The objective of investing is to generate attractive risk-adjusted returns for investors. In response to the notion that every investment is unique, risk is the common variable. And the greatest risk is derivative of price.
“We think no asset is so bad that there’s not a price at which it’s attractive for purchase, and no asset is so good that it can’t be overpriced.”
Investing revolves around the ability to measure risk, which I would define as uncertainty surrounding outcome and the possibility of loss under unfavorable outcome. The first objective should always be to protect your principal, and the easiest way to do this is with price. A business can be in a growing or declining market, it could have a terrific management team or be without proper management, it could benefit from high barriers to entry or sell a low-margin commodity; it does not matter how attractive an investment is if you acquire it at the wrong valuation. So, what is the number one thing to look for when evaluating an investment? An attractive price, which to borrow from that gentleman Seth Klarman , provides a “margin of safety.”
In a letter to investors Klarman wrote that he “…ran across a quote form an unlikely source that seemed surprisingly apropos for investors. In the words of that famous boxer and philosopher Mike Tyson, ‘Everyone has a plan until they get punched in the face. Then they don’t have a plan.” Paying too high a price is the equivalent of goading Mr. Market into punching you in the face.
We are including this high-level banter on price and intrinsic value because it is essential to understanding that most flaws an asset may possess can be overcome with price discounts. Please keep this in mind as the remainder of this lesson will highlight only the attractive qualities a company should possess, and the one serpentine quality to be looking for.
When evaluating a new opportunity, the most important questions a private equity professional must answer are threefold:
- Is this a good business?
- Is this a good investment?
- Is this a good investment for me?
Addressed in reverse order to allow for a detailed description of a good business, the third question is most often a question of strategy. By way of example and per the introduction, while price may be sufficiently low to make an asset in distress appear attractive, some investors do not have the desire or the toolkit to work with distressed businesses. Investors may conclude that their strengths as an investor are limited to a certain industry, or that they will only work with companies where existing management will remain post acquisition. In an effort to raise capital around their strengths, such investors might outline these restrictions in the limited partnership agreement such that these specific strategies are codified in the fund’s mandate. For example, a fund may not be allowed to invest in a particular industry such as energy or real estate, or it may be focused on businesses of a certain size, or required to abstain from non-control equity positions, regardless of whether those situations represent good businesses or good investments.
The second question revolves largely around price. If there is anything most veterans in the industry can agree on, it is that there is very little that can be done by even the most well-resourced and enterprising of private equity investors to remedy the combination of poor underwriting and overpayment. In private equity there is a unique window afforded for a valuation exercise that will heavily influence the success of the investment. If the underwriting process fails to accurately reveal the quality of the asset acquired, then the opportunity to control risk with the variable that influences it most – price – is lost.
“For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.”
-Howard Marks (again)
Author’s Note: In my career as a private equity professional I have been involved in only two processes where the business identified was so good that we tried to win the auction even though it was admittedly outside of our core competency.
- The first was a leading advanced materials company that protects high-value components when critical materials cannot be compromised. In due diligence we determined that it exhibited exceptionally strong barriers to entry and little downside.
- The second was a nuclear pharmacy (pharmaceutical drugs containing radioactive isotopes), where we again identified high barriers to entry.
In both instances we were ultimately outbid. It was a difficult outcome to accept, but we had to consistently revisit the idea that a “perfect” business is not a perfect investment at the wrong valuation.
Which brings us to the first question: Is this a good business? To properly answer this question requires ignoring valuation. The purpose is to objectively define a good business, because mistaking a bad business for a good one can be devastating.
“When a manager [or investor] with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
The text that follows will focus on 10 characteristics that are universally considered traits of good businesses. This list will be helpful to keep in mind as you start interviewing for jobs, and it will likely evolve as you spend more time looking at potential investments and develop your own risk-reward framework. Very few businesses will hit the mark on all of these characteristics, but most truly good businesses will exhibit the majority of them. So, without any further ado, let’s get into the stuff that really revs most successful investors’ (Ferraris or yacht) engines.
Please see the PDF Notes available for download for the full text.