Everyone should be investing in compounding machines, companies
that continue to compound their intrinsic value year after year
after year. What I've tried to do with my
investing strategy is accumulate an entire portfolio of these
type of companies. These companies aren't just
financial companies, They're not just tech companies.
There's some specific hidden attributes that make these
companies stand out from the rest.
Microsoft and Apple are other examples of companies that have
compounded for a long period of time.
It seems like every year for the past decade they hit all new
highs. In fact, Microsoft soft stock
just today hit an all time high. Some compounding machines are
much smaller. Texas Roadhouse, for example, is
so small that it's not even in the S&P 500.
Yet this company has compounded far more than most companies in
the market. Chipotle is another example of
this type of company. The type of company that grows
and grows and grows and the price goes up more and more
every single year, Investors become perplexed of what is
causing this company to go up so fast.
There's something about Costco that causes this company to grow
and grow and grow every single year for decades.
Like a juggernaut. It has so much momentum it can't
be stopped. All of these companies have
something in common. They're what I call compounding
machines, which is a title given to a specific type of company,
the highest quality companies in the world.
And like I've said, my goal has been to accumulate this type of
company in in a single portfolio and to do it as best as
possible. I spent the past week creating
an entire presentation based around my investing philosophy.
This presentation breaks down compounding machines, examples
of them, how to find them, and how to hold them well.
It breaks down intrinsic value, buy and sell criteria as well as
investor temperament. My goal is to create a quality
and concise presentation about my investing philosophy.
And in this episode, we're going to be going over all of it.
I'll be walking through this presentation in full step by
step. So we have a lot to get to in
this episode. Let's go ahead and jump in.
I've been investing for a number of years and over that time
period, I've been able to study a lot of great investors and
learn from some of the best. We have information that's
publicly available on every super investor.
These are investors that control hundreds of millions of dollars.
In some cases, they run hedge funds or they run their own
businesses. Either way, they're investing
their money and we get to see the performance of them
overtime. Now, out of these super
investors, which many of them are great, there's an elite few
that outperform the market consistently over a long period
of time. Investors like Warren Buffett,
Charlie Munger, Terry Smith, Dev Cantasaria, Chuck Aukrey.
These investors aren't just good, but they're incredibly
good and they have a long history of outperforming the
market on a consistent basis. And what I've done is
deconstructed the way that they invest, and I've tried to
improve and elevate my investing philosophy to be more like
theirs. So I've learned from these
investors, improve my investing strategy and the results have
shown on my Patreon. Every month I release a monthly
update on My Portfolio as a summary of my strategy, my total
allocation and comments on the portfolio month by month.
In this I also have My Portfolio performance where I put my
portfolios time weighted returns against the benchmark.
The S&P 520 Twenty two was a bad year.
The stock market went down 18.14%.
My Portfolio went down 16.22%. So it's not immune to a sell
off. It's still sold off just like
the market, but it did so a little bit less than in 2023.
My portfolio's return was 32% to the S&P 5 hundreds 26%.
So it not only held up on a down year, but it also did well on an
up year. Now again, I don't credit this
performance to myself. The playbook has already been
written before. US Written by investors like
Warren Buffett and Charlie Munger, they've shown the way to
invest. But the real?
Difficulty in investing like them is accurately implemented.
Their strategy? A lot of investors say they
invest like Warren Buffett or Charlie Munger, and they do the
exact opposite. They invest nowhere close to
them. So my goal with this portfolio
is to invest as close to the best as possible, to have
exceedingly high standards for the portfolio for the
performance for every trade I do and my temperament and
decisions. And this presentation I made is
supposed to be somewhat of a starter guide into this
investing philosophy. So let's go ahead and jump into
it on page one. Now this first initial slide
works as an introduction to my investing philosophy.
