Ezra's Notes: Todd Combs Investment Philosophy
Ezra's Notes #1 - How Todd Combs thinks about investing
Welcome to Ezra's Notes. Each week (hopefully) I share timeless insights from the most worthwhile content I’ve read, watched, or listened to.
Everything is condensed into clear notes you can read in minutes.
These are my notes from Todd Comb’s “Introduction to Part IV” of the new edition of Security Analysis.
Enjoy!
In investing, and in life for that matter, you can’t choose outcomes, but you can choose the decisions that may get you the outcomes you want.
— Todd Combs
The goal in investing is to make educated bets based on facts and not stories.
A great analyst has the ability to keep things simple and determine what matters most. Its willing to rip a company down to its studs and understand each part before they reassemble it.
A spreadsheet is not business reality.
Todd’s three buckets
1. Find a good (great) businesess
In determining if a business is great, I like to start on the quantitative side: I focus on the balance sheet, accounting practices, and unit economics, and then turn to cash flow generation. Meanwhile, the qualitative side involves reference calls to assess the quality of management and channel checks to reveal how a company’s products are selling in real time.
— Todd Combs
According to Todd, a good (great) business has:
A wide moat
Low capital intesity
Pricing power
Recurring revenues
Staying power
The likelihood of long-term growth
Investment process
Start with facts and not opinions. “If you start with opinions, it’s very easy to become wedded to them even when the facts run counter to the popular narrative.”
SEC filings, annual reports, trade magazine articles (NO management or colleague’s narratives or sell-side reports.
Don’t look at earnings (worse: adjusted earnings)
Instead, start with the balance sheet and the cash flow statement.
Think about the business in terms of unit economics: “Think in terms of a dollar of revenue that flows into a business and runs through the cash flow statement, then the balance sheet, and last the income statement.”
Review the last 10 years and examine the changes in retained earnings, debt, and overall capital intensity as compared to the top-line growth of the business itself.
2. Find good (great) management teams
The importance of good management is almost universally underestimated, yet it is one of the most crucial determinants of a company’s intrinsic value.
— Todd Combs
Don't assess management based on conventional marketplace narratives. Go deeper.
When analyzing management's track record, examine their incentives; how the spend their time, and perform scuttlebutt research. (Not presentations or meetings with management).
Persistent tailwinds can also make a corporate management team seem smarter than they are.
Good capital allocation is crucial; a wonderful business and a talented CEO is not enough to offset poor capital allocation
Yes, capital allocation is one of the most important parts of the track record that must be examined.
You want management teams focused on long-term and not short-term results (not quarterly earnings, meeting market expectations, stuffing sales channels, pursuing aggresive accounting treatments, or withholding long-term investments to improve reported shor-term results).
CEO focused on running the business, not spending months on the road promoting the company or meeting with investors.
Ask yourself, if this were your family business, wouldn’t you want your CEO single-mindedly focused on running the business? I want to back CEOs who are focused on substance, not collecting style points.
Scuttlebutt research on CEOs: speak to current and former executives who have either reported to the CEO. The goal? Go deeply into their personalities to gain context. Are they toxic? Are they intense as a leaders?
A quick checklist to assess management's incentives
Read the proxy statements and look for changes year to year:
Is the basis for management compensation and stock option awards sensible?
Are they being measured for enduring accomplishments or instead for favorable short-term share price fluctuations that could be purely the result of luck or even manipulation?
Do they reward actual returns on capital or simply profitless growth?
Do they create asymmetric upside for the CEO for taking outsized risks?
Is the CEO regularly selling his or her shares for “personal reasons,” or are they acting like a true owner and fiduciary?
If the company were private, how different would the structure of the CEO’s compensation and incentives be?
3. Find a the “right” price
The best businesses are anti-fragile; that is, they continue to thrive and even deepen their moats in times of adversity and volatility, such as when competitors get in trouble and their best customers and employees may be up for grabs.
— Todd Combs
Start by your own. Do not base your analysis on someone else's opinion, story, conference calls. "he danger of this process is that it often leads to the formation of an opinion based on someone else’s perception and analysis, rather than your own."
Assess a moat. Not the quick and easy way (long track record of high ROIC); go deeper to see if the moats of the company are strong or porous.
Business moats are not static and come with different characteristics—brands, low costs, convenience, and network effects all constitute real but very different moats.
Do channel checks: talk to customers, suppliers, and former employees. Ask yourself: " if I were considering putting 100% of my net worth in this business, what would I want to know?"
Moats checklist
Does the business have a sustainable and/or expanding moat?
What are the weakest links over the next five years?
Are there hidden path dependencies?
Does the business have pricing power, and how has it been exercised?
How (anti) fragile is the business, and will it thrive in the next downturn?
What would it take to replicate this business?
Will the business be in a better position with an even wider moat five years from now?
Remember that simple is usually better; in investing, there is no extra credit for degree of difficulty.
Valuation
A business is worth the sum of its discounted cash flows in perpetuity.
Find a capital light business that can grow for prolonged periods of time.
The worst business is one taht grows and consumes increasing amounts of capital at returns that fail to exceed its cost of capital.
Great businesses can be terrible investments at the wrong price, and an average business can be a great investment at the right price. Fast-growing businesses can be attractive, but only at the right price.
It's not growth at all costs. Price still matters.
Always have a margin of safety
Focus on owner earnings, NOT EBITDA (or even worse - Adjusted EBITDA)
Take into account the company's capital structure.
To finish, some Todd’s great quotes
Human beings constantly process complex information about the world and simplify it to make sense of it and put it into context.
Investors attempt to look behind the curtain of a company’s operations, but they often realize how little they actually know.
Even extensive research will uncover only a small fraction of what one can possibly know about a business.
Investors must find a way to navigate through uncertainty and randomness. There are decisions being made every day, and sometimes made decades earlier, that are still affecting outcomes today in every business and industry.
Perfect information does not exist; there are only confidence intervals. This is, of course, at the heart of why a margin of safety matters so greatly in investing. If you start with the premise that there is only so much one can know, of course you need a margin for error. The less you know, the greater the margin needed.
See you next week with more timeless notes.
Until then, keep compounding knowledge.
— Ezra