Nine Investment Questions

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Nine Investment Questions

July 2019

PE Investment Committee Course

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My Background

• My writing and speaking are on digital China and Asia’s latest

tech trends.

• LinkedIn Top Voice for Finance and China for 2016-18.

• Named one of 15 Global Influencers by Alibaba in 2017-18.

• Most followed waiguo Professor in China? +3M Followers.

• Do healthcare PE deals and M&A advisory in the US and Asia.

• Teach at Peking University, CEIBS and others.

• MBA from Columbia, MD from Stanford, BA in Physics.

• Based in Bangkok and Las Vegas.

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Prince Alwaleed – the “Arabian

Warren Buffett”

• The world’s 4th richest person (2004)

• The largest owner of Citigroup

• The largest investor in the Middle East

• The largest foreign investor in the USA

• The 2nd largest owner of media in the world

• Owner of 200+ hotels

• Grew $200k into $28 billion over 20 years – with 3 biz staff

• China assets include Bank of China, JD, lots of hotels, and

portfolio companies

2www.jeffreytowson.com

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• Nine Investment Questions

• Ques #2a: Has a Competitive Advantage? Is the

Company GGTB?

• Break – 20 min

• Case: SABMiller

www.jeffreytowson.com

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Typical Due Diligence Includes:

5

• Market and customer assessments

• Industry and competition

• Operations

• Management

• Financial projections and valuation

• Accounting due diligence

• Tax due diligence

• Regulatory due diligence

• Technology due diligence


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6

• Income Statement

• Balance Sheet

• Cash Flow

• ROIC

• Reproduction Value

• EPV

• DCF

• Owners’ Earnings


Typical Financial Projections

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”Checklist routines avoid a lot of errors.

You should have all of this elementary

wisdom, and you should go through a

mental checklist in order to use it. There

is no other procedure that will work as

well.”

- Charlie Munger, Vice Chairman,

Berkshire Hathaway


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3a. Valuation chart

3b. Graham: Criteria list

2a. 5 CA questions

2b. Management

2c. CGTA and destiny ques

2d. Barrack: Sellable RE or FA?

2e. Fisher’s 15 questions

Is the company

Great, Good, Bad

or Too Hard?

Does it have a CA?

21 Is the business

(company or asset)

attractive and / or

predictable (in long or

short-term)? 5

How much can

financial engineering

improve returns at

purchase and / or

sale?

3What is the

intrinsic value?

What is the margin

of safety?

What is the Exit?

What is R&R

outcome tree with

odds? Second

level thinking?

What is the worst

case?

What is time / effort

vs. return?

Deal & Value Add Ques

Is this company good,

great, bad or too hard?

Has a competitive

advantage?

7 Who are the

competing bidders?

How eliminate? What

is your edge or

acquisition

advantage?

Who is selling?

Why is it cheap?

Is there a

catalyst?

6. 3G playbook Pass punch card

test? Check

against common

ways to lose $

4

How much

operational value add

in 3 months? In 1

year? 3 years? Effort

and difficulty vs.

return?

6

8

9

1a. Customer view

1b. Industry questions

1c. Porter: Five Forces

1d. Russo: 5 + “and then what?”

1e. Munger: Psych list

1f. Marks: “Where are we?”

4a.Klarman: FEMs and sits

4b.Marks: Investor behavior

4c.Gabelli: Catalysts & 4 steps

4d.Icahn: Anti-mgmt activism

Risk & Returns Ques

7a.Alwaleed / Barrack

approach

7b.Search lists • Do checklist for follow-up

• A prime bet (for $) or small

action bet (for psych)?

Value and Price Ques


9 QuestionsPause 1: Do

external view,

how can

company fall by

30%?

Pause 2:

Send to “no

man”

Company Ques

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1. Attractive or Predictable Business?