We have an overview here. To Simply put this, I believe
that outperformance is most likely to be achieved by buying,
holding and maintaining a portfolio of compounding
machines with a disciplined and long term approach, never
speculating, gambling or investing out of fear, FOMO or
hype. That is easier said than done.
A lot of people say I'm going to be like Buffett.
I'm going to invest in all these great companies, these
compounding machines that just grow and grow and grow.
I'm not going to speculate and gamble.
And then a month later, they're looking at the latest fintech
speculation craze, they're looking at the latest EV trend.
They're going into companies that have no proven business
model. So these type of rules of never
speculating gambling. Or investing out of fear are
easier said than done. Never investing out of FOMO.
The fear of missing out is incredibly difficult to do.
Lots of investors meet these temptations, and they can't
resist. They dive into FOMO buys, they
dive into gambling. We've seen the amount of hype
that happens on YouTube. So part of this investing
philosophy, what's core to it, is maintaining this discipline.
I define the three different categories that I think are the
biggest categories in investing out performance.
Three main focuses are finding exceedingly high quality
companies in stock selection, maintaining the right
temperament, and exercising prudent portfolio management.
So there's three basic categories to investing in stock
selection. This is simply finding good
companies to invest in, which is much easier said than done.
A lot of people like to believe that their portfolios are full
of good companies. When I look at their portfolios,
I don't agree. I think they hold a lot of
average and subpar companies. When I look at stock selection,
I want monopolies now, not legal monopolies, but I want companies
that have high barriers to entry.
I want companies with pricing, power, operating leverage,
organic growth, capital, light, smart capital allocation.
If you find a company that has these six attributes, that's an
exceedingly high quality company.
Once we have stock selection down, we can move on to
temperament. Even if you select great
companies, if you do not have the right temperament for
investing, you are going to have subpar performance.
Temperament means having discipline, being unemotional,
being patient, being long term focused.
These are the four core categories of temperament.
Every investor needs to have this temperament.
Then finally, it's not only important to find good
companies, but knowing when to buy them, knowing when to sell
them, knowing how to manage their allocation and waiting is
also very important. So I have another section here
titled Portfolio Management, Smart Position Sizing, Specific
Buy Criteria, Specific sell Criteria, and Intrinsic Value
Estimates. We don't want to be investors
that just randomly buy companies or randomly sell them.
We want to have some reasoning and structure and thought behind
our sell and buy decisions. We also want to have good
metrics to gauge the intrinsic value of companies.
And if the intrinsic value is increasing or decreasing, so
these three categories overall, I believe, encompass everything
it takes to be a great investor and to have really good
performance. But I think it's important to
define terms and get into more detail of how this strategy
works. One of the terms we're looking
at here is compounding machines. Now, compounding machines, like
any other word, is just a phrase, and it may have
different meanings to other people.
So I put down my definition of what this phrase means.
The specific attributes that a company must have to be a true
compounding machine. I have attractive attributes and
unattractive attributes. The companies that have the
attributes on the right are not compounding machines.
The companies that have the attributes on the left are
compounding machines. So let's go through these one by
one. The first attractive attribute
we're looking for with every company is monopoly.
And this is such an incredibly important attribute.
That I put it at the very top of the attributes, just to
emphasize how important it is. Now, when you look at the word
monopoly, it has some negativity connected to it.
But I'm not talking about illegal monopolies.
I'm talking about companies that already have a large market
share in a very concentrated industry.
I want to look for companies that are already the leaders in
their market share. They're at the very top of the
food chain. Think of companies like Google
that have 92% market share of search.
Think of companies like Visa, MasterCard that have huge market
share in this duopoly of digital payments.
Think of companies like Intuit that already have over 80%
market share in taxes and small business accounting.
It's not by random chance that most of the companies in My
Portfolio have these deeply dominant and entrenched
positions in these concentrated industries.
This was intentional. This was one of the first things
I looked for when buying these companies.
These companies have entrenched distribution, brand names,
install bases, and subscriber bases.
