How To Find Compounding Machines - A Full Guide

everyone should be investing in compounding machines companies that continue to compound their intrinsic value year after year after year what I've tried to do with my investing strategy is accumulate an entire portfolio of these type of companies these companies aren't just Financial companies they're not just tech companies there's some specific hidden attributes that make these companies stand out from the rest Microsoft and Apple are other examples of companies that have compounded for a long period of time it seems like every year for the past decade they hit all new highs in fact microsof soft stock just today hit an all-time high some compounding machines are much smaller Texas Roadhouse for example is so small that it's not even in the S&P 500 yet this company has compounded far more than most companies in the market Chipotle is another example of this type of company the type of company that grows and grows and grows and the price goes up more and more every single year investors become perplexed of what is causing this company to go up so fast there's something about Costco that causes this company to grow and grow and grow every single year for decades like a juggernaut it has so much momentum it can't be stopped all of these companies have something in common they're what I call compounding machines which is a title given to a specific type of company the highest quality companies in the world and like I've said my goal has been to accumulate this type of company in a single portfolio and to do it as best as possible I spent the past week creating an entire presentation based around my investing philosophy this presentation breaks down compounding machines examples of them how to find them and how to hold them well it breaks down intrinsic value buy and sell criteria as well as investor temperament my goal is to create a quality and concise presentation about my investing philosophy and in this episode we're going to be going over all of it I'll be walking through this presentation in full step by step so we have a lot to get to in this episode let's go ahead and jump in I've been investing for a number of years and over that time period I've been able to study a lot of great investors and learn from some of the best we have information that's publicly available able on every Super investor these are investors that control hundreds of millions of dollars in some cases they run hedge funds or they run their own businesses either way they're investing their money and we get to see the performance of them over time now out of these super investors which many of them are great there's an elite few that outperform the market consistently over a long period of time investors like Warren Buffett Charlie Munger Terry Smith Dev kantaria Chuck arrey these investors aren't just good but they're incredibly good and they have a long history of outperforming the market on a consistent basis and what I've done is deconstructed the way that they invest and I've tried to improve and elevate my investing philosophy to be more like theirs so I've learned from these investors improved my investing strategy and the results have shown on my patreon every month I release a monthly update on my portfolio it has a summary of my strategy my total allocation and comments on the portfolio month- by mon in this I also have my portfolio performance where I put my portfolio's time weighted returns against the benchmark Mar the S&P 500 2022 was a bad year the stock market went down 18.14% my portfolio went down 16.22% so it's not immune to a selloff it still sold off just like the market but it did so a little bit less then in 2023 my portfolio's return was 32% to the S&P 500's 26% so it not only held up well on a down year but it also did well on an upe now again I don't credit this performance to myself The Playbook has already been written before us written by investors like Warren Buffett and Charlie Munger they've shown the way to invest but the real difficulty in investing like them is accurately implementing their strategy a lot of investors say they invest like Warren Buffett or Charlie Munger and they do the exact opposite they invest nowhere close to them so my goal with this portfolio is to invest as close to the best as possible to have exceedingly high standards for the portfolio for the performance for every trade I do and my temperament and decisions and this presentation I made is supposed to be somewhat of a starter guide into the investing philosophy so let's go ahead and jump into it on page one now this first initial slide works as an introduction to my investing philosophy we have an overview here to Simply put this I believe that outperformance is most likely to be achieved by buying holding and maintaining a portfolio of compounding machines with a disciplined and long-term approach never speculating gambling or investing out of fair fomo or hype that is easier said than done a lot of people say I'm going to be like Buffett I'm going to invest in all these great companies these compounding machines that just grow and grow and grow I'm not going to speculate and Gamble and then a month later they're looking at the latest fintech speculation craze they're looking at the latest EV Trend they're going into companies that have no proven business model so these type of rules of never speculating gambling or investing out of feir are easier said than done never investing out of fomo the fair of missing out is incredibly difficult to do lots of investors meet these Temptations and they can't can't resist they dive into fomo buys they dive into gambling we've seen the amount of hype that happens on YouTube so part of this investing philosophy what's core to it is maintaining this discipline I Define the three different categories that I think are the biggest categories in investing out performance three main focuses are finding exceedingly high quality companies in stock selection maintaining the right temperament and exercising prudent portfolio management so there's three basic categories