1. Tom Russo

2. Charlie Munger (Psych stuff)

2. G/G/B/TH?

1. Warren Buffett

2. Philip Fisher

3. Tom Barrack

3. Valuation?

1. Ben Graham

2. Seth Klarman

4. Situations and Catalysts?

1. Seth Klarman

2. Mario Gabelli

3. Carl Icahn

4. Joel Greenblatt

5. Financial Engineering?

1. John Malone

2. Henry Kravis / KKR

3. Carl Icahn

4. William Zeckendorf

5. Jiuding Capitalwww.jeffreytowson.com

People to Study

6. Operational Value-Add?

1. 3G Capital / Jorge Lemann

2. KPS Capital

3. Alwaleed

4. Unitas Capital

5. Prestige Brands?

7. Advantage?

1. Alwaleed

8. Risk vs. Return Cases. Worst Case?

1. Howard Marks

2. Dead Companies Walking

9. Punch Card Test?

1. Charlie Munger

2. Jim Chanos

3. Shorts (Muddy Waters, etc.)

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10



Company GGTB?


• Case: SABMiller


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Buffett’s Most Important Piece of

Information?


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”Warren...likes investments in which he

can predict winners a decade in

advance – an almost impossible feat

when it comes to technology.”

– Bill Gates

Page 12


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Economic Theory – A Company Creates Value

When Its ROIC is More than Cost of Capital

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• Value creation comes from the company’s ability to earn a

return, after all operating costs, that is greater than the capital

deployed in the business, equity as well as debt. This excess

return is what economists call “economic profits.”

• ROIC (return on invested capital) - WACC (weighted

average cost of capital)

• This shouldn’t exist. High economic profit (high return on equity

capital) should attract competition.


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Competitive Advantages Protect This

Attractive ROIC Situation from Competition

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• It has multiple names:

• Franchise

• Moat around the castle

• Barrier to entry

• Most companies don’t have one – but think they do. And for those that do,

few are sustainable for that long. Average is like 8 years.

• It is not high profits. It’s about protecting economic profit. About keeping

ROIC>WACC

• ROIC = NOPAT/IC

• NOPAT = Revenues – Operating Expenses – Cash Taxes

• So it’s about having higher revenue or lower expenses.


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To Simplify, Let’s Say There Are Only Two Types of

Companies

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• Those with no CA - “Treadmills” (Bad and Too Hard Co.)• Continually fighting competitors. No protection or strong

advantage so all about execution.

• Spending money to upgrade facilities, grow, etc.

• Often little cash produced

• EPV is equal or less than AV

• Running on treadmill to survive – but never get anywhere

• Those with CA - “Snowballs” (Good and Great Co.)• ROIC>WACC

• Often cash producer

• Protected from competition

• Living the good life

• “Life is like a snowball. The important thing is finding wet snow

and a really long hill“ – Warren Buffett


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”There are two kinds of businesses: The

first earns 12%, and you can take it out at

the end of the year. The second earns

12%, but all the excess cash must be

reinvested — there’s never any cash. It

reminds me of the guy who looks at all of

his equipment and says, “There’s all of my

profit.” We hate that kind of business.”

- Charlie Munger, Vice Chairman,

Berkshire Hathaway

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How Long It Lasts is Critical

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What is a Competitive Advantage?


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How to Test if it Exists?

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1. ROIC

• Sustained high profitability as measured by return on invested

capital (ROIC)

• Significant, and sustained, differences between the profitability

(ROIC) of various market participants.

2. Market Share - Entry/Share Stability

• High share stability over time (low change in average share

among participants)

• Few new entrants / failed entry attempts

• Local, long-term company dominance


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How Can ROIC > WACC?

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• ROIC = (Revenue – Cost) / Invested Capital

• For ROIC to be higher than competitors, revenue has to be

higher or costs have to be lower.


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1. Revenue Cost Advantages

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• Revenue = units x price

• Somehow you can charge higher prices or sell more quantity that your

competitors.

• It’s usually about some type of customer captivity

• 3-4 types of competitive advantages on revenue side:

• “Share of consumer mind”: Like / love, buying / usage habits, etc.

• Switching costs: Installed systems, perceive risk, training costs,

etc.

• Searching costs: Difficult to assess, brand names, etc.

• Temporary Supply-Demand Imbalance – including from network

effect and first mover situation.

• How would you check?

• Ability to charge a premium

• Repeat purchases


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2. Production Cost Advantages

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• Lower cost per unit – regardless of volume.

• If a company has manufacturing / production advantages, it has a

cost structure that other companies cannot duplicate. A company with a

cost advantage will be more profitable than all of its rivals.

• Increasingly about IP / tech costs. Innovative business models can

change these (e.g., online retail removes real estate costs).