Netflix, for example, just reached 260,000,000 subscribers.
They're at such a massive scale and they have massive
reoccurring revenue. Adobe earns over 80% of their
income through reoccurring subscription, their install base
and relationships with colleges and campuses and the workforce
is deeply entrenched in multiple countries.
Now when we find. Companies that already have this
large market share that are already deeply entrenched with
their brand name, install base, subscriber base, their
distribution. We also want companies that have
very high barriers to entry. The more difficult it is to
compete with them, the better. The 2nd attribute that I believe
is the most important for compounding machines is pricing
power, a demonstrated history of raising prices above the rate of
inflation. This can be difficult to find
because a lot of companies don't like to say that they're raising
prices incredibly fast on their customers.
That's not a popular thing to say, So you have to do a little
bit of digging, a little bit of research.
Simply look at their core products, look at the pricing of
their core products over time, and compare that against the
rate of inflation. These companies will have
histories of raising prices far above the rate of inflation.
Whether you look at MasterCard or Visa, whether you look at S&P
Global or Moody's, whether you look at Adobe or Netflix, all of
these companies have raised the prices far above the rate of
inflation. And they've done that while
seeing little pushback from their customers.
Now if a company raises prices but they lose a lot of customers
and competition eats away at their market share, that is not
pricing. Power.
Pricing power is strictly the ability to raise prices above
the rate of inflation without losing customers to competition.
Now, the type of companies that have a lot of pricing power are
ones that have few competitors. The fewer the competitors, the
easier it is to raise prices. This is why companies like Visa,
MasterCard can raise prices every single year.
If there was 1000 different credit card issuers, then it
would be much more difficult for them to raise prices.
So few competitors leads to more pricing power.
Also, if they have a lot of upside in the value of their
product or service, if people like their products so much that
they're willing to pay a lot more for it, that gives them
flexibility to raise prices in the future.
So after finding companies that are deeply entrenched, that have
high barriers to entry, we want to find companies that have
pricing power year after year after year.
Now the next attribute we're looking for after pricing power
is operating leverage in the business model.
Operating leverage is a financial term.
To some people, this may seem complicated.
It's actually an incredibly simple concept to understand.
It simply means that the company has fixed costs.
That stay fixed over time. And then variable revenue, as
the revenue goes up, their margins get higher and higher
and higher. We can look at a few examples.
Let's take a look at MasterCard. MasterCard is a great example of
a company that has a lot of fixed cost to run the initial
business and then a lot of variable and growing revenue
creating operating leverage in the business.
And we can view this by looking at the profit margins over time.
Look at 1998, the profit margins were 2% overall.
It was very low and very volatile while they were scaling
up, but then they reached scale in 2007.
The operating leverage kicks in, The profit margins jump up to
27%. Then what do we see over time
with the mechanics of this business?
The costs are more fixed than the revenue.
The revenue is outgrowing the cost, which makes the profit
margins go up over time from 36% to 45%.
If I draw a line through this, it looks like this growing
profit margins over decades of time.
This is a company where every incremental dollar they earn,
the profit margins get a little bit higher.
MasterCard is a clear cut example of operating leverage.
Another company that has operating leverage is Netflix.
This is a company where they have an enormous amount of fixed
costs creating their content. Every year costs around 16 to
$17 billion. They have to pay for that every.
Year that they want to create new content.
So they have this big fixed cost every year, but their revenue is
variable and their costs don't scale perfectly with their
revenue. We can look at their operating
margin. In 2016, it was 4%.
In 2023, it was 20.6%. Their profit margins as well go
up overtime. We see this nice trend year
after year after year of their profit margins increasing, their
operating margins increasing. This happens the most when a
company has operating leverage. One of the nice things about
operating leverage is that analysts have the most.
Difficult time getting this metric accurate.
