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  • Writer's pictureRyan

Qualitative Factors

I’ve updated this post from earlier this year with recent learnings.


Risk is the probability of permanent loss so limiting it as much as possible is incredibly important. Below are 12 risk filters that I run companies through to increase our odds. Most of these are subjective/qualitative and they can change over time as we uncover more information or new information becomes available.


1. Founder or amazing management


At the end of the day, businesses are just groups of people providing value in exchange for dollars. So the people are crucially important, especially earlier in the lifecycle of a business if the moat isn’t impenetrable yet. Buffett is famous for saying that a terrible business will always win against a great manager and that’s true. But pair an amazing management team with a great business, and watch out!


2a. Deep Moat/Hard to Replicate


A company with a flimsy moat will likely get upended at some point, especially if it has a large market opportunity and strong margins. Money-making businesses attract competition and if there is no moat to protect those dollars, they will be competed away. It’s capitalism at its finest. There are various forms of moats like high switching costs, scale economies, process power, network effects, branding, counter positioning, and I believe, at times, culture can be a moat. The fact that you can identify one of these as a potential moat is a good start but it’s more important to understand the depth of the moat. Tesla’s advantage in autonomous miles driven is likely a much deeper moat than Zoom’s brand. The determining factor is replicability. A good question to ask is: if an incredibly well-funded, focused competitor came in, could they replicate the core value prop of this company? 


2b. Pricing Power/Consumer Surplus


When thinking about moats, pricing power is often mentioned. It’s a very interesting concept because I think there are two sides to it – demand side and customer acquisition pricing power. Demand side is what you probably think of immediately – an Hermes Birkin bag can go for $10,000 whereas a Michael Kors handbag may go for $100. Hermes has pricing power. If the Birkin bag price was doubled, people would likely pay the price. The roots of demand-side pricing power are usually brand or stickiness. Buying an Hermes bag is a huge signal that you’re super rich and people should be impressed by you. Therefore, people are willing to pay a high price for that. In fact, a lower price would actually be less attractive because, in Clayton Christensen language, the job to be done by a Birkin bag is to show-off. Sure, the quality is extremely high but not multiples higher than something like a Coach bag. So a higher price actually serves the main purpose. Another consistent source of demand-side pricing power is switching costs. If SAP wants to raise prices by 20%, customers will pay it. It’s simply too painful to switch ERP providers. One more, less reliable, source is simply a better product. That gets people in the door, but it’s not necessarily a sustainable source of pricing power. There will also be competition gunning for your customers. However, if you turn your better product into quite a bit of scale, you can lower comparative production costs. Ultimately, all great businesses started out by offering something better than the existing alternatives. But that doesn’t constitute a moat. That’s just the castle. But the protection of the castle is what we are talking about.


This leads us to the other side of pricing power – customer acquisition. This means that a business can raise its customer acquisition cost and still be quite a bit lower than competitors. The main source of this is counter-positioning. A good example here is Nubank in Brazil. Brazilian banks make most of their money fees and high-income customers that prefer physical bank branches. Nubank decided to take away all fees and bank branches. Therefore, the customer acquisition costs are extremely different, by an order of magnitude. But the incumbent banks don’t want to give up their main revenue sources. So Nubank can raise its customer acquisition cost to reach higher-income consumers over time and still outcompete.


Maybe this is just another source of replicability rather than pricing power, but regardless of the framing, it’s helpful to think through different ways of business advantages. At the end of the day, I think pricing power and replicability just expound upon each other in different ways. A company like Costco doesn’t necessarily have demand-side pricing power because its entire value proposition rests on having the lowest prices. But that’s also why they don’t have to invest in marketing. In fact, that’s almost, by definition, the perfect signal that you’ve found a company with customer acquisition pricing power. Think about Tesla, Amazon, Nubank, or Costco. All of these companies spend very little on marketing because they have great products with strong word-of-mouth viral marketing. But they have turned this advantage into hard-to-replicate advantages. So maybe the answer is that moats fall into two dimensions that are self-reinforcing – very hard to replicate and a very strong customer value proposition. 


For example, the brand of Hermes couldn’t really be replicated with a $1 billion. The fact that it has been around so long gives it a mystique that would be hard to copy if you just threw around a bunch of money. And the value prop is the brand and the inherent signaling that’s associated. Further, Costco’s low price proposition is a no-brainer for customers and it has built sufficient scale that is very hard to replicate.