to investing in stock selection this is simply finding good companies to invest in which is much easier said than done a lot of people like to believe that their portfolios are full of good companies when I look at their portfolios I don't agree I think they hold a lot of average and subpar companies when I look at stock selection I want monopolies now not legal monopolies but I want companies that have high barriers to entry I want companies with pricing power operating leverage organic growth Capital light smart capital alloc if you find a company that has these six attributes that's an exceedingly high quality company once we have stock selection down we can move on to temperament even if you select great companies if you do not have the right temperament for investing you are going to have subpar performance temperament means having discipline being unemotional being patient being long-term focused these are the four core categories of temperament every investor needs to have this temperament then finally it's not only important to find good companies but knowing when to buy them knowing when to sell them knowing how to manage their allocation and waiting is also very important so I have another section here titled portfolio management smart position sizing specific buy criteria specific sell criteria and intrinsic value estimates we don't want to be investors that just randomly buy companies or randomly sell them we want to have some reasoning and structure and thought behind our sell and buy decisions we also want to have good metrics to gauge the the intrinsic value of companies and if the intrinsic value is increasing or decreasing so these three categories overall I believe Encompass everything it takes to be a great investor and to have really good performance but I think it's important to Define terms and get into more detail of how this strategy works one of the terms we're looking at here is compounding machines now compounding machines like any other word is just a phrase and it may have different meanings to other people so I put down my definition of what this phrase means the specific attributes that accomp must have to be a true compounding machine I have attractive attributes and unattractive attributes the companies that have the attributes on the right are not compounding machines the companies that have the attributes on the left are compounding machines so let's go through these one by one the first attractive attribute we're looking for with every company is Monopoly and this is such an incredibly important attribute that I put at the very top of the attributes just to emphasize how important it is now when you look at the word monopoly it has some negativity connected to it but I'm not talking about illegal monopolies I'm talking about companies that already have a large market share in a very concentrated industry I want to look for companies that are already the leaders in their market share they're at the very top of the food chain think of companies like Google that have 92% market share of search think of companies like Visa Mastercard that have huge market share in this doop of digital payments think of companies like in that already have over 80% market share and taxes and small business accounting it's not by random chance that most of the companies in my portfolio have these deeply dominant and entrenched positions in these concentrated Industries this was intentional this was one of the first things I looked for when buying these companies these companies have entrenched distribution brand names install bases and subscriber bases Netflix for example just reached 260 million subscribers they're at such a massive scale and they have massive reoccurring Revenue Adobe earns over 80% of their income through reoccurring subscription they're install based and relationships with colleges and campuses and the workforce is deeply entrenched in multiple countries now when we find companies that already have this large market share that are already deeply entrenched with their brand name install base subscriber base their distribution we also want companies that have very high barriers to entry the more difficult it is to compete with them the better the second attribute that I believe is the most important for compounding machines is pricing power a demonstrated history of raising prices above the rate of inflation this can be difficult to find because a lot of companies don't like to say that they're raising prices incredibly fast on their customers that's not a popular thing to say so you have to do a little bit of a little bit of research simply look at their core products look at the pricing of their core products over time and compare that against the rate of inflation these companies will have histories of raising prices far above the rate of inflation whether you look at Mastercard or VISA whether you look at S&P Global or Moody's whether you look at Adobe or Netflix all of these companies have rais the prices far above the rate of inflation and they've done that while seeing little push back from their customers now if a company raises prices but they lose a lot of customers and competition eats away at their market share that is not pricing power pricing power is strictly the ability to raise prices above the rate of inflation without losing customers to competition now the type of companies that have a lot of pricing power are ones that have few competitors the fewer the competitors the easier it is to raise prices this is why companies like Visa Mastercard can raise prices every single year if there was a th different credit card issuers then it would be much more difficult for them to raise prices so few competitors leads to more pricing power also if they have a lot of upside in the value of their product or service if people like their product so much that they're willing to pay a lot more for it that gives them flexibility to raise prices in the future so after finding companies that are deeply entrenched that have high barriers to entry we want to find companies that have pricing power year after