Meaning that if you find a company that has operating
leverage, odds are that the analysts have not accurately
accounted for this company, which typically means it's
harder for them to accurately price these stocks and there's
more potential upside. Now with operating leverage, I
also want companies that can scale for a long period of time.
Operating leverage doesn't matter if the total addressable
market is very small. So we're looking for companies
that have a long runway of a large total addressable market
to scale into. This is very important.
I've given the example of MasterCard and Visa as companies
that have operating leverage well.
MasterCard and Visa also have the benefits of having global
scale. Everyone, everywhere can benefit
from digital payments. If you're in India, If you're in
Europe, if you're in East Asia, if you're in Japan, you could
benefit from Visa, MasterCard. Think about the global scale
potential of Netflix. This company offers
entertainment. Who in the world doesn't like
entertainment? So Netflix's runway of growth,
their total addressable market, is absurdly huge.
It's basically planet Earth, aside from the highly regulated
parts like China and Russia. Now, after operating leverage,
compounding machines have what's called organic growth.
Organic growth is different than just simple growth because a lot
of companies try to grow by buying other companies.
They're paying up for their growth.
You may notice in My Portfolio that I don't have any
pharmaceutical companies. Why do I not have any
pharmaceutical companies? Well, for one thing, they grow
inorganically. They don't grow by building out
new drugs and tools and services for their customers.
They grow by buying other, smaller pharmaceutical
companies. They buy growth over and over
again. That's how the entire industry
works, is by acquisition. The companies that I own grow
primarily through increasing prices and gaining more
customers, in the case of Texas Roadhouse and Chipotle.
They grow by increasing prices and opening up more locations to
get more traffic. Most compounding machines are
also capital light. We have a strong preference for
companies that have a low amount of fixed costs.
They have low R&D and CapEx relative to their revenue.
The more capital light they are, the better.
And then finally, one that I believe is underrated by a lot
of investors is having smart capital allocation.
But if you find a great company that is above the fold, they
will spend their excess cash on buybacks, they'll spend their
excess cash on dividends, they'll spend their excess cash
on tuck in acquisitions, tuck in acquisitions, are buying small
companies that only benefit their core business.
They don't do it for growth. They do it to benefit their
already enormous core business. Smart capital allocation by the
executive team can make or break a great company.
So off to the left, there are these attractive attributes of
compounding machines. Now we get into the unattractive
attributes, things that we actively want to avoid in our
investments. First of all.
Companies that participate in risky reinvestment.
They have high amounts of CapEx and research and development
with unpredictable returns on that CapEx and research and
development. This is the pharma industry.
The pharma industry puts a lot of money into the development of
new drugs. That is a very high risk
venture. Those new drugs have to go
through a series of clinical trials, they have to go through
testing. It can take up to 20 years for
those new drugs to be approved for use to the general public
and then even. After it's approved, there's
always room for lawsuit or getting recalled, so the
riskiness in the reinvestment is a big aspect that I want to
avoid. I want companies that when they
put money into the reinvestment, it's very predictable.
They know the return they're going to get before they make
the reinvestment. Costco knows almost exactly what
to expect when making the reinvestment in opening up new
warehouses. They have 800 warehouses of data
to measure it against. It is predictable.
It is consistent. It is not risky.
So how predictable the ROI is on their investments are a big
thing. And in general I like companies
that don't have to do a great deal of reinvestment to earn
high returns. Now the other thing we're
looking to avoid are moon shot bets or vanity projects with
high chances of failure. Capital allocation from the
executives is a huge part of finding a compounding machine.
You entrust the executive team to use that money wisely and I
avoid companies that have undisciplined use of cash flows.
It's an unattractive attribute if the company issues too much
compensation to the employees and executives.
We've all seen examples of this. The ritzy tech companies where
they pay their employees hundreds and hundreds of
thousands of dollars in stock based compensation and in their
salary. They have incredibly fancy,
extravagant work. Parties.
They have celebrities close by in the offices.
They will try to justify it as improving morale.
