robot systems. But it also supplies the accessories that are used with the robots and provides the necessary maintenance services. The accessories and maintenance services generate recurring revenues for Intuitive Surgical and accounted for 70% of the company’s total revenue of US$3.7 billion in 2018.
5. A proven ability to grow.
It’s important that a company has shown that it’s able to grow so that the chances of future growth are higher. And by growth, I’m looking at big jumps in revenue, net profit, and free cash flow over time. Sometimes, just revenue and free cash flow are good enough. I am generally wary of companies that (a) produce revenue and profit growth without corresponding increases in free cash flow, or (b) produce revenue growth but suffer losses and/or negative free cash flow. But I will be happy to make exceptions for some relatively young SaaS (software-as-a-service) companies that produce strong revenue growth but currently still generate losses and/or negative free cash flow.
A company’s track record is important, because it is easy for anyone to promise the sky – delivering on the promise is another matter, and it’s not easy to do. Amazon is a good example of a company with a strong history of growth. From 2013 to 2018, revenue tripled from US$74 billion to US$233 billion, while free cash flow jumped nearly nine times from US$2 billion to US$17 billion. PayPal Holdings is another good instance. From 2013 to 2018, revenue more than doubled from US$6.7 billion to US$15.5 billion, profit rose from US$1 billion to US$2 billion, and free cash flow increased from US$1.6 billion to US$4.7 billion.
6. A high likelihood of generating a strong and growing stream of free cash flow in the future.
The actual value of a company, in general, is the amount of cash it can generate over its entire life. So, the more free cash flow a company can produce, the more valuable it is. It’s important to note that free cash flow is not a relevant metric to use when assessing banks – the book value per share will be more appropriate.
A good example of a company that embodies this criterion, in my view, is Alphabet, the parent of the internet search giant Google (I own shares of Alphabet). Alphabet has a strong history of generating free cash flow, and it likely can continue doing so in the future, since the advertising business of Google is so lucrative. From 2013 to 2018, Alphabet’s free cash flow increased from US$11.3 billion to US$22.8 billion, while the free cash flow margin (free cash flow as a percentage of revenue) only slipped slightly from 20% to a still-strong 17%.
Conclusion
Companies that excel in all six criteria may still turn out to be poor investments. It’s impossible to get it right all the time in the investing game, so I believe it is important to diversify. And believe me, there are stocks in my family’s portfolio that are big losers (down 50% or more). But by sticking with companies that meet most or all of the six criteria above, I believe that the winners can more than make up for the losers. This is something that has happened to my family’s portfolio.
Another important point to note is that patience is needed in investing. Even the best winners in the market suffer painful declines from time to time. From 1997 to 2018, the peak-to-trough decline for Amazon’s stock price in each year ranged from 12.6% to 83.0%, meaning to say that Amazon’s stock price had experienced a double-digit peak-to-trough fall every year. Over the same period, Amazon’s stock price climbed from US$1.96 to US$1,501.97, for an astonishing gain of over 76,000%. My family’s portfolio still holds many of the stocks bought in 2010, 2011 and 2012 (we first bought Amazon shares in 2014 and are still happy owners). By having patience, we allow the underlying businesses of the companies we own shares in to shine and carry our portfolio to new heights over time.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.