• Main sources of production / manufacturing advantages:

• IP or proprietary technology

• Labor costs

• Lower cost of inputs from suppliers

• Special resources

• Location or transportation cost advantage


• Per unit cost at different volumeswww.jeffreytowson.com

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3. Economy of Scale & Scope Advantages

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• Lower cost per unit at higher volume, relative to competitors.

• Economies of scale provide a company with a lower long-run average cost

curve because of high fixed costs and greater production volumes than all

other vendors.

• Not the same as being big. Is about being big (in volume and/or spending)

relative to others in a circumscribed market. Usually a niche. Almost all

local. Few are national. Very few are global.

• Usually cheaper in:

• Manufacturing

• R&D

• Marketing

• Logistics / distribution


• Fixed cost spending as a % (including capex and M&A)www.jeffreytowson.com

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4. Government Advantages

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• Depending on the type of regulation, governments can effectively

limit entry into specific markets. This barrier can help to provide the

existing firms with a competitive advantage which would be

sustainable for as long as the regulation stays in place.

• Sources of governmental influences:

• Licenses (big competitive advantage)

• Regulation (antitrust, zoning, environment). Can be helpful.

• Patents. Usually a competitive advantage. Especially if

exclusive.

• Tariffs and quotas


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5. Efficiency of Scale

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• A situation with one dominant company in small, circumscribed market

with big initial capital costs. A history of attacking new entrants helps.

• Examples:

• The only powerplant in a small town.

• The only two hospitals in town.

• Not really a competitive advantage. It’s just not worth it to enter, as there

not enough market to support additional companies.


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6. MSPs and Network Economics

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• Lots of important things happening here – including demand side

economies of scale.

• One-sided network effects:

• Each new user increases the value of the product to other users.

• Communications networks: Telephones, fax machines, etc.

• Most social networks: Skype, WeChat, Facebook, etc.

• Standardization / collaboration situations: PDFs, Slack, etc.

• Two-sided MSPs and network effects:

• Each new user increases value to the supplier network. Each new

supplier creates value for the user network.

• Can be transaction marketplace like Ebay and TaoBao.

• Can be payment system like American Express.

• Can be innovation platform like the App Store.

• Discussed later under digital.


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Competitive Advantages (1 of 2)

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1. Revenue Advantages – captive customers / control over pricing / repeat purchases

• Share of consumer mind and buying habits

• Switching costs

• Searching costs

• Temporary supply-demand imbalance

2. Production Cost Advantages – proprietary production capability / manufacturing cost advantages


• Labor costs

• Lower cost of inputs

• Special resource

• Location or transportation costs

3. Economy of Scale Cost Advantages – lower average costs at higher volumes

• Manufacturing

• R&D

• Marketing

• Distribution / logistics

• Real estate?


• License

• Regulation (antitrust, zoning, environment)

• Patents



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Competitive Advantages (2 of 2)

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5. Efficiency of Scale – One dominant company in small market – with high initial capital costs

and history of attacking new entrants.

• Not a strict CA. But strong disincentive to new entrants.

6. MSPs and Network Economics Advantages

• One-sided network effects – Facebook, Wechat, telephone

• Two-sided MSPs and network effects – UnionPay, American Express, Apple App Store

• Combos – Tencent multiplayer gaming is one sided and two sided.

• Usually not (but not always) a competitive advantage:

• Most brands. You can buy a brand with cash. It’s an asset.

• Being smarter. This can be copied.

• Most expertise. Can be copied over time.

• Lower cost of capital – nope.

• Lower cost of labor – nope. Transitory.

• Most government regulations and tariffs


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Example: Coca-Cola

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• Founded in 1886. Now operating in +200 countries.

• Coca-Cola, Diet Coke, Dasani Water, Sprite, Poweraid

• 500 brands

• $32B in operating revenue and $8.7B in operating income

(2018)

• 70% of sales outside of USA

• Operations:

• Coca Cola America

• Coca Cola International

• Coca Cola Bottling


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• Coke’s Market Share (of cola)

• USA: 40% (approx.)

