Fundamentally Strong Businesses: How do you know one when you see one?
When Carpedia Capital considers investment opportunities, we always frame the potential for returns against the magnitude of risk (recall our definition of risk as the likelihood actual realized returns are lower than those required over a reasonable time period and the potential for permanent loss of capital) we are taking to ensure this relationship is appropriately balanced.
In our opinion, the primary determinant of investment risk in private equity deals is how “good” the business is today and how likely it is to become great during our holding period than it is likely to become the converse. Consequently, we spend the bulk of our time assessing businesses against these two criteria when deciding which companies to seriously pursue.
But what exactly is a “good” business and how would you know one if you saw one? While beauty is often in the eye of the beholder, we pay particular attention to the following attributes in gauging whether a business is fundamentally strong:
- Growing or stable in terms of end market demand, market share thereof, brand presence, customer loyalty, basis of competitive advantage, rate of change in products or services;
- Diverse in terms of customer base and geography; and,
- Consistent in terms of historical profit margins, low capital expenditures, growth in unit volumes, pricing, revenues and profits, ability to innovate new products and services.
The presence of numerous of these attributes contributes to our ability to believe in the sustainability of the Company’s base level of profitability through good times and tough times, and the likelihood that the base level of profitability will actually be sustainable.
The absence of any one of these attributes is a cautionary note requiring particular attention to understand, while the absence of two or more of these attributes is a red flag.
Similarly, there are several attributes which indicate to us that a business may not be fundamentally strong:
- Converse of the above factors, no raison d’etre, fads and things that seem too good to be true or are dependent upon government subsidy;
- Long sales cycles with low unit volumes;
- Strong labour unions with restrictive labour policies and or poor labour relations;
- Significant input cost risk, supplier dependency, inability to pass through raw material cost volatility or asymmetrical exposure to adverse C$/US$ exchange rate fluctuations; and,
- Displacement within end markets by new competitors, particularly offshore competition.
The presence of any one of these attributes is a cautionary note requiring particular attention to understand, while the presence of two or more of these attributes is a red flag.
Conclusion: The degree to which a business is “good” is strongly correlated with how favourable private equity investment returns prove to be and the actual degree of investment risk. Therefore, we focus our investing efforts on fundamentally strong businesses and eschew those which do not meet our preconditions.
What’s Next: How we assess the likelihood that a “good” business can become great during our holding period will be the subject of our next blog.
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