by Long Equity
January 27, 2023
"The Investable Universe" explores the concept of finding elusive businesses with rare financial characteristics within the vast investable universe. The book presents mental models, thought processes that quickly turn complex information into actionable insights. Focused on four essential attributes—growth, capital allocation, pricing power, and valuation—the mental models use financial ratios: FCF per share growth, FCF return on capital, FCF margin, and FCF yield. The goal is to identify companies that consistently generate high returns on capital, have pricing power, and are resilient to competition and economic cycles. The book can be read in one hour and covers finding, analyzing, and constructing a portfolio of high-quality investment ideas.
Chapter 2: Free Cash Flow Per Share Growth
The metric considered by many investors and companies for evaluating growth is free cash flow per share. Unlike net income, which can be influenced by accounting practices, free cash flow represents the actual money entering and leaving the company during an accounting period, making it less susceptible to manipulation. Free cash flow is allocated for specific purposes, including reinvesting in growth, debt reduction, dividends, acquiring other companies, and buying back shares. To account for stock-based compensation (SBC) that dilutes shareholder equity, FCF per share is emphasized as a more reliable metric for growth evaluation.
Chapter 3: Compounding Capital
Companies acquire capital, represented by debt (bonds) and equity (shares), to fund their operations. This capital is obtained by issuing financial instruments in financial markets. Once secured, companies engage with their supply chain, involving interactions with suppliers and customers. The lifecycle of a company's capital includes borrowing from investors, exchanging funds with suppliers for goods and services, providing goods and services to customers for payment, and returning surplus profits to investors.
Corporate finance involves how a company funds itself and invests capital, with the goal of maximizing its value. The three rules of corporate finance are to buy high returning assets, use low-cost debt to finance such assets, and only return capital to investors when reinvestment opportunities are limited. Investors should aim to maximize total return by focusing on high-quality assets with good return opportunities across regions and sectors. When evaluating a company, consider the return on assets, the cost of debt, and the framework for returning capital to investors.
Chapter 4: Pricing Power
Companies have two key relationships: one with investors (reflected in a high return on capital) and the other with the supply chain (reflected in a high margin). The Free Cash Flow (FCF) margin, calculated as FCF divided by revenue, indicates the cash generated by a company as a percentage of its revenue. A consistently high FCF margin over time signifies pricing power, and increasing margins suggest strengthening pricing power. Companies maintaining high FCF margins often come from sectors like software, semiconductors, payment services, credit ratings, financial exchanges, healthcare, and luxury items. Qualitative analysis complements financial metrics in understanding a company's resilience and business models.
Chapter 5: Valuation
Two key valuation principles are highlighted: 1) A high valuation doesn't necessarily mean overpaying, as quality assets can be expensive; low valuation doesn't guarantee a cheap deal, as low quality may be cheap for a reason. 2) Paying an expensive price can still yield significant returns, and valuations are snapshots of moving objects. Factors influencing a company's share price include the market's view of its growth prospects, the broader economic situation, and the market's ability to invest, influenced by central banks' actions like interest rates and quantitative easing.
Chapter 6: Intelligent Portfolio Construction
Deciding how a high-quality company fits into a portfolio involves considering its position size, whether it should be the largest position, starting small, or making room by selling other investments. A hypothetical scenario where you must invest all available funds and can't make changes for several years encourages a concentrated, buy-and-hold strategy focused on high-quality companies. Academic research suggests that concentrated and infrequently traded fund managers often outperform in such scenarios.
Chapter 7: Quality Companies Worth Analysing
The book concludes by providing a list of generally accepted high-quality businesses from around the world. This list is not exhaustive but aims to offer inspiration and serve as a starting point for readers' research. ∞ALPHA
The Intelligent Quality Investor: How To Invest In The World’s Best Companies
by Long Equity
January 27, 2023
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