• China: +50% (AC Nielsen)

• India: +60%

• Latin America

• Global

• ROE (1998-2002): average 37%

• ROC (1998-2002): average 33.6%


Example: Coca-Cola (continued)

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Example: Coca-Cola’s Competitive Advantage1. Revenue Advantages – captive customers / control over pricing / repeat purchases

• Share of consumer mind and buying habits

• Switching costs

• Searching costs

• Temporary supply-demand imbalance

2. Production Cost Advantages – proprietary production capability / manufacturing cost

advantages


• Labor costs

• Lower cost of inputs

• Special resource

• Location or transportation costs

3. Economy of Scale Cost Advantages – lower average costs at higher volumes

• Manufacturing

• R&D

• Marketing

• Distribution / logistics


• License


• Patents


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Which Are Sustainable?


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Which Require Effective Management?


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Ques 2a: Checklists for Competitive

Advantage


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35

1. Does company (or asset / product / service) have a competitive advantage (a

long-term forces view)?• What is it?

• Wide or narrow moat?

• Is it getting stronger or weaker? Moats have a lifecycle.

1a. Has a high ROIC – WACC?

• Sustained high profitability as measured by return on invested capital (ROIC)

• Sustained high market value / book value (replacement value)

• Significant, and sustained, differences between the profitability (ROIC) relative to

other market participants.

• Note: You can have high profits with no CA. Needs to be relative to capital.

1b. Stable market share? - Entry/Share Stability

• High share stability over time (low change in average share among participants)

• Few new entrants/failed entry

• Local, long-term firm dominance. How long?

• Is the market strictly circumscribed? Niche? Better for maintaining CA. Think local

(Greenwald).

• If in an uncertain period, market share will still be there. But ROIC and earnings

can be low or negative.www.jeffreytowson.com

Five CA Questions (1 of 5)

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36

2. How does CA compare to existing competitors with or without CA? To giants?

To dwarfs? How long will it last?

• Think about the key competitive relationships (giants to giants, giants to dwarves, both to

new entrants).

• How long it lasts? 0-1 years, 0-10 years, 10-20 years?

• Key to sustainability is usually competitive advantage + sharply proscribed market.

Dominate a niche (customer type, geographic, functional)

• Compare the existing competitive advantage with the existing resources / assets.

• Verizon – a Buffett company with a big competitive advantage based on the

economies of scale of their national network (huge capex expenses every year (fixed

costs) and a big expensive tangible asset). This is about a tangible asset that is hard

to replicate and expensive to maintain and upgrade every year.

• Visa – a Buffett company with a big competitive advantage based on two-sided

network economics in their global payment network. No real tangible assets or fixed

costs (some marketing). They have a big intangible asset (customers, merchant

network) that is very hard to replicate.


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37

3. What is the cost and / or difficulty for a Dwarf or a well-funded, well-run new entrant to replicate

this or overcome the CA? Think about the tangible and intangible assets that create the

competitive advantage (the resources view)?

• A CA shows up as high revenue or low cost relative to capital. But is the result of resources / assets or

intangibles / capabilities. These things can often be bought so someone can jump the barrier. The key is

how must does it cost (tons of capital?) or how difficult (a new railroad approved?).

• Replace them on shelves? Convince loyal customers? Build pipeline? Launch a big furniture

store? Develop a drug?

• Think about entry costs and special entry difficulties versus ongoing costs:

• Keeping an existing customer cost (A) << Grabbing a new un-attached customer cost (B) << (C)

Taking a customer from a competitor (C).


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38

4. Cheetah Qestion: What is the company superspecialized in?

Relative to a specific market / situation and against a specific competitor. Think

Cheetah plus the ecosystem it is in.

• Cheetah is specialized for 17 seconds of speed. BUT...this only works when after the

gazelle that others cannot catch. Need to be super-specialized against a specific

situation? Think what do you give up to do this?

• Be extreme at one thing. You usually have to give up lots of things to superspecialize

(cheetah is all about acceleration). Costco is extreme low cost retailer.

• More powerful is when it is a combination of 2-3 different and intertwined activities. That

is very difficult to replicate.

• Nascar has stadiums and Nascar media / race teams

• Sirius Radio has unique content but also tons of devices in cars. Very different skills

to create content and coordinate with car dealerships.


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39

5. Mgmt Behavior Question: Is there unhealthy competitive fighting between

companies with CA?

• Is this like Coke vs. Pepsi in the 1980’s?

• Very common in China.


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When confused:

•Identify the key activities (content,

mktg,distribution) and ask "what doing

that others cannot?". That is the barrier.