year after year now the next attribute we're looking for after pricing power is operating leverage in the business model operating Leverage is a financial term to some people this may seem complicated it's actually an incredibly simple concept to understand it simply means that the company has fixed costs that stay fixed over time and then variable Revenue as the revenue goes up their margins get higher and higher and higher we can look at a few examples let's take a look at MasterCard MasterCard is a great example of a company that has a lot of fixed costs to run the initial business and then a lot of variable and growing Revenue creating operating leverage in the business and we can view this by looking at the profit margins over time look at 1998 the profit margins were 2% overall it was very low and very volatile while they were scaling up but then they reached scale in 2007 the operating leverage kicks in the profit margins jump up to 27% then what do we see over time with the mechanics of this business the costs are more fixed than the revenue the revenue is outgrowing the cost which makes the profit margins go up over time from 36% to 45% if I draw a line through this it looks like this growing profit margins over Decades of time this is a company where every incremental dollar they earn the profit margins get a little bit higher MasterCard is a clear-cut example of operating leverage another company that has operating Leverage is Netflix this is a company where have an enormous amount of fixed costs creating their content every year costs around 16 to 17 billion they have to pay for that every year that they want to create new content so they have this big fixed cost every year but their revenue is variable and their costs don't scale perfectly with their revenue we can look at their operating margin in 2016 it was 4% in 2023 it was 20.6% their profit margins as well go up over time we see this nice trend year after year after year of their profit margins increasing their operating margins increasing this happens the most when a company has operating leverage one of the nice things about operating Leverage is that analysts have the most difficult time getting this metric accurate meaning that if you find a company that has operating leverage odds are that the analysts have not accurately accounted for this company which typically means it's harder for them to accurately price these stocks and there's more potential upside now with operating leverage I also want companies that can scale for a long period of time operating leverage doesn't matter if the total addressable Market is very small so we're looking for companies that have a long Runway of a large total addressable Market to scale into this is very important I've given the example of MasterCard and Visa as companies that have operating leverage well MasterCard and Visa also have the benefits of having global scale everyone everywhere can benefit from digital payments if you're in India if you're in Europe if you're in East Asia if you're in Japan you could benefit from Visa Mastercard think about the global scale potential of Netflix this company offers entertainment who in the world doesn't like entertainment so Netflix's Runway of growth their total addressable Market is absurdly huge it's basically planet Earth a side from the highly regulated Parts like China and Russia now after operating leverage compounding machines have what's called organic growth organic growth is different than just simple growth because a lot of companies try to grow by buying other companies they're paying up for their growth you may notice in my portfolio that I don't have any pharmaceutical companies why do I not have any pharmaceutical companies well for one thing they grow inorganically they don't grow by building out new drugs and tools and services for their customers they grow by buying other smaller pharmaceutical companies they buy growth over and over again that's how the entire industry works is by acquisition the companies that I own grow primarily through increasing prices and gaining more customers in the case of Texas Roadhouse and chipotle they grow by increasing prices and opening up more locations to get more traffic most compounding machines are also Capital light we have a strong preference for companies that have a low amount of fixed costs they have low R&D and capex relative to their revenue the more Capital light they are the better and then finally one that I believe is underrated by a lot of investors is having smart Capital allocation but if you find a great company that is above the fold they will spend their excess cash on buyback they'll spend their excess cash on dividends they'll spend their excess cash on tuck-in Acquisitions tuck-in Acquisitions are buying small companies that only benefit their Core Business they don't do it for growth they do it to benefit their already enormous Core Business smart Capital allocation by the executive team can make or break a great company so off to the left there are these attractive attributes of compounding machines now we get into the unattractive attributes things that we actively want to avoid in our investments first of all companies that participate in Risky reinvestment they have high amounts of capex and research and development with unpredictable Returns on that capex and research and development this is the Pharma industry the Pharma industry puts a lot of money into the development of new drugs that is a very high-risk Venture those new drugs have to go through a series of clinical trials they have to go through testing it can take up to 20 years for those new drugs to be approved for use to the general public and then even after it's approved there's always room for lawsuit or getting recalled so the riskiness in the reinvestment is a big aspect that I want to avoid I want companies that when they put money into the reinvestment it's very predictable they know the return they're going to get before they make the reinvestment Costco knows almost exactly what to expect when making the reinvestment in opening up