Retaining employees doing the right thing for the talent of
the company. In reality, it's undisciplined
use of cash flows from an executive that prefers to spend
the money on what he or she wants to spend it on, rather
than what's best for the shareholder.
Companies like S&P Global MasterCard, Moody's, and Intuit
have done so well, in part because of their culture, their
continual discipline, use of cash flows and their incentive
structure, the retainment, the rewards, and their culture.
On the other hand, there's many companies ran by executives like
they're in a Country Club. They want to spend the money on
themselves. They're unwilling to return the
excess cash back to shareholders through buybacks or dividends.
When I rank order the quality of companies, it's a big demerit.
When a company has undisciplined use of cash flows, the other
attribute we want to avoid is unpredictable cash flows.
Economically sensitive cash flows.
Companies that are financial institutions like JP Morgan or
Bank of America are so big at this point that they're less
sensitive. But smaller regional banks,
small fintech companies, Pharmaceutical industry, heavy
industrials, and construction, all of these are economically
sensitive and have huge booms and busts.
We also want to avoid companies that have unpredictable cash
flows because they're discretionary products or they
sell large durable goods that the lifespan can be extended
during difficult times. And then finally, what I like to
avoid is dual class share structure.
I believe this is a risk to the management of the company.
If the owner has a different class of share that has more
voting rights than they do ownership of the company, they
then have a disproportionately high voting right to their
ownership. Which means that they're not as
invested in the company as the rest of the shareholders, but
they have more voting rights than everyone else.
This doesn't align the incentives of the executive with
the rest of the shareholders. They should both have
proportionate ownership of the company and the owner.
In these cases where they have disproportionately high
ownership, are not beholden to the majority of shareholders.
They can do whatever they want, which brings in additional.
Risk. So those are the unattractive
attributes, the things I want to avoid.
But overall, this is the CHEAT SHEET for a compounding machine.
This is what I truly believe defines the best companies in
the world against the worst. Ones the qualities that we want
to have against the qualities that we want to avoid.
Now once we go through the overview of a compounding
machine, I also go through a few specific examples of some of the
most important financial metrics of a compounding machine.
For example, the revenue, the top line of the company is
incredibly important. We should look for companies
that have strong top line organic revenue growth.
Costco is a compounding machine that's shown consistent revenue
growth, primarily through price increases.
Increases in new customers and opening new locations.
AT&T on the other hand, which we can see the revenue right there
is not a compounding machine. Its growth has been inconsistent
and in large part due to major acquisitions outside of its core
business, so. At.
First, appearance. Underneath this revenue line, it
may look like AT&T is growing. In fact, they just have these
sporadic huge jumps. Well, that's not really
accurate. If we went over a timeline of
what's happened with AT&T, they did different acquisitions.
They bought things like DIRECTV, they bought Warnermedia.
When AT&T financed these deals, we can see the heavy toll this
took on the company. We can first look at the cash
and debt of the company. Qualtrum shows the cash along
with the debt. Now if we got rid of the debt,
the cash is sporadic over time, but the debt's the real story
here. Look at the massive amount of
debt. It is dramatically more than the
amount of cash. They are heavily indebted
company. But where did this all start?
Right back during that first acquisition in 2006, boom, the
debt doubled. And this is long term debt which
is more risky. They're not paying this off
fast. They're holding on to this for a
long period of time. Notice when they take on this
debt, they never pay it back. Now the debt stays pretty flat
and then boom, they do another acquisition.
That acquisition cost them even more debt, more additional
interest payments on the shareholder, more of a tax on
the future profits of the company.
Then they raised debt further and further, reaching a high of
$180 billion. This massive, staggering pile of
debt that the company has to deal with.
That sounds bad, right? That sounds like it wasn't worth
it because of the amount of debt they had to raise.
Well, that isn't the half of it. They also diluted the
shareholder for this revenue. If we go down to the shares
outstanding, we can see the other half of this picture.
