PowerPoint presentations, heavy in graphics and light in text, make it easy to BS and seem knowledgeable without having much expertise. Steve Jobs opined, “I hate the way people use slide presentations instead of thinking”. Jeff Bezos would ban them from his boardroom in favor of written memos that require a clarity of thought bullet points cannot convey. With Drew having started his career publishing research on the sell-side at Goldman Sachs and then consuming research on the buy-side at Capital Group, it is apparent that most research suffers from the same problems that PowerPoint presentations do.
Ask a sell-side firm for a primer on a company and you’ll likely get a document with over 100 pages and no fewer than 4 charts per page, yet when you finish reading, there is very little that registers. With each sell-side team member focusing on producing a dizzying array of chart permutations, few stop to think what they are trying to prove. The pressure for a sell-side analyst to constantly be publishing, coupled with the narrow universe on what they can publish on, means that they are always writing, even when there is nothing worth writing about.
How many sell-side reports that were published just a year ago would you want to read today? Not many, if any. The lack of shelf life is indicative of a lack of signal and insight. Most companies change far less than you’d think by the publishing cadence of the sell-side. Costco’s value prop is essentially unchanged from several decades ago, the competitive advantage of Moody’s rating agency business still stands, and the virtues of BlackRock’s business model have endured quarter after quarter since their first index fund launched in 1999. While companies definitely will go through many changes that require keeping up with, they change far slower than quarterly. It is our claim that a focus on the minute will force an investor to miss the big picture.
In fact, we think of our research process like a camera focusing its lens. We start with a big and crude picture that is easy to understand, then slowly turn up the resolution to bring in more detail. Then we zoom into particular areas of the picture that are worth examining further. In contrast, most sell-side research is like getting a data dump of RGB values.
What am I looking at?
In line with that idea of increasing the resolution of a photo, our first aim is to understand what we are “looking at”. How this is done will depend on the company. For consumer products, interacting with the company’s products and talking to consumers is essential. It is very easy to understand what Floor & Decor is about after visiting one of their stores. Companies that service other businesses are harder to get a handle on. Typically, we rely on secondhand sources of a user’s experience with the companies’ products. While Constellation Software has far too many products to look at each, we compiled an assortment of different software services they offer and tried to understand them individually. This is typically buttressed with scuttlebutt and trying to find out what customers like or don’t like about the product or services.
Before diving into all of the financial and business material, we like to understand what the company is “about”. For many consumer-facing companies like McDonald’s, Amazon, Best Buy, Home Depot, Alphabet, Meta, you probably built up this sense before you even thought of investing in them. It is tougher for B2B companies, and you might have to get creative to figure out how to get in touch with users of their product or service, but building out that sense of what a company is “about” is critical.
While this step is admittedly fraught with bias and personal anecdotes, it is a very important step. It also serves as a vetting process that helps inform what companies are worth learning more about.
Explain the big picture. Your predecessors (MBAs) failed over a long period of time. It has nothing to do about their ability to do a spreadsheet. It has more to do with the big picture. I focus on the big picture. Think of the logic, not just the formula.
What is their operating model? How did they get here?
We put these two questions together because a business’ operating model is typically born from a need, and their history gives us a better understanding of how they’ve iterated on their original value prop over time. Understanding these changes can help you better understand what consumers value. Floor & Decor was started after founder George Vincent West was fed up with the limited selection and prices of local alternatives. Sam Walton wanted to provide better value for money to his customers. Jeff Bezos wanted to create a service that could take advantage of the unlimited “storage” space the internet enabled. Starbuck’s Howard Shultz wanted to create a “3rd space” that wasn’t home or work. The original problems founders tried to solve and the ethos they imbue their companies with are usually still true decades later. The founding history of a company will give an investor a much better understanding of what the company is optimized for, and will allow them to better grapple with how they will potentially handle future obstacles. This is why our report on Meta includes a 10,000+ word history section with even more history weaved in throughout the analysis.
With history in mind, it is much easier to understand a company’s optimization equation. Floor & Decor, trying to solve for cheap prices and vast selection, would employ a warehouse model to keep costs low and increase storage for their SKUs. Coupling that with direct sourcing allowed them to get products for cheaper. They then improved on the model by pushing their ever growing volumes to negotiate better terms with manufacturers and better leverage their distribution centers. Knowing what they are solving for gives better insight into what the consumer value prop is, and how it can improve over time.