new warehouses they have 800 warehouses of data to measure it against it is predictable it is consistent it is not risky so how predictable the ROI is on their Investments are a big thing and in general I like companies that don't have to do a great deal of reinvestment to earn high returns now the other thing we're looking to avoid are moonshot bets or vanity projects with high chances of failure Capital allocation from the executives is a huge part of finding a compounding machine you entrust the executive team to use that money wisely and I avoid companies that have undisciplined use of cash flows it's an unattractive attribute if the company issues too much compensation to the employees and Executives we've all seen examples of this the ritzy tech companies where they pay their employees hundreds and hundreds of thousands of dollars in stock-based compensation and in their salary they have incredibly fancy extravagant work parties they have celebrities close by in the offices they will try to justify it as improving morale retaining employees doing the right thing for the talent of the company in reality it's undisciplined use of cash flows from an executive that prefers to spend the money on on what he or she wants to spend it on rather than what's best for the shareholder companies like S&P Global MasterCard Moody and in it have done so well in part because of their culture their continual discipline use of cash flows and their incentive structure the retainment their rewards and their culture on the other hand there's many companies ran by Executives like they're in a country club they want to spend the money on themselves they're unwilling to return the excess cash back to shareholders through BuyBacks or dividends when I rank order the quality of companies it's a big demerit when a company has undisciplined use of cash flows the other attribute we want to avoid is unpredictable cash flows economically sensitive cash flows companies that are financial institutions like JP Morgan or Bank of America are so big at this point that they're less sensitive but smaller Regional Banks small fintech companies pharmaceutical industry heavy Industrials and construction all of these are economically sensitive and have huge booms and busts we also want to avoid companies that have unpredictable cash flows because they're discretionary products or they sell large durable goods that the lifespan can be extended during difficult times and then finally what I like to avoid is dual class share structure I believe this is a risk to the management of the company if the owner has a different class of share that has more voting rights than they do ownership of the company they then have a disproportionately high voting right to their ownership which means that they're not as invested in the company as the rest of the shareholders but they have more voting rights than every one else this doesn't align the incentives of the executive with the rest of the shareholders they should both have proportionate ownership of the company and the owner in these cases where they have disproportionately high ownership are not beholden to the majority of shareholders they can do whatever they want which brings in additional risk so those are the unattractive attributes the things I want to avoid but overall this is the cheat sheet for a compounding machine this is what I truly believe defines the best companies in the world against the worst ones the qualities that we want to have against the qualities that we want to avoid now once we go through the overview of a compounding machine I also go through a few specific examples of some of the most important Financial metrics of a compounding machine for example the revenue the top line of the company is incredibly important we should look for companies that have strong Topline organic Revenue growth Costco is a compounding machine that's shown consistent Revenue growth primarily through price increases increases in new customers and opening new locations AT&T on the other hand which we can see the revenue right there is not a compounding machine its growth has been inconsistent and enlarge part due to Major Acquisitions outside of its core business so at first appearance underneath this Revenue line it may look like AT&T is growing in fact they just have these sporadic huge jumps well that's not really accurate if we went over a timeline of what's happened with AT&T they did different Acquisitions they bought things like direct t TV they bought Warner media When AT&T financed these deals we can see the heavy toll this took on the company we can first look at the cash and debt of the company qualum shows the cash along with the debt now if we got rid of the debt the cash is sporadic over time but the debts the real story here look at the massive amount of debt it is dramatically more than the amount of cash they are a heavily indebted company but where did this all start right back during that first acquisition in 2006 boom the debt doubled and this is long-term debt which is more risky they're not paying this off fast they're holding on to this for a long period of time notice when they take on this debt they never pay it back now the debt stays pretty flat and then boom they do another acquisition that acquisition cost them even more debt more additional interest payments on the shareholder more of a tax on the future profits of the company then they raise debt further and further reaching a high of $180 billion this massive staggering pile of debt that the company has to deal with that sounds bad right that sounds like it wasn't worth it because of the amount of debt they had a raise well that isn't the half of it they also diluted the shareholder for this Revenue if we go down to the shares outstanding we can see the other half of this picture every incremental acquisition they did increased their share count in fact it nearly doubled it they went from 2 billion to 32 billion then they went from 4 billion hair up to 6 billion adding on another $2 billion of share count then when they started doing BuyBacks which was