Every incremental acquisition, they did increase the share
count. In fact, it nearly doubled it.
They went from 2 billion to 3 1/2 billion, then they went from
4 billion here up to 6 billion, adding on another $2 billion of
share count. Then when they started doing
buybacks, which was the smart thing to do, they halted the
buybacks to do more acquisitions, increasing the
share count over and over again. So when we talk about organic
growth, we're talking about a very important concept.
You want companies that have nice consistent organic growth,
not lumpy growth that has been purchased through major
acquisitions that take a toll with the amount of debt and with
the amount of shares. Costco is an example of a
company that has had that nice organic growth.
When I look back through Costco's history, they have not
done hardly any acquisitions. They did a couple really early
on, but almost all of their growth comes from price
increases on their membership, growing more members per store
and increasing the amount of store count globally Overtime.
That organic growth leads to a nice growth chart growing
overtime that most importantly doesn't have a toll on the
investors. Costco in this respect is the
example of a compounding machine.
AT&T is not the next core financial metric we can look at.
One that I pay attention possibly more than any other, is
the free cash flow of the company and specifically the
free cash flow per share. Compounding machines grow their
free cash flow per share over time on a steady and predictable
basis. Other companies like Citigroup
have unpredictable and low growth rates with their free
cash flow per share. So looking at the history of a
company, this is a telltale of what the quality of the company
is. And companies like MasterCard
are very, very difficult to find.
Ones like Citigroup, they have this type of sporadic free cash
flow per share. You can find these companies
everywhere. We can see this clearly
illustrated through all different examples.
We have Visa as well as MasterCard.
We go over to the free cash flow chart and we look at the free
cash flow per share. The free cash flow per share is
a little bit different because it factors in some dilution of
the company when they buy back or they issue more shares.
So you get to see how much free cash flow your shares have on a
per share basis. And Visa, like MasterCard are
not perfectly consistent every day.
That's not realistic for a company that has some variable
expenses and taxes. But over time, you can see the
trend, it is mostly a consistent overall trend of growing the
free cash flow per share. And these companies that are
very high quality do this on a very, very fast pace.
For the past five years, they've grown.
There's 12% per year that is not counting in dividends.
So that's an additional aspect of return.
This is just the core intrinsic value of the company growing
over time. We can also look at Costco as
another example of a company that's doing this right.
You can see the free cash flow over time.
If we filter by the per share count, it looks similar.
Costco keeps their share count relatively steady while they
grow their free cash flow and we can see the free cash flow per
share over time. It's not perfectly consistent.
Visa, MasterCard have a little bit more predictability here,
but you can see the overall trend in the past decade.
You can see this even clearer. Costco on an overall basis is
growing its free cash flow per share on a relatively consistent
basis. Companies like Citi.
On the other hand, financial institutions, pharmaceutical
companies, airlines, they have 0 consistency with their free cash
flow or their free. Cash flow per share, even
zooming in over the past five years.
There is no pattern here. There is no consistency.
There's no predictability. If you're buying this company,
you have no clue how much money you'll earn over the next year.
So we want to find companies that have the type of history in
this metric that MasterCard has, or as close to it as we can
find. Now the final.
Example of a compounding machine.
A trait that I see similar in virtually all of them is the
shares outstanding over time. This is such an important factor
to look at because when you're looking at buying a company,
you're buying it on a per share basis.
You own shares of the company whether or not the company buys
back shares or issues more shares.
That has a huge impact on every per share metric, especially
earnings per share and free cash flow per share.
I have here 2 examples. We have the example of Moody's,
which is a company in My Portfolio.
It's my newest holding. I believe it's a very strong
compounding machine that meets almost all of these qualities,
especially the shares outstanding going down over
time. Moody's uses its excess cash to
buy back shares, which increases its free cash flow per share and
reduces the total shares outstanding over time.
