🔑 #1 - Margin of Safety in SMB

🔑 #2 - How the Pros Read Financial Reports

🔑#3 - Is AI Coming for Analysts?

🔑 #1 - Margin of Safety

This is a bit of a long thread (I’ll share my takeaways below).

I can’t help but read this thread and think to myself:

there is no such a thing as margin of safety with debt in small business

There are many incredible small businesses out there that you can buy for 3-5x earnings.

If you buy them all in cash, and you don’t break anything, you will net a return of 20-33% per year.

That’s an incredible return. There is no reason to try and do better.

However, that’s not the way investors think.

Everyone wants to squeeze more results out of the same company.

Debt is a way to do that. But with debt your margin of safety disappears.

🔑 #2 - How the Pros Read Financial Reports

I’ve been wanting to learn how the pros read public company financial reports.

So this week I called a friend (let’s call him Brandon).

He has an incredible track record as a value investor.

His job is to find companies trading at 50 cents on the dollar (not an easy task these days).

His returns after fees stand at 18% which is a hard record to beat.

Here is a detailed overview of performance for the past 6 years (obscured his fund name for confidentiality)

I asked Brandon to teach me how he does company research, and here’s what he taught me.

If you read nothing else, here are the key takeaways:

🔑 You can’t shortcut reading public fillings. The only way to read them is cover to cover.

🔑 Understand executive compensation, and make sure it serves shareholders.

🔑 Short annual reports are markers of a good company. Super long reports are a red flag.

First…

Brandon will print the public fillings out. Key reports include 10k, 10q, quarterly reports, current reports (8k), and proxy statements.

He uses the first page of the report as his note sheet.

As he reads through the report, he will mark things he doesn’t understand along with the page reference on the front page (ex: page 45, footnote 3).

Understand Incentives…

Brandon suggests you start your research by reading the Proxy Statement (14a) which includes executive compensation.

Why?

Because Charlie Munger says

“show me the incentives and I’ll show you the outcome”

Brandon wants to understand how the executives are compensated.

He wants to know, who’s side are they on? the shareholders? or just themselves?

🚩He does not like to see Revenue or EBITDA growth as a driver of incentives

These types of goals may lead the executives to behave in an irresponsible way.

For example, they may take on risky debt in order to buy other companies.

This will quickly grow the revenue and EBITDA, but overall is likely to lower company value & the stock price.

⭐️ He DOES like to see the following as an aligned goal for execs:

Return on invested capital: which he finds limits executive willingness to change the balance sheet dramatically. And limits frivolous spending.

Cash flow growth: 5-15% per year is good.

Pay attention to how cash flow is described. The language they use is important.

If they’re using EBITDA as a proxy for cash flow, that should be a red flag. 🚩

A good definition for ‘cash flow’ can be EBITDA minus cappex or operating cash flow minus cappex.

Brandon is looking to make sure the management’s terminology for cash flow is closely aligned with his definition for cash flow.

If that’s the case, he gives them bonus points.

Intrinsic value per share growth: means they are growing value for current shareholders.

Duration of pay structure: he does not want to see an executive get their compensation structure based on just 1 year.

Ideal performance targets are over 3-5 years to incentivize long-term value creation.

Pay attention to management compensation with stock.

You need to understand how executives are being compensated with stock.

You may see a business with $50M of Net Income, trading at 6x. Sounds interesting, until you learn that the company also gave out $40M of stock-based compensation in the same year.

This isn’t technically a cash-based compensation, but it should be counted as such by you, a smart and savvy investor.

If you’re just getting started…

Brandon suggests you avoid research reports from banks, lenders or insurance companies.

They’re too complex, and understanding accounting practices is a mind-bender.

Read the chairman’s letters

When investing in a business, you are underwriting the team and the business fundamentals.

Pay attention to what the executive team is promising and track their performance.

If they hit their goals, even during challenging times then this could be a good indicator of future success.

Final note from Brandon:

• read at least 5 years of reports on a company to understand how it behaves
• read reports from competitors to see how other companies do their accounting and compare them
• review the risk disclosure sections. It may seem boilerplate but will help you come to terms with the risks you don’t expect in the industry.
• review legal proceedings - those are usually downplayed

That’s it from Brandon. If you enjoyed this let me know, and I’ll pass it to my friend. I’m sure he will love hearing from you.

🔑 #3 - Is AI Coming for Analysts?

This week I’ve been testing the OpenAI playground tool for investing research. You simply type a prompt, and it gives you the answer (in green). Pretty cool.

Let’s see how Lululemon is performing year over year.

I previously wrote about Joel Greenblatt’s Magic Formula (high return on investment, and low price-to-earnings ratio).

Instead of doing the calculations myself, the AI may help (I haven’t validated these results).

You can compare stock buyback programs, which is sometimes a good strategy to increase value for shareholders.

Stock grants are a cost to shareholders and often sail under the radar. Let’s see if these companies are carefully compensating their executives.

Sometimes companies will change auditing firms, which can be a red flag 🚩. Note some states require it, so it’s not inherently a problem.

To my readers: What did you think? Is AI coming for analysts jobs?

Which 🔑 did you enjoy most this week? 1, 2 or 3?

Thanks for reading and have a great week,

Sieva