the smart thing to do they halted the BuyBacks to do more Acquisitions increasing the share count over and over again so when we talk about organic growth we're talking about a very important concept you want companies that have nice consistent organic growth not lumpy growth that has been purchased through major Acquisitions that take a toll with the amount of debt and with the amount of shares Costco is an example of a company that has had that nice organic growth when I look back through Costco's history they have not done hardly any Acquisitions they did a couple really early on but almost all of their growth comes from price increases on their membership growing more members per store and increasing the amount of store count globally over time that organic growth leads to a nice growth chart growing over time that most importantly doesn't have a toll on the investors Costco in this respect is the example of a compounding machine AT&T is not the next core Financial metric we can look at one that I pay attention possibly more than any other is the free cash flow of the company and specifically the free cash flow per share compounding machines grow their free cash flow per share over time on a steady and predictable basis other companies like City group have unpredictable and low growth rates with their free cash flow per share so looking at the history of a company this is a Telltale of what the quality of the company is and companies like MasterCard are very very difficult to find ones like City Group they have this type of sporadic free cash flow per share you can find these companies everywhere we can see this clearly Illustrated through all different examples we have Visa as well as MasterCard we go over to the free cash flow chart and we look at the free cash flow per share the free cash flow per share is a little bit different because it factors in some delution of the company when they buy back or they issue more shares so you get to see how much free cash flow your shares have on a per share basis and Visa like MasterCard are not perfect L consistent every day that's not realistic for a company that has some variable expenses and taxes but over time you can see the trend it is mostly a consistent overall trend of growing the free cash flow per share and these companies that are very high quality do this on a very very fast pace for the past 5 years they've grown their's 12% per year that is not counting in dividends so that's an additional aspect of return this is just the core intrinsic value of the company growing over time we can also look at Costco is another example of a company that's doing this right you can see the free cash flow over time if we filter by the per share count it looks similar Costco keeps their share count relatively steady while they grow their free cash flow and we can see the free cash flow per share over time it's not perfectly consistent Visa Mastercard have a little bit more predictability here but you can see the overall trend in the past decade you can see this even clearer Costco on an overall basis is growing its free cash flow per share on a relatively consistent basis companies like City on the other hand financial institutions pharmaceutical companies Airlines they have zero consistency with their free cash flow or their free cash flow per share even zooming in over the past 5 years there is no pattern here there is no consistency there is no predictability if you're buying this company you have no clue how much money you'll earn over the next year so we want to find companies that have the type of history in this metric that MasterCard has or as close to it as we can find now the final example of a compounding machine a trait that I see similar and virtually all of them is the shares outstanding over time this is such an important factor to look at because when you're looking at buying a company you're buying it on a per share basis you own shares of the company whether or not the company buys back shares or issues more shares that has a huge impact on every per share metric especially earnings per share and free cash flow per share I have here two examples we have the example of Moody's which is a company in my portfolio it's my newest holding I believe it's a very strong compounding machine that meets almost all of these qualities especially the shares outstanding going down over time Moody's uses its excess cash to buy back shares which increases its free cash flow per share and reduces the total shares outstanding over time other companies like the one pictured here Jet Blue dilute shareholders by issuing more shares to buy new businesses and pay stock-based comp for their expensive pilots and the expensive staff they need to have because they have all these costs and they don't have other ways to pay for them they're continually issuing more and more shares that may grow the market cap of the company but it does not help the investor the shares outstanding is so important to look at now it's true that some companies have a history of issuing shares when it makes sense when they're growing fast and when they're building value for the customers but over time the type of companies that typically do the best are ones that transition to a steady state of BuyBacks they don't do it based on price they don't do it here and there they do buybacks all all the time Apple started doing this in 2013 Tim Cook did not try to time the market he just started pulling that buyback lever using Apple's incredible cash balance to start to buyb shares dollar cost averaging over time doing so has reduced the total shares outstanding from the peak in 2013 of 26 billion all the way down to current day 15.6 billion this amount of BuyBacks is why the stock price has increased faster than the market cap it's why investors that have owned apple have done so incredibly well even more well than the company has grown they've increased the earnings per share the free cash flow per share at an absurdly high pace and you can see the Staggering results this has had since 2019 5 years ago Apple's up over 400% I bought