GWII Investment Framework, BMPB – Business
This is the first in a series of posts about the GW Investment Institute (GWII) Investment Framework BMPB: Business, Management, Price vs. Valuation, and Balance Sheet. Our GW students working as analysts and portfolio managers use this framework to evaluate companies for our GWII Student Investment Funds. We’ll start the review of the Business framework component.
What makes a good business? What distinguishes one business from another? As business people and investors we want to own the highest quality business that operate within industries that have tailwinds, i.e., favorable market conditions, this may seem obvious, however, is worth noting. Good businesses generally have high profit margins and cash flow that are consistent over time. We look for companies that have dominant market positions, companies where customers/clients love their products/and or services. We want to understand how much capital a business needs to grow, less is more in this area.
We work to understand the competitive landscape. What are the barriers to entry? Is there consolidation in the industry with limited new entrants, e.g., freight rail in the U.S. Is it a newer industry where an early mover has established a dominant position, e.g., Amazon (AMZN) Web Services (AWS). What portion of the client’s budget does the product and/or service represent, if a small portion, the company may have some pricing power, e.g., Apple (AAPL). More on pricing power in another post. What are the switching costs for customers? Steep, limited, or non existent? Some companies provide a high degree of value to their customers each day, e.g., a Starbucks (SBUX) coffee. What brand recognition and loyalty does a company have? For example: Tide, produced by Procter and Gamble (PG).
Has the business created a network effect, the most obvious examples are the social media companies like Facebook (FB), Twitter (TWTR), and LinkedIn (now part of Microsoft (MSFT). Payment systems, like Visa (V), Matercard (MA), and now PayPal (PYPL). Once a company or a few companies establish a significant presence it can become difficult for new entrants to the industry.
Does the company make individuals or companies more efficient? examples include, Apple (AAPL) iPhone, Amazon (AMZN) Prime and AWS, Salesforce (CRM).
How regulated is the business? And if regulated how does that impact the economics of the business, consider the difference between power generation and biotechnology, both industries have regulation, however, the return profile for a regulated electric utility company is quite different from that of a biotechnology company that’s drug approval process is regulated by the FDA.
What has been the track record of the industry, consider software companies compared to airlines companies, as an investor you have access to either one.
We use a few basic metrics to start our analysis, for example: Return on Equity (ROE), using the Dupont Formula ROE = Profit Margin x Asset Turnover x Equity Multiplier; the revenue growth rate, and change in profit margin over time.
This is by no means a comprehensive overview of how to evaluate a business nor all the tools to do so. Hence, more to follow in future posts. The next post will review the Management component of the GWII Investment Framework. Thank you.
Rodney Lake
March 5, 2021