But there are instances where a company has a strong value proposition but it’s replicable. I think a lot of software companies might fall into this bucket. Our failed investment in SentinelOne is a perfect example. On the other hand, some companies are hard to replicate but may not have a lot of pricing power. Carvana could fall into this category. If they price cars too highly, someone will just go to CarMax. The value prop is strong but the nature of the transaction is such that there isn’t a ton of price inelasticity.

 

3. Mission Critical


I didn’t lump this business characteristic under “moat” because I think it’s slightly different. It’s similar to switching costs but varies in the sense that it touches more on the nature of the customer transaction. The above Carvana example is great because if you mash pricing power and consumer value surplus together, Caravana would probably fail the first test but pass the second test with flying colors. However, I would not say it’s mission critical. People don’t need to buy a car when the economy begins to turn. People also don’t need a Birkin bag. So a company can be incredibly hard to replicate and have extreme pricing power but the product may not be mission critical. This risk factor relates more to how the business will react in an economic downturn. Even mission critical products will get hit but likely not quite as hard as companies that are dependent on good times.


4. Moat Trajectory


A company may not have a super strong current moat, but maybe they are getting stronger and stronger. This is where the moat trajectory comes into play. Are there signs that costs are coming down with scale? Are there hints of lower customer acquisition costs as the brand grows? Are retention rates actually improving as customers adopt more products, increasing switching costs and potentially, network effects? This is also very important for more mature companies. The direction of the moat is key. I think we’ve seen this with Facebook/Meta over the past 5-ish years. The big blue app has been dwindling for a while and TikTok has taken quite a bit of share. The fact that a competitor could storm the scene in 5 years made investors a little more wary of the terminal assumptions implied in Facebook’s previous multiple. Maybe investors overshot to the downside, time will tell, but this drives home the importance of moat trajectory. 


I think revenue growth is a good test here. If revenue is growing at a good clip, it’s likely that customers still think the product is solid and so is the value prop. If revenue is decelerating like crazy, it may be a sign that the relevance of the business is going the wrong direction.

 

5. Large and growing addressable market


High returns on capital coupled with a big reinvestment runway and a deep moat is the key to compounding. There are certainly riches in niches but if the company saturates its market, it can’t really grow. The best companies even constantly expand their market size as they venture into other areas. Amazon is the best example of this as it started as a book reseller but from early on, Bezos knew they would expand into other categories. And then, of course, AWS was completely unexpected. However, a large market alone is not a good enough reason to make an investment. The classic “if we only get 0.1% of the market, we’ll be a great company” pitch isn’t really convincing in my opinion. Big markets also mean more competition. So there are upsides and downsides. However, a big market with tailwinds offsets some of the effects of competition. That’s why this criterion (fancy word, huh?) is a large and growing market. 

 

6. Recurring revenue


Companies with recurring revenue have multiple advantages. For one, they can predict demand easier. This enables them to hire efficiently rather than overhire when demand peaks while also investing wisely for growth. Two, customer acquisition costs are typically much lower in these businesses. Retaining a customer is so much cheaper than getting a new one and that plays right into companies with recurring revenue. Now, this doesn’t have to mean a software/subscription business. I would say that Starbucks has a certain degree of recurring revenue and maybe even Chipotle. Or a company like Pool Corp distributes chemicals and pool equipment to maintain pools, of which 80% is recurring. And the same goes for Bill.com. 80% of its transactions are recurring as businesses pay bills to their regular suppliers. 

 


7. Leader/limited competition


This is similar to the moat but a little different. A company like Datadog can still have quite a bit of competition but it’s the leader in the space which attracts some of the best employees and lowers its cost of capital. In short, there are benefits to being the leader. Moreover, we love it when a company is in a growing space but has limited competition. A company like Airbnb might fit this description. Sure, VRBO exists but Airbnb is the behemoth that leads to more unique homes which leads to greater demand. Ideally, the company is a leader by default because it has very few competitors but more often, there are always competitors. I see this dynamic more in medical devices where a company is the sole provider of a particular type of device through FDA approval. Shockwave Medical is a good example of that. 