my first shares in apple in 2017 it's been the biggest winner that I've owned by far BuyBacks are not the only important part of a stock but companies that are compounding machines almost always have this trait where they return the excess cash primarily through bu backs and then through dividends so I hope this part works as a guide for which companies to pick this is all part of step one which is stock selection remember that this is only one of the three parts of my investing philosophy after stock selection we move on to temperament temperment is the personality traits that determine how someone will react given certain circumstances so this is basically a word to describe if you picked someone up and put them in a certain specific circumstance what do you think they would do what would be their reaction what would be their temperament and a lot of this is genetic but we do have control over our temperament I fully believe that this is something that can be learned and improved on over time some of these traits are conducive to successful investing while other traits are detrimental not all temperament is the same controlling your temperament is key to long-term investing success so we've heard this before with people like Warren Buffett and Peter Lynch that controlling your temperament is incredibly important but what does that mean here is what outline as having good temperament for investing or bad temperament for investing now I'm not saying that these are good and bad morally I'm not saying that people that have these traits on the left are better than these people that have these traits on the right I'm speaking specific in terms of application of investing if you have the traits on the left you'll be a better investor than if you have the traits on the right that is a simple fact the traits that good investors have with their temperament is that they do not get excited when the market goes up they do not get sad or anxious or depressed when the market goes down they're patient and okay with being bored they don't need to fit in with the pack they have no emotional attachment to stocks they're systematic calculated in their decision-making during distressed times these are the examples of excellent investors that have control over their temperament that stay consistent to their investing strategy bad temperament for investing are people that enjoy gambling many people out there enjoy excitement they want something new and exciting to happen they like rolling the dice that is a horrible trait for an investor investors like predictable returns not exciting unpredictable returns bad temperament is being excited when the market goes up you get happier you get more enthusiastic that is something that naturally happens to most people but we need to control this temperament we can't get excited when the market goes up we should be excited when the market goes down when we can buy companies at better prices bad temperament is having anxious and bearish Views when the market goes down the exact opposite of what we should do 20122 was an excellent example of people becoming bearish after the market went down remaining excited and enthusiastic during a time period where we're in a 2-year bare Market becomes very difficult it's much easier said than done when the Market's making all new lows every single week when you have forecasters on CNBC saying that the end is near that the economy is Tak thinking that companies can't post profits that everything's different now that creates anxiety depression and bearishness avoiding that temperament and being part of the pack with other people that are bearish is imperative in investing bad temperment is making buys out of the fair of missing out you see stocks going up the cathywood arc Investments during 2021 seeing those go up creates the fear of missing out and a lot of people have greed take over when that happens they see a stock going up yesterday and they want to be part of of it tomorrow bad temperaments also making sells out of fair future losses during declines seeing the market go down every single week seeing your account becomes smaller and smaller and smaller losing tens of thousands of dollars by the day can become incredibly distressing you may sell out of fair of future losses you may sell to preserve your current capital you may become convinced that selling now is a thing to do but good investors control their temperament they do not buy out of fair they do not sell out of fair they buy based on the merits of the company the valuation and the future cash flows bad temperament takes comfort in following the crowd you should take neither Joy nor comfort in following or avoiding the crowd your decisions should be made independent of the crowd they should be made based on your own research your own judgment your own calls many of the best buys that I've made have been specifically avoiding the crowd when I first started buying Costco it was not a popular investment on YouTube there was literally no one else talking about about Costco I couldn't find another video made about it I invested in Costco based on my own conviction and on Research determining it was a quality company that I wanted to own with the size of the viewership here every investment that I've made has had a notable amount of push back it doesn't matter what the company is there's always a number of people that harshly disagree with the decisions I'm making I could give you the example of Texas Roadhouse which has had incredibly good Market beating return since buying it but I received a lot of comments of why am I buying this company that makes no sense I can buy a different company than this one I've been invested in Apple for years and years and years the entire time I've been invested in this company I've received enormous push back that the best days are behind it that it's not going to have any Alpha when Apple has turned out to be one of the companies with the most Alpha over the past 5 years an investor needs to make their own decisions make their own Investments and hold true to their own convictions you