An interesting notion I came across in my Zen training is that all phenomena are dependent on, and penetrated by all other phenomena. Looking at a flower, for example, we can see it is dependent on the sunshine, the nutrients in the soil, the rain and so on. If you take any one of these conditions away, the flower would not be the way it is. Looking deeper, we see that each of these conditions is, in turn, dependent on a series of other conditions. Looking in this way we can see the interdependent co-arising of all things. Indra’s Net is an analogy that is often used to help students grasp this rather large concept.
In this third, of the four note series, we cover the process of exploring Indra’s Net through the gathering and analysing of information, the legwork of investing. The first note, Xero: a Beautiful Business, sketched the story behind our investment and the aspect which we find attractive. The second, Investing in Xero: the Science, outlined our valuation framework when making investment decisions. The final note will cover the Art of Investing, looking at distortions in our perceptions and factors influencing our judgement when starting into Indra’s Net.
implied cash flows
As outlined in the last note, the implied DCF methodology provides us with a cash profile to assess. Below is Xero’s implied free cash stream using an $85 market price, 10% return rate and 5.5% terminal growth rate. In other words, if we buy a share today at $85, and these cash flows come to fruition, then mathematically our return will be 10% pa, independent of future share price movements. Our task now is to step into the real world and assess the likelihood of this cash stream coming to fruition.
xero and indra’s net
From the perspective of Indra’s Net all phenomena, whether visible or invisible, will have an influence on Xero’s future cash stream. Fortunately for us, it turns out some conditions are more important than others. In the case of the flower, for example, the sun is a primary condition for its formation, whereas your reading of this note is not. Our task is to identify the primary conditions needed for Xero’s implied cash stream to be at least equal to that implied by the model. And then assess the likelihood of these conditions forming and sustaining, by examining the secondary conditions they depend on, and so on. If we are able to do this relatively better than others, we increase our chances of meeting our investment objective of generating a 10% pa net return on our funds.
Looking into Indra’s Net seems like a monumental task, but fortunately a number of scholars and investors have recognised and shared with us the many silent interlinkages that shape the fortunes of businesses. Michael Porter for example, recognised how a company’s industry structure can influence its profitability over time. Clayton Christensen identified the difficulties incumbents face in responding to certain types of innovation. Warren Buffet recognised the key attributes of successful managers; and so on. We can draw on the work of these teachers in identifying and assessing the primary conditions that shape a company’s future cash flows.
where to begin?
The cash stream has two key attributes that are of interest: the gradient (growth) and the strength (economic moat). A single factor can impact both; for example, the more market share Xero gains in a region, the higher its growth and the wider its economic moat.
Our research effort is structured around identifying questions that help us see more clearly where things are and how they are likely to evolve. Our time and resources are pointed to answering these questions by gathering and analysing information.
When looking at a business, our starting point is always to understand its core offering with the questions: What is the value proposition; What is the basis of competition; and What are the core competencies required for success. In the case of Xero, the legwork we undertook to answer these questions included:
Test drive Xero’s accounting software (Kasa uses Xero)
Test drive accounting marketplace apps
Read and watch third party reviews of SMB accounting software, practice management software, and accounting marketplace apps
Listen to cloud accounting software podcasts
Acquire third party pricing analysis of Xero vs Quickbooks
Extract and analyse market shares in AU, NZ, UK & RoW
Speak with accountants (in Australia and the UK)
Speak with Xero investor relations
Speak with Xero app marketplace software developers
Speak with Xero senior management
Speak with Intuit senior management (Australia)
Read Xero’s 2007 initial public offering prospectus
Read all Xero annual reports & investor presentations since listing
Read investor presentations & transcripts Xero, MYOB, Intuit, Sage
Watch Quickbooks Connect (Aus & US)
Watch MYOB capital markets day, and Intuit investor day
Read MYOB 2014 prospectus
Read articles about the history of Xero, MYOB, Intuit, Sage
Read Wikipedia pages of Xero, MYOB, Intuit, Sage
Read about the history of accounting software industry development
Scan for emerging accounting software players
And so on …
free flowing approach
We have a number of standard ‘check-list’ questions, but rather than work through them methodically as you would a research project, we prefer a looser, more free-flowing approach. Keeping an open mind allows us to more easily recognise the most important conditions shaping a company’s future. As we explored Xero, a number of core factors presenting downside risk to implied cash flows were identified. Two questions of particular interest were: 1) What are the chances MYOB will ‘turn the tide,’ and starts to take market share from Xero? and 2) What are the chances of Xero failing to retain their lead position in cloud accounting in the UK?
While these questions were contemplated as we conducted the research listed above, we shifted our focus to help specifically answer them:
Reread Clayton Christien’s The Innovator’s Dilemma
Analyse and identify the factors that lead to Xero’s ability to become the dominant player in Australia
Assess Directors and Senior Management capability and history at Xero, MYOB, Quickbooks, Sage
Analyse Glassdoor employee reviews of Xero, MYOB, Quickbooks, Sage
Scrape data from Xero UK and Quickbooks UK websites
Obtain copy of Quickbooks UK accounts
Research legislative changes in the UK
Research Xero UK acquisition
Research other accounting software players owned by KKR (the new owner of MYOB)
Read ACCC review of MYOB bid for Reckon
Read Reckon investor presentations
And so on …
probabilistic vs deterministic
Going back to Indra’s Net, it is likely that we live in a deterministic world – or at least outcomes are a lot more deterministic than we might expect. However, we only see a tiny fraction of all phenomena in the universe and have a very limited understanding in how they relate to one-another. To handle these limitations, we can use the lens of probabilities to make investment decisions. So while we may well live in a deterministic world, we apply a probabilistic approach for practical reasons.
The raw information gathered and analysed through the legwork on Xero is the foundation on which assessment of these probabilities is based. A glimpse of the picture that formed for us appears in this note Xero: a Beautiful Business. In our judgement, there is a relatively high probability of the cash flows implied in Xero’s share price coming to fruition.
the art of investing
Interestingly, another investor may have looked at exactly the same information we gathered and ended up with a very different view. This is because our judgement is partly a function of our wiring, experiences, and mind state. Conditions such as our emotional state can significantly influence our perception. This is the topic we will be exploring in the next note.