8. Net cash position and free cash flow positive


 

These next two are pretty straightforward. First, I like to see a positive net cash position. I’m fine if the company wants to use debt if its stock isn’t richly valued but I feel better if there is more cash than debt on the balance sheet. I’m not really looking for management to optimize the balance sheet. That’s for companies with a super deep moat and few reinvestment opportunities. Ample cash is like slack in a system. Sometimes it’s healthy because it provides a cushion when unexpected things happen. For example, I’d much rather a company hold a bunch of extra cash on the balance sheet and then buy a big slug of stock in a huge sell-off rather than just offset dilution. Likewise, it’s awfully hard to go out of business if you’re making cash and you don’t have any debt. In fact, it’s really hard to do! If we can chop off the left tail just like that, I’m all for it. 


9. Diversified customer base and supply chain


Some companies, especially smaller companies, have very concentrated customer bases. For example, there is a small skin cancer company where 75% of revenue comes from one customer. Upstart also had this dynamic but more on the supply side where Cross River Bank made up more than 50% of the company’s funded loans and Credit Karma accounted for more than 30% of leads. It’s not the end of the world to have a big customer but it increases the risk. What if the customer leaves? Then that’s a huge short-term risk. The stock could be down 50-70% in one day. Some companies have a few big customers but they are very ingrained in their business. Something like Taiwan Semi might be a decent example because Apple makes up a decent chunk of revenue but it’s a little far-fetched that Apple would insource the manufacturing or use anyone else. So there is a bit of nuance here but watching out for concentration on both the customer and supplier side is very important. 

 



10. Acquisition status



Companies that make too many acquisitions are risky, in my opinion. Now, that isn’t necessarily the case always. Constellation Software or roll-up players like Transdigm have been some of the best-performing compounders of the last few decades. I do think there is a difference between a company that does big acquisitions and one that is specifically created with the purpose of doing so. I think the differentiator is decentralization. It’s awfully hard to do a bunch of acquisitions and stay centralized. Salesforce might be a solid example of doing it well but there are many more companies that have fallen by the wayside because of empire-building (too many big acquisitions). If a company has done a lot of acquisitions, it makes me more nervous. Lightspeed, Teladoc, or ZoomInfo would be examples of that and it’s something I think about with Bill.com. It’s not a hard and fast rule, but it should be accounted for in our risk score. 

 



11. Would I be proud to be a shareholder?


I love this question because it gets at the heart of something very important – negative externalities. That’s just a fancy way of saying that something isn’t win-win. A company like Altria has plenty of negative externalities as smoking kills people. Plain and simple. Therefore, they face multiple headwinds. Now, of course, Altria has been a great performer because it is highly addictive and they can just raise prices and buy back stock. However, I do think there are tailwinds to doing the right thing. Upstart was an example where I was sort of on the fence. I couldn’t really say that I was proud to be a shareholder. Now, this is a very subjective question and some people invest using the inverse of this question. Companies like Warrior Met Coal, Exxon, and Altria are really cheap because people don’t want to own them and there is likely embedded alpha in those “unownable” companies. That’s fine but with a long-term perspective, it feels like we’re chopping off the right tail for things to go really right. Sure, these types of companies can continue to outperform, but we’re trying to zone in on risk and I think it certainly adds risk. 


12. Can I explain all three financial statements in depth?


I really like this question because it’s actually quite difficult to understand all the dynamics of a business, through the financial statements. One of the most useful things I do in my research process is go through each of the financial statements and ask questions on things I don’t quite understand and then I try to find the answers.


For example, maybe accounts receivables are growing faster than revenue, why is that? Is a large customer delaying payments? Are customers pushing out payment terms? But then these questions lead to other questions about the nature of the business. If customers can push payment terms, is the product not mission critical enough? Or are customers weak and therefore, put the business in a more susceptible position? Or what’s the level of customer concentration and is that normal for this industry? So you can just keep going down the rabbit hole. 


Or another hypothetical – if G&A is larger than R&D, why is that? What does it say about the innovation of the company? Is that because of an excessive CEO-incentive grant?


Or why are gross margins deteriorating? Is it because of rising input costs or lowered prices because of competition?


I could go on and on. The financial statements tell a story. It’s our job as investors to understand that story and see if the narrative around that story is too bullish or too bearish.



 

Conclusion

 

I have a big spreadsheet where I rank all of the companies along these criteria. For example, if the company is free cash flow positive, the company will get a “Yes” and on and on. Then, I count all the “No’s”. The companies with the lowest number of “No’s” has the lowest “risk” score. Once again, it’s pretty subjective but I’ve found these filters to be very helpful. 


Some of the very top performers on the checklist right now are Axon, Amazon, Microsoft, and MercadoLibre. Not a bad group!

 

All the best,

Ryan

 


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