Once a person has an idea, we then start whacking at it. We invert the concept. Instead of trying to prove a person’s idea, we try to kill it, and if we can’t kill it then the person is onto something. Whether it is my own idea or someone else’s that is the process we go through.
If they failed, what went wrong?
After analyzing the value prop, most of our energy is spent on “killing” the business. What are all of the things that could go wrong? If it is a very strong company, you will find yourself becoming ever more creative in trying to eliminate it from the future. Constellation Software may not be able to acquire as many companies in the future as the past, but can you really think of any scenario where their hundreds of niche, vertical market SaaS companies suddenly disappear after a multi-decade period of consolidated growth? For some companies, your answer may be fairly prosaic—you can kill Apple by saying the next generation of user will prefer different phones, but a mundane answer shouldn’t be confused for a probable answer. Knowing everything that can go wrong is the first step. The second step is understanding the likelihood of that.
“Invert, always invert” Jacobi said. He knew that it is in the nature of things that many hard problems are best solved when they are addressed backwards.
If successful, what are your assumption?
We progress along our prior line of reasoning, and move to see what assumptions are needed for success. In our Apple example, we need users to keep buying Apple iPhones, an assumption most investors will be comfortable with. The corollary question to this is, “What is the return an investor would earn for making these assumptions?”
To answer this question, we like to use a reverse DCF. With this simple method, we can make an assumption about the future of a business, calculate the approximate cash flows, and see what rate an investor can earn at today’s prices. If you are a Tesla investor looking for at least a 12% annual return, you may find out that you must assume car sales quintuple and gross margins expand significantly in order to achieve that (this is an illustration; we did not run the math). It is easier for an investor to know what return they want in the context of the assumptions they must make.
You can, of course, sensitize around a large set of variables, but we try to hone in on the couple key variables that really matter. The output (the reverse DCF discount rate output) is a table of business returns at current market price for various assumptions. This “business return” can be thought of as your return on the purchase of the business at today’s market price if you were to directly receive the excess cash flows (and all assumptions held).
When we think of a company as under- or over-valued, it is mathematically the same as saying the implied discount rate for the risk inherent in the business is too high (business is cheap) or too low (business is expensive).
In our opinion, framing the opportunity in terms of discount rates makes it easier to conceptualize the investment opportunity by making the assumptions and returns explicit. (It can also keep an investor from making mistakes with multiples. In theory, a multiple is shorthand for a DCF, but it is commonly used out of convenience, leading to investors being blithely unaware of the assumptions that their multiples imply. Most commonly, the multiple makes implicit assumptions investors would be uncomfortable with were they to be explicit. The Reverse DCF avoids this by making all assumptions explicit).
Ultimately, it is an investor’s judgement whether or not certain assumptions adequately compensates them for the risk. This is why we called our firm Speedwell: it is named for the boat that helped deliver passengers to the Mayflower, because ultimately, it is the investor, and not us, that must make the journey.
We write to teach.
Berkshire is my way of teaching things that mean the most to me and what I want to get out of others.
Lastly, we do not use a bunch of jargon, but instead write as if this is the reader’s first encounter with many of the industry terms or concepts. Essentially, each report is an initiation report on not just the company, but the industry as well. We assume little prior knowledge of the company and have mini “industry-primers” in each piece to increase an investor’s understanding.
Our philosophy is to write as if we are learning this for the first time, in as simple as possible terms. However, simplicity shouldn’t be taken for shallowness: experienced analysts have repeatedly noted their surprise at how often they learn something new from our pieces. Even if you are not interested in each particular company we write about, our reports will increase your understanding of new industries which could lead to tangential investment opportunities.
Since we aim to put a diligent reader of our reports on par with a seasoned analyst, our reports turn out to be rather long. However, we also provide a short “PM Summary” with each report, which is a distillation of our key analyses and insights.
Our reports are exactly what we wish we could have had when we were on the buyside—if that is you, please reach out for a sample today.
Drew Cohen and Kevin G.