•“Could a well-funded and well-managed

company enter this business? What

would it cost? Cost vs. difficulty to jump

the barrier?


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1. Revenue Advantages - Checklist

41

• For Share of Consumer Mind / Customer Buying Habits:

• This is often about brand power and intangible assets. It shows up as repeat business or

willingness to pay more. Frequency of purchase usually matters.

• Example: Coca-Cola, Starbucks

• Aging consumer population is often the problem.

• For High Switching Costs:

• Switching means cost, hassle and/or time. Switching can also be perceived as risk.

Customer will ignore lower price and better product if big switching costs.

• Best is a low cost item with high perceived risk. Such as airbag pellet in car. Not worth

switching.

• For High Searching Costs:

• This is similar to switching costs. You tend to stay with what you know if it’s complicated for

evaluating quality. The devil you know.

• Example: doctor, lawyer, accountant, management consultants.

• Another example is limited shelf-space in stores. Leading companies are amplified as 1

of 5 available in Walmart or 7-11. This is especially powerful for Heinz as stores only carry

1-2 ketchup. Try to find another ketchup or beer to buy.


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2. Production Advantages

42

• If a company has manufacturing or production advantages, it has a

cost structure that other companies cannot duplicate. A company with a

cost advantage will be cheaper or more profitable than its rivals at any

volume

• Four main types of competitive advantages on production side:

• Proprietary technology (often new technology)

• Example: Software, trading

• Process advantage and learning curve – that is hard to replicate

• Example: BYD

• Lower cost of inputs – such as bargaining power with suppliers

• Example: Managed care / United Healthcare

• Special resources

• Example: Saudi Aramco

• Location and transportation costs

• Example: granite mine in town, Carlsberg


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2. Production Advantages - Checklist

43

• For Proprietary Technology:

• Technology can be for lots of activities (call center, etc.) but we are looking

at production costs.

• Example: manufacturing technology, drilling tech, software

• New or disruptive technology shows up as a cost advantage. Like Netflix

DVDs against blockbuster. Allows a new entrant. But it can usually be

copied fast. So new entrant needs to get big and build a real competitive

advantage asap.

• For Process Advantage and Learning Curve:

• This is rare. Hard to have process that can’t be replicated.

• Learning curve / cumulative experience can be a real cost advantage.

Unlike economies of scale which is in a set period of time, this is about time

it takes to capture low costs..

• Example: BYD, McKinsey?


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2. Production Advantages – Checklist (cont)

44

• For Lower Cost of Inputs – and Bargaining Power with Suppliers:

• Low cost labor, low cost energy, low cost capital and other factors tend to

be fleeting cost advantages. Almost never more than just efficient.

• However, bargaining power with suppliers is important and durable.

• Example: Health insurers (vs. doctors)

• Ques #5: What discount are you getting relative to competitors? What % of

costs is this?

• Ques #6: Are suppliers consolidating?

• For Special Resources:

• You have access to Lithium, oil, or other. Planet has limited resources so

geological resources can matter. Can be other things.

• Ques #7: Do you have unique or lower cost resources? What % of costs is

this?

• For Low Location and Transportation Costs:

• Transportation is important cost. For products with low value / weight ratio.

• Example: beer, furniture, granite mine, railway versus trucks

• Ques #8: Do percent of costs are transportation for you versus competitor?


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3. Economies of Scale Advantages

45

• Lower cost than competitors when at higher volumes. So can undercut on price or

keep price the same and make larger profits.

• Do you have lower per unit costs than your competitors at higher volumes?

• Economies of scale provide a company with a lower average cost curve because of

high fixed costs and greater production volumes than others.

• The company’s advantage translates into a lower per unit cost for a certain

volume - that other vendors cannot duplicate. For economies of scale to be in

effect they must result in lower per unit manufacturing costs as volume

increases. But this effect reverses when volume hits certain point.

• Look at fixed costs in Sales/Marketing, R&D, manufacturing, distribution and

other. Is about being big in a local market, relative to others. Need to bash small

competitors. For Sales / Marketing, R&D and local promotion, you spend them

into the ground. For manufacturing and distribution, you cut your prices cause

they cannot match your cost per unit at higher volumes.

• Need sharply prescribed market (local, local). Need to keep others small.

Almost all local. Few are national. Need market of certain size to get economies

of scale - but if too big cannot get.

