When I presented to my alma mater’s student investment club last week, the club president asked me how I broke into research from not having any technical skills before MBA. I answered: brute force.
Today I want to discuss the foundational skills necessary one needs to analyze businesses. There is no way around it - you must work hard to internalize the foundational skills.
There is an investment book “Investing: The Last Liberal Art” by Robert Hagstrom. I find the book title very relatable: It’s not just about financial modeling, it’s not just about understanding the business, it’s not just about knowing how the stocks trade and what the consensus expectation is – It’s all of that, it's interdisciplinary.
To make matters worse, everyone invests differently (though I made effort to categorize all investment styles). I get it and have been there – learning how to invest is hard.
I am not sure but I assume most find the quantitative skills relatively more tangible to learn. I would recommend starting with the quantitative technical: accounting, financial modeling and then moving into competitive analysis which is part quantitative and part qualitative. From my experience, the qualitative is the much harder part of investing so I will discuss that in the subsequent articles.
If you do not speak accounting, the language of business, you cannot understand a business.
Instead of memorizing accounting rules formulaically, understand what the accounting numbers mean to the business.
The following items show up enough for most companies that you should know how the accounting works for them: accruals and deferrals (working capital), stock options (dilutions), leases, one-item item adjustments, accretion / dilution analysis for M&As, net operating losses, and convertible debt. There is a great primer floating around written by Chris Senyek from Wolfe Research, I will read it and keep that as a reference when reading a company's filing (Google “10-K Navigation Guide”).
The goal of financial modeling is to sensitivity-test drivers of a business and its free cash flow generation ability. As discussed previously in my discussion on 7 Powers, here are the key drivers to free cash flow generation:
- Revenue growth, Margin, Tax gets you to NOPAT
- Capex and D&A gets your maintenance capex needs
- Working capital intensity (which requires understanding accrual / deferral).
When I started out, I wish someone taught me the concept of unit economics: how a business makes money on a per unit of product basis.
- For most businesses, revenue = price * quantity.
- Some stocks are a quantity / volume story (eg. How many new patients can a primary care clinic get where pricing pressure is well understood)
- Other stocks are a pricing story (eg. Netflix being a classic example as subscriber growth plateaus eventually, so it's testing how elastic their pricing can be)
- For toll road-like business such as e-commerce marketplace or payment platforms, revenue = traffic * toll rate (a toll road makes fees based on how many cars pass through the toll road and how much each driver pays).
- For example, the market understands the rapid growth of GMV (gross merchandise value, which represents how much goods exchange hands on a particular e-commerce marketplace), but can underestimate a marketplace’s ability to increase take-rate because of increasing value-add as it scales or additional value-add services.
- For more mature marketplaces, it can become a GMV story, as take-rate cannot go any higher, so the bet becomes whether the marketplace can expand into an adjacent category.
- Some stocks are cost stories
A competitive analysis framework is one of the best tools a novice investor can have because it is systematically applicable to all businesses: Why does Apple have higher gross margin than commodity producers do? Why are some industries cyclical? What are some businesses higher ROIC than others?
After learning the competitive analysis framework, you can more confidently understand why a business is a good business and develop a financial outlook on the business: for example, if you believe the company you are analyzing is gaining bargain power, you can expect its pricing power and thus gross margin to expand over your forecast time horizon.
Read one or more of the books here:
- Understanding Michael Porter, Joan Magretta
- Competition Demystified, Bruce Greenwald
- 7 Power, Hamilton Helmer
That’s it for this week. I will spend the next two articles to discuss extensively on the subject of idea generation and how to read a 10-K, which build on the foundational skill pillars I discussed in this article.
If you are interested in learning more about professional equity investing (the "buy-side"), I have two other great articles for you:
Don't know where to start to research and value a company? Have trouble generating stock ideas and differentiating on stock pitch? I can help you. Let's meet!