Other companies like the one pictured here JetBlue, dilute
shareholders by issuing more shares to buy new businesses and
pay stock based comp for their expensive pilots and the
expensive staff they need to have because they have all these
costs and they don't have other ways to pay for them.
They're continually issuing more and more shares That may grow
the market cap of the company, but it does not help the
investor. The shares outstanding is so
important to look at. Now, it's true that some
companies have a history of issuing shares when it makes
sense, when they're growing fast and when they're building value
for the customers. But over time, the type of
companies that typically do the best are ones that transition to
a steady state of buybacks. They don't do it based on price,
they don't do it here and there. They do buybacks all the time.
Apple started doing this in 2013.
Tim Cook did not try to time the market.
He just started pulling that buyback lever using Apple's
incredible cash balance to start to buy back shares.
Dollar cost averaging over time. Doing so has reduced the total
shares outstanding from the peak in 2013 of 26 billion all the
way down to current day 15.6 billion.
This amount of buybacks is why the stock price has increased
faster than the market cap. It's why investors that have
owned Apple have done so incredibly well, even more well
than the company has grown. They've increased the earnings
per share, the free cash flow per share at an absurdly high.
Pace and you can see the staggering results this has had
since 2019. Five years ago Apple's up over
400%. I bought my first shares in
Apple in 2017. It's been the biggest winner
that I've owned by far. Buybacks are not the only
important part of a stock, but companies that are compounding
machines almost always have this trait where they return the
excess cash primarily through buybacks and then through
dividends. So I hope this part works as a
guide for which companies to pick.
This is all part of step one, which is stock selection.
Remember that this is only one of the three parts of my
investing philosophy. After stock selection, we move
on to temperament. Temperament is the personality
traits that determine how someone will react given certain
circumstances. So this is basically a word to
describe. If you pick someone up and put
them in a certain specific circumstance, what do you think
they'd do? What would be their reaction?
What would be their temperament? And a lot of this is genetic,
but we do have control over our temperament.
I fully believe that this is something that can be learned
and improved on over time. Some of these traits are
conducive to successful investing, while other traits
are detrimental. Not all temperament is the same.
Controlling your temperament is key to long term investing
success. So we've heard this before with
people like Warren Buffett and Peter Lynch that controlling
your temperament is incredibly important.
But what does that mean? Here is what I outline as having
good temperament for investing or bad temperament for
investing. Now, I'm not saying that these
are good and bad morally. I'm not saying that people that
have these traits on the left are better than these people
that have these traits on the right.
I'm speaking specific in terms of application of investing.
If you have the traits on the left, you'll be a better
investor than if you have the traits on the right.
That is a simple fact. The traits that good investors
have with their temperament is that they do not get excited
when the market goes up. They do not get sad or anxious
or depressed when the market goes down.
They're patient and OK with being bored.
They don't need to fit in with the pack.
They have no emotional attachment to stocks.
They're systematic, calculated in their decision making during
distressed times. These are the examples of
excellent investors that have control over their temperament,
that stay consistent to their investing strategy.
Bad temperament for investing are people that enjoy gambling.
Many people out there enjoy excitement.
They want something new and exciting to happen.
They like rolling the dice. That is a horrible trait for an
investor. Investors like predictable
returns, not exciting, unpredictable returns.
Bad temperament is being excited.
When the market goes up. You get happier, you get more
enthusiastic. That is something that naturally
happens to most people. But we need to control this
temperament. We can't get excited when the
market goes up. We should be excited when the
market goes down, when we can buy companies at better prices.
Bad temperament is having anxious and bearish views when
the market goes down, the exact opposite of what we should do.
2022 was an excellent example of people becoming bearish after
the market went down. Remaining excited and
enthusiastic during a time period where we're in a two year
bear market becomes very difficult.