should not be persuaded by whatever's popular on Twitter whatever's popular on YouTube you should be buying the company companies that you've done your research in and that you know are great Investments but if you can exercise discipline and control over the way that you behave during certain Market events you'll have a much better outcome so we've gone over section one which is stock selection identifying what a compounding machine is examples of it we've also gone over temperament staying disciplined unemotional patient and long-term focused now we get to the final part which is portfolio management this is something that's not talked about that much but it's actually very important this has asked aspects of position sizing specific buy criteria specific sell criteria and intrinsic value estimates the first concept we'll talk about is intrinsic value this is estimating the fair value of a company or the value at which the company will have Market average returns if a company is trading under its intrinsic value that means the company's undervalued it means that if you buy it now you will beat the market if the company's trading overs intrinsic value well that means that company's overvalued and you'll likely have underperformance so intrinsic value is a gauge by which we value the actual company based on real fundamentals of the company intrinsic value is determined by ranking companies by free cash flow growth and predictability those are the two major variables in determining intrinsic value free cash flow growth and predictability then we discount them by determining the appropriate free cash flow yield those companies deserve to trade at so we look into the future and see what this type of company deserves to trade at with its fre cash flow yield based on the free cash flow growth and predictability now a lot of investors like to put a finite number on this but don't be mistaken everything behind this are guesses they're guesses that are informed by information and we're trying to make our guess as accurate as possible even Warren Buffett and Charlie Munger have said many times that intrinsic value is ultimately a subjective guess and you try to get as close as possible the more accurate and well researched the assumptions the more accurate the inic Value Estimate will be so we want good information to go off of we want to study the financials of companies we want to know what to expect with their growth in the future now this bottom part here I outlined the drivers of intrinsic value and I think that this is incredibly important when we look at the growth of intrinsic value over time it's primarily because of three different factors first of all organic Revenue growth we've already gone over what organic Revenue growth is we want want to see strong Topline organic Revenue growth with a company we want to see strong free cash flow per share growth with a company over time and we want to see predictability improving that is the third driver of intrinsic value predictability improving means that the durability the moat the company itself is becoming more entrenched more dominating more monopolistic more predictable if the company's being beaten up by competitors if there's new products stealing customers if the company's having lots of employees leave and things go wrong with it that lowers the intrinsic value because the company's now less predictable so we need predictability in the mix here and that again is a judgment call based on studying the company if these three factors go up the organic Revenue growth free cash flow per share growth and predictability the company's intrinsic value is increasing over time my estimates of intrinsic value are informed by the history of the company assumptions over the financial metric projections about their future growth and then what I believe the company will trade at in the future what their free cashow yield will be based on that I can get an idea of what their annualized return will be once I've done that along with studying the company I build a range of what I believe the intrinsic value is where I believe the company's overvalued and will have subpar returns and where I believe the company's undervalued my goal is to always buy companies with a margin of safety close to the undervalued category now there's different methods to calculate intrinsic value I don't believe that this is the ultimate truth but I believe it's an accurate way to gauge it and overall these three metrics of organic Revenue growth free cash flow per share growth and predictability I do believe are the most important attributes on tracking ongoing intrinsic value changes now finally we get to the portfolio management segment where we talk about buying and selling I believe strongly that successful outperformance of The Benchmark is most likely to occur with a portfolio concentrated into the highest quality companies buying losers which which is something nobody wants to do can be usually avoided by following a disciplined buying and selling strategy Step One is buying only compounding machines that is a hard rule to follow many people sacrifice buying compounding machines for different companies for all different types of reasons or they start to bend the rules a bit and they lower the overall quality of their portfolio I believe I'll have better performance by strictly adhering to only investing in the highest quality companies so properly identifying and selecting in the stocks that are compounding machines is the first step to making a new buy the second one is buying when they're trading below their intrinsic value estimates so after you studied the company you've run through the scenarios you've looked at the valuation and the ranges that it trades at and you've determined an intrinsic value you want to buy the company when it's a bit below that intrinsic value to give you a margin of safety these are two steps to buying really good companies and buying them at good valuations the things we want to avoid is do not sacrifice quality for valuation if you're buying high quality companies there will at every