We explain, what we look for in a investment!
The Oracle investment team spends a good portion of their time looking for quality, growing businesses trading at reasonable prices. However, “quality”, “reasonable price” and even “growing” mean completely different things to different investors. Therefore, it’s important for investors to have a framework to define exactly what each of these terms means to them.
Our framework involves researching seven primary areas of a business to see if it meets our criteria of a quality, growing business at a reasonable price. The seven areas are: Business History, Culture, Management/Board, Industry/Competition, Business Model, Financials and Valuation. Within each area we have observed there are common traits that arise in quality and poor businesses. Below, I have shared some of the attributes we find common across quality, growing businesses within each primary area of our research process.
We are looking for businesses that have consistently had an organic product/service driving their business for duration of their history. We also are searching for founders, that are still involved in the business as well as businesses who have been able to adapt to change. An example of this is reinvesting in new segments, adapting a product/service ahead of the market etc.
To put it simply we are looking for businesses whose employees want to come to work every day. Some of the common traits of these employers include above industry standard compensation, low turnover or employee churn, internal promotion bias, non-monetary benefits, high employee stock ownership levels, and businesses organised in team structures.
There is no one size fits all management team. However, the best teams we have seen promote internally, have skin in the game (stock ownership), are still run by founders, are extremely honest with mistakes (also not afraid to fail). They also have low executive turnover and have incentives for bonuses tied to financial/other metrics that aren’t easy to manipulate.
For example, metrics like return on invested capital rather than equity, earnings per share rather than net income and organic revenue growth rather than revenue growth. Some of the better incentive packages we have seen consider non-financial metrics as well like safety, employee engagement etc. We are looking for boards with deep expertise in business, where most of the members don’t need the paycheck and aren’t sitting on twenty boards.
Companies that operate in monopolistic/oligopolistic structures in non-regulated industries are our preferred targets. These businesses tend to be mission critical to consumers or other businesses and as a result customer/revenue churn in downturns is lower than your average market constituent. They also have pricing power and negotiation power with their suppliers. We also want Industries that are experiencing structural growth tailwinds.
Regarding competitive dynamics, we search for businesses that are best in-class. In most cases we want to own the number 1 player who garners most of the industry profits. These businesses typically have the best margins, organic growth, cashflow generation and the best balance sheets.
Ideally, we want simple to explain business models rather than complex multifaceted models.
Simple business models are typically easy to replicate, have capital light investment profiles, have low downside risks, efficient go to market strategies and products/services that are easy for the customer to adopt. Examples include: store rollout stories, consumer brands with a track record, consumer/business technology with low expertise hurdles and low signup hurdles.
Other common traits include businesses that reinvest in themselves, have a customer focus, and constantly pivot either with extensions of their product/service or diversifying into new businesses without betting the house on those ventures. Most of the business models we define as quality have a competitive moat/s most commonly in the form of switching costs, network effects, brand/ Intellectual Property, regulation hurdles and/or scale.
Just like the Business Model section above, we are looking for simple, easy to understand accounts rather than complex ones (industry-specific). We also look for businesses with simple capital structures e.g., Equity mostly and little convertible instruments. Ideal target companies have low debt on their Balance Sheets, capital allocation plans that place importance on reinvestment opportunities, strong gross margins, profits that convert to cashflow, low capital expenditure requirements, expense everything, don’t exclude real costs and have organic revenue growth above their industry.
We also place high importance on Return on Invested Capital (ROIC) and how this is changing over time. Generally, we find businesses that are growing their ROIC are also growing their customer propositions and competitive advantages. Some other common traits include loss-making divisions, investing in other companies (minority stakes) and hidden assets on the Balance Sheet.
Typically, we want businesses that are growing their cashflows at above 10% per annum. The multiple we pay for these businesses is dependent on their forecast growth rate and their underlying quality compared to the market/peers. Growing businesses with quality attributes rarely ever trade at large discounts to their value and we take this into consideration, so we aren’t too picky on price.
While it is great to know the attributes of successful investments within our framework, very few companies will tick all the boxes. The best investors know which attributes are the most important to each business and have an unwavering focus on them.
In my next blog, I’ll share brief global examples of businesses that possess some of the above attributes.
Written by Nick Cummings
Oracle Global Equities Portfolio Manager
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