• Usually also need customer captivity. otherwise new entrants chip away at your

size advantage over time. (greenwald)www.jeffreytowson.com

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46

• Depending on the type of regulation, governments can explicitly or

effectively limit entry into specific markets. This barrier can help to provide

the existing firms with a competitive advantage which would be sustainable

for as long as the regulations stays in place.

• Sources of governmental advantage:

• Licenses and regulations

• Patents

• Presence of strategic SOEs

• Government impacts that are not competitive advantages but can influence

competition:



• Subsidies and taxes

• Contracting and purchase preferences

• Government-related assets and capabilities


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I Put Companies In Four Buckets

47

• Great (i.e., Protected and Value Increasing)• Has a competitive advantage. More predictable future (and valuation).

Won’t decrease in economic value per share over time.

• Also, increase in economic value per share over time. Often a cash

producer.

• Good (i.e., Protected and Value Protecting)• Has a competitive advantage. More predictable future (and valuation).

Won’t decrease in economic value per share over time. Often capital

intensive.

• Bad (i.e., Unprotected. Can be predictable or unpredictable.)• No competitive advantage. More unpredictable future.

• Lots of companies here that seem fine. Just operationally intensive. Often

can be growing and showing profits.

• Too Hard• Can’t figure it out.

• Or too complicated.www.jeffreytowson.com

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Is the Company “Great, Good, Bad or Too Hard”?

48

Good

(preserving)

or Great

(creating)

Too HardBad

(unprotected)

1 2 3 4 5 6

Company Filters are Industry Specific


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t0

MP

IV0IVLT

Great Companies Grow Over Time in Economic

Value Per Share. Often Cash Producers.


Good co.

(protected and

wealth-preserving)

• Rule #1 is Never

Lose Money

Great co.

(protected and

wealth-creating)

• Time is Our Ally

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t0 tLTt-LT tNT

50

Good (i.e,. Protected) Companies Don’t

Decrease in Economic Value Per Share.

Predictable on the Downside.


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”The difference between a good

business and a bad business is that

good businesses throw up one easy

decision after another. The bad

businesses throw up painful decisions

time after time.”

– Charlie Munger, Vice Chairman,

Berkshire Hathaway

Page 51


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52

1 2 3 4 5 6


Good

(preserving)

or Great

(creating)

Too HardBad (unprotected)

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Bruce Greenwald on Competitive Advantage

53

Makes you cheaper than competitors

• Proprietary technology – it makes you cheaper

• Lower cost of capital – nope

• Lower cost of labor – nope. Transitory

• Smarter – nope

• Learning curve – probably. Makes you cheaper

• Special resources – Yes. Makes you cheaper

Makes your demand higher than competitors – therefore can

raise prices or lower overhead as % of sales

• Customer habit – yes. Like Starbucks

• High search costs – yes. Hard to find another you’re

comfortable with. Surgeons, management consultants,

complex services.

• High switching costs – yes. Like banks and computer systems

• Brand – nope. Can buy it.


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Bruce Greenwald on CA (continued)

54

Sustainable Competitive Advantages

• New customers

• New technologies

• Economies of scale

• Others can’t match your costs (you beat them on fixed costs).

Determined by footprint of fixed costs

• Can’t match benefits of using systems

• But this only works if you have barriers to entry. You need to keep

your competitors small

Examples:

• Oxford has local economies of scale over national plans

• Dr. Pepper has local economies of scale in south over coke

• Local franchises are very defensible

• Can also do local economies of scale that are non-geographic

• Intel did CPUs

• MSFT did operating systemswww.jeffreytowson.com

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Bruce Greenwald on CA (continued)

55

Who Knows What?

Banks, HMOs, etc. know a lot

Financial services – they have the best customers

Government regulation

Both Coke and Pepsi have CA but don’t want to compete

THIS IS ALMOST ALWAYS ABOUT LOCAL CONCENTRATION

• Dominant market share relative to competitors

• Allows you to drop costs


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56



Company GGTB?


• Case: SABMiller


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“Rule No 1: Never lose money.

Rule No. 2: Never forget rule No. 1.”

- Warren Buffett

(i.e., think the red line first)

Page 57


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Contact Info:

Jeffrey Towson

www.jefftowson.com

http://www.jefftowson.com/

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Nine Investment Questions

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