given time every single day every minute of the day be a different company at a lower valuation that is inherent with the quality that you're buying there's always going to be a cheaper company to every MasterCard trading at a 34d PE there's an AT&T trading at a 7 PE like the old phrase in many cases you get what you pay for trading quality for valuation is a recipe for disaster over time your portfolio will become lower and lower quality until you own a lot of subpar companies trading at low valuations because they have distressed business models this is not the type of investing that Warren Buffett does or Charlie Munger they wait to buy great companies that have traded below their intrinsic value the majority of gains in the market the majority of companies that push the index up higher and higher and higher are very high quality companies they're not the ones trading with distress business models now another common thing that I believe is important to avid void is do not add to companies buying more of your companies in your portfolio if they're becoming less predictable if you already own a company and you've done initial research on it but it's running into distressed circumstances it's becoming a little bit less predictable you can see the moat fading a bit those are not companies that I would add to I only add to positions where I believe the moat is as strong or even stronger than the day I first spot the companies I like adding to companies that are getting stronger that are winning more their dur ability is better than the day you bought it I don't like adding to companies where they're becoming weaker over time and I can see the fundamentals fading so that's another thing that I avoid and then we have selling this is one of the most difficult parts of investing is knowing when to sell a stock there's three different areas where I think it's good to sell a stock three different categories one of them is when you made a mistake on your original analysis simply put if you just miss something with your analysis and you realize that there's something that's wrong with the company that you didn't catch the first time you bought it I will admit the mistake in my analysis say that I missed something and exit the position now hopefully if you've done your job right you can avoid these type of mistakes with analysis but nobody's perfect if we do make a mistake with our analysis if I get something wrong that I missed and it changes my thesis I'll exit the position the other bucket that I believe selling falls into which I think is more common is selling the company no longer meets the quality standards the originally bought the company for if you buy a company because because you believe it's a compounding machine you believe it meets all of these quality characteristics and then as time goes on the quality decays the company becomes weaker you can see a lot of missteps by management they're no longer acting like the company that you first bought that's a time to sell it's tough to sell companies in this condition because typically they go down in price and you want to hang on for Recovery we don't want to lose money but in most cases holding on to subpar companies that are going in the wrong direction is not a good way to get returns rather sell that company and invest it back into a company that's doing everything right so even if a company that I've done research on I've made videos about and I'm bullish on at one standpoint if that company decays in its quality if I no longer believe in the future and it no longer meets my standards I will replace it for one of the many companies on my watch list that are doing everything right there's a handful of really good companies to invest in so I don't need to hold any ones that are subpar and then finally the last bucket of cells I believe falls into this category where you sell a company because simply put there's just far more of an attractive opportunity now this one's a tricky one because if you have a portfolio of compounding machines in most cases it's good to hang on to them until the quality goes lower but when you have a company that offers an incredibly attractive opportunity while meeting the high standards of quality you're looking for you want to raise capital for that opportunity in some cases you can dig in portfolio and find the least attractive investment opportunity in it to put that money into the most attractive opportunity there should be a wide discrepancy between the attractiveness of the opportunities if they're close then there's no reason to take the tax burden of trading one position for another and this all summarizes my buy and sell criteria so like I said this presentation is meant to be a starter pack for my investment philosophy to boil down all the ideas that I have into one simple presentation it's not perfect that and I'll be making additions and changes to it over time but this version of this investment philosophy presentation is included for free in the pin comment below so you can go to the pin comment and download it if you want share it with people if you want them to learn about this type of investing and I really hope you enjoyed it and I hope you get value from it if you do want to try out qual trim this website that shows you all the fundamentals of a company you get all this information as well as a watch list and the scenarios tool and a portfolio tracker a lot of different things that we're building this is $1 a month it's included as part of the patreon membership with exclusive content and a Discord community so you can try that out with a free trial if you want there's also going to be a link in the description I'll have more videos out soon on this channel with commentary on the latest news earnings report and a lot more things on the market and my investing strategy so make sure you subscribe to the channel if you want to see that and I'll catch you in the next one

Channel: Joseph Carlson

Views: 211,366

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Id: wENEfGzuRVA

Length: 44min 54sec (2694 seconds)

Published: Thu Jan 25 2024