Investing is about understanding businesses and as with all things business-related, nothing is ever clearcut. Businesses are comprised of a set of strategies which have been selected and implemented by management. However no one can guarantee the success of a business strategy - not even management themselves. So what hope does an investor have? In this article I’ll explore the characteristics of a certain type of investor who holds an advantage. I’ve termed them the ‘entrepreneurial investor’.
Business owners think differently
In 1947 Benjamin Graham coined the term the ‘enterprising investor’. He outlined how an edge could be gained by delving deep into the numbers to determine the true underlying value of a business. But that edge is harder and harder to find these days. There are simply less cigar butts and more people looking for a free puff. It’s a tough game if you’re only relying on that strategy.
So if studying the numbers won’t give you an edge, what will? One of the answers I believe, lies in the saying ‘walking a mile in one's shoes’. If you’ve ever run a business or grown a business, big or small, you have an edge over those that haven’t. You are an entrepreneurial investor. You possess an understanding of business that can’t be understood through research alone. As important as the numbers are, they are only the first step of analysis. What’s more important is being able to judge which numbers are important and knowing when to use intuition.
So put yourself in the shoes of a founder - someone focused solely on growing the business over the long term. What truly matters to you and how you operate your business will be drastically different to a fly-in CEO chasing a bonus.
If you haven’t owned a business or run a business, all is not lost. You just need to understand a few principles of how good business owners think, then apply them to your judgement as an investor.
Seeing opportunities when conservative investors don’t
Running and growing a business involves the optimisation of multiple levers - decisions about the best allocation of fixed resources for maximum long term return. If you have been in that position, you will know what constitutes good capital allocation
I’ll illustrate this by way of a real life example of a company we are currently tracking. Consider a dominant furniture retailer going through a transition period. After many years of leading the market, lower consumer sentiment has led to a recent decrease in sales. In addition, customers are increasingly heading online for homewares. Investment analysts have punished the stock for its recent earnings decreases. In response to the evolving market, the founding family and majority shareholder recently appointed a new CEO with a mandate to spend significant resources on a new digital online store. This expenditure has led to an even greater short term cost blow out.
Conservative investors would steer clear of this investment. On the surface it seems like a dinosaur industry set for extinction. Investors would look instead for the ‘safe’ cash cow blue chip that pays a high yield.
However for entrepreneurial investors, this represents a clever investment opportunity. Sentiment is low and the stock has not been this cheap for many years. The significant investment in the online store is a shrewd move by the founders. The direction towards digital distribution has been managed prudently and early results are promising. The once-off investment cost has masked the imminent turnaround. This transition represents a sensible opportunity to take a calculated risk.
Entrepreneurial investors understand that allocation to growth projects is not optional, it is a necessity. Risk is part and parcel of improvement. Improvement is not a choice; if you’re not improving, you’re a sitting duck. What’s most important is that the allocation of capital to this project is thoughtfully considered and prudently managed. In this case, this is a favourable risk/reward tradeoff even though conservative investors may see differently.
Betting on moats, not news
Anyone who’s started their own business venture knows that new initiatives take time. Usually longer than anticipated. Jeff Bezos, one of the world’s most successful founders, outlines his thinking on results -
“Today I’m working on a quarter that is going to happen . Not next quarter. Next quarter for all practical purposes is done already and it has probably been done for a couple of years.” - Jeff Bezos
For most fundies, Bezos’s 3 year time frame is too long. Afterall, a fundie could change careers multiple times in that period. Fundies need to pick up quick results and so they favour a quarter-to-quarter game of news arbitrage. Because this approach is short term, it relies on betting on news announcements, rather than betting on business moats. For investors to truly bet on a business moat, they need to allow ample time for the growth initiative to crystallize. This requires patience and an understanding that initiatives take time to bear fruit.
One such business I visited recently in Japan transformed itself from a printing company into a data provider. They now dominate the Japanese food industry - a slow moat-building process which has taken them 10 years to establish. Initially starting by digitising print data for their customers, they developed software that now owns the pricing data of the Japanese food advertising market. Because the moat has taken so long to build, it is very difficult for competitors to erode.
The most important thing in business
Business owners understand the power of human nature. People, when aligned and motivated, can achieve great things. Drive, heart and nous are the most important things in a business but are instead often overlooked in favour of well-credentialed management teams with little vested interest.
When Warren Buffett took over Berkshire Hathaway, it was a struggling textiles business. Although you wouldn’t have backed the original textile business itself, you would have backed Buffett’s ability to change the core business. Great operators with the right motivation will find a way to navigate through any challenge.
Australian visionaries Roger and Andrew Brown (ARB Corporation), David Teoh (TPG Telecom), Andrew Hansen (Hansen Technologies), Barry Lambert (Count Financial), and Graeme Wood (Wotif.com) have been the heart and soul behind their companies. These founders have demonstrated an incredible ability to compound shareholder wealth i.e. their own wealth. Those who have invested alongside them have been repaid handsomely. They’ve all demonstrated a shrewd ability to take calculated risks and look for hidden opportunities.
Entrepreneurial investors understand that backing the right people is just has important as backing the right business. To do this sensibly, investors need to ensure there is genuine motivation and desire to further the growth of the business for the long term. For this reason we favour investing in founder-led companies.
Investors with experience owning and running their own business have an edge over the typical conservative investors. They’ve been in the shoes of management. They know what’s important and they’re comfortable backing the right people with carefully considered strategies. They recognise that business success requires continual improvement and calculated risk-taking.
By drawing on this experience and combining it with financial analysis, they have more strings to their bow than the typical conservative investor. There is no better example of a business owner, entrepreneur and investor than the the world’s greatest entrepreneurial investor himself, Mr Warren Buffett.