Common Stocks and Uncommon Profits gets frequently recommended to me by top performing equity managers. It’s 15 rules for evaluating growth stocks. I read it and summarized it.
Rote changes in revenue and earnings are less interesting than their quality and repeatability. Invest in a company with capable, honest and adaptive management entering an under penetrated market that invests its resources in such a way to give it optionality into new spaces. High quality sales organizations, and long term investments into customer support with expanding margins due to automation are the killer combination. categories: book summary
1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
- If market is fully penetrated, not interesting
- YoY growth not needed, sometimes comes in spurts
- “Fortunate because they are able” – technical capability to pivot into the relevant growth area.
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potential when the growth potential of currently attractive profit lines have been largely exploited
- Research should be a cluster of trees around initial seed – not unrelated ventures
- Company needs to be self aware re: how tapped out its markets are so that it can plan R&D appropriately
3. How effective are the company’s research and development efforts in relation to its size?
- R&D as percentage of sales is tricky to measure, but useful – history of producing results
- Management’s ability to drive diverse researchers towards a common goal is super important
- Feedback loop between Sales & R&D is super important
- Crash goals are the enemy of effective R&D “have to sign this deal” then drop real development work
- R&D has 3 tiers:
- Bad: You make something. As soon as you act, 2nd movers can act to capture all the profits
- Okay: You make something and someone, and the process of making it is sufficiently obscure that it’s hard to repeat
- Good: You make something with utility that cross applies to different domains, allowing you to be a first mover in other areas using an R&D moat (example: texas instruments)
- R&D efforts need to be aligned with TAM
4. Does the company have an above average sales organization?
- Salespeople meet with tons of customers. First party information about the quality of a sales team is a massive asset
- Having an in depth sales training process is important
5. Does the company have a worthwhile profit margin?
- You should look at margins over multiple years
- You want to see aggressive margin expansion correspond with revenue growth, conceptually to imply an economy of scale
- If somebody’s margins are depressed, they can still be good investments but:
- You need to make sure that “investments for growth” are actually investments in the sense they actually feasibly pay off
- Sometimes margins can change due to a thematic, long term shift
6. What is the company doing to maintain or improve profit margins?
- Be wary of peak margins where margins have increased due to ARPU increases because that eventually feeds back into demand
- It’s better if margins are improving due to efficiency gains
7. Does the company have outstanding labor and personnel relations?
- Relative labor turnover
- Size of waitlist of job applicants
- “The company that makes above average profits while paying above average wages is likely to have good labor relations”
- If management doesn’t care about its employees, it’s a bad sign
8. Does the company have outstanding executive relations?
- Confidence in President
- Feeling that promotions are based on ability
- Salary increases given without being demanded
- Only bring in outsiders if you have to
- Low friction at the top of the company
9. Does company have depth to its management?
- No key man risk
- At sales level between 15-40m USD you need to have executive process in place
- Management needs to have autonomy. Micromanagement is really bad
- “Those organizations where the top brass personally interfere and try to handle routine day to day operating matters seldom turn out to be the most attractive type of investments”
- Does management consider feedback from younger employees
10. How good are the company’s cost analysis and accounting controls?
- “If management does not have a precise knowledge of the true cost of each product in relation to others it is under an extreme handicap”
- This is hard to analyze
11. Are there other aspects of the business, somewhat peculiar to the industry involved which will give the investor important clues as to how outstanding the company may be in relation to its competition?
- Are there passive effects like lower cost of insurance that indicate a structural advantage in skill? For example if an insurer thinks a company is always less risky handling goods, they’re probably better handling goods
- Are there regulatory and patent advantages?
- Are there more valuable structural moats than just IP (patents run out):
- Manufacturing know how
- Sales and service organization
- Customer good will
- Knowledge of customer problems
12. Does the company have a short range or long range outlook in regard to profits?
- Companies oftentimes maximize short term advantage by harming supplier relationships that bite them later on
- Good customer support is a metric
13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will cancel benefit from growth?
- You have to anticipate future raises impact on share dilution
- “It is well to consider that all senior converts have been converted and that all warrants, options have been exercised when calculating the real number of common shares outstanding”
- “If equity financing will be occurring within several years of the time of the common stock purchase and if this equity financing will leave common stockholders with only a small increases in subsequent per share earnings, run”
14. Does management talk freely to investors about its affairs when things are going well but clam up when troubles and disappointments occur?
- When things are going poorly it’s to be anticipated, it’s really if the management has a program, doesn’t panic and feels accountable to shareholders
- IF it hides bad news, run
15. Does the company have a management of unquestionable integrity?
- Management enriching itself / its family members at shareholders is sheer sign of badness
- Issuing common stock to pay themselves absurd amounts
- “REGARDLESS OF HOW HIGH THE RATING MAY BE IN ALL OTHER MATTERS IF THERE IS A SERIOUS QUESTION OF THE LACK OF A STRONG MANAGEMENT SENSE OF TRUSTEESHIP FOR STOCKHOLDERS< THE INVESTOR SHOULD NEVER SERIOUSLY CONSIDER PARTICIPATING IN SUCH AN ENTERPRISE”