It's much easier said than done when the market's making all new
lows every single week. When you have forecasters on
CNBC saying that the end is there, that the economy's
tanking, the companies can't post profits, that everything's
different now. That creates anxiety, depression
and bearishness. Avoiding that temperament and
being part of the pack with other people that are bearish is
imperative in investing. Bad temperament is making buys
out of the fear of missing out. You see stocks going up, the
Kathy Wood Ark investments during 2021.
Seeing those go up creates the fear of missing out and a lot of
people have greed take over when that happens.
They see a stock going up yesterday and they want to be
part of it tomorrow. Bad temperaments also making
sells out of Fair future losses during declines.
Seeing the market go down every single week, seeing your account
become smaller and smaller and smaller, losing 10s of thousands
of dollars by the day, can become incredibly distressing.
You may sell out of fear of future losses.
You may sell to preserve your current capital.
You may become convinced that selling now is a thing to do.
But good investors control their temperament.
They do not buy out of fear. They do not sell out of fear.
They buy based on the merits of the company, the valuation, and
the future cash flows. Bad temperament takes comfort in
following the crowd. You should take neither joy nor
comfort in following or avoiding the crowd.
Your decision should be made independent of the crowd.
They should be made based on your own research, your own
judgment, your own calls. Many of the best buys that I've
made have been specifically avoiding the crowd.
When I first started buying Costco, it was not a popular
investment on YouTube. There was literally no one else
talking about Costco. I couldn't find another video
made about it. I invested in Costco based on my
own conviction and on research, determining it was a quality
company that I wanted to own. With the size of the viewership
here, every investment that I've made has had a notable amount of
pushback. It doesn't matter what the
company is, there's always a number of people that harshly
disagree with the decisions I'm making.
I could give you the example of Texas Roadhouse, which has had
incredibly good market being returned since buying it, but I
received a lot of comments of why am I buying this company?
That makes no sense. I can buy a different company
than this one. I've been invested in Apple for
years and years and years. The entire time I've been
invested in this company, I've received enormous pushback that
the best days are behind it, that it's not going to have any
alpha. When Apple has turned out to be
one of the companies with the most alpha over the past five
years, an investor needs to make their own decisions, make their
own investments, and hold true to their own convictions.
You should not be persuaded by whatever's popular on Twitter,
whatever's popular on YouTube. You should be buying the
companies that you've done your research in and that you know
our great investments. But if you can exercise
discipline and control over the way that you behave during
certain market events, you'll have a much better outcome.
So we've gone over Section 1, which is stock selection,
identifying what a compounding machine is, examples of it.
We've also gone over temperament, staying disciplined
on emotional, patient and long term focused.
Now we get to the final part which is portfolio management.
This is something that's not talked about that much, but it's
actually very important. This has aspects of position
sizing specific by criteria, specific cell criteria, and
intrinsic value estimates. The first concept we'll talk
about is intrinsic value. This is estimating the fair
value of a company or the value at which the company will have
market average returns. If a company is trading under
its intrinsic value, that means the company's undervalued, it
means that if you buy it now, you'll beat the market.
If the company's trading over its intrinsic value, well, that
means that company's overvalued and you'll likely have
underperformance. So intrinsic value is a gauge by
which we value the actual company based on real
fundamentals of the company. Intrinsic value is determined by
ranking companies by free cash flow growth and predictability.
Those are the two major variables in determining
intrinsic value, free cash flow growth and predictability.
Then we discount them by determining the appropriate free
cash flow yield those companies deserve to trade at.
So we look into the future and see what this type of company
deserves to trade at with its free cash flow yield based on
the free cash flow growth and predictability.
Now a lot of investors like to put a finite number on this, but
don't be mistaken, Everything behind this are guesses.
They're guesses that are informed by information and
we're trying to make our guess as accurate as possible.
Even Warren Buffett and Charlie Munger have said many times that
intrinsic value is ultimately A subjective guess and you try to
get as close as possible. The more accurate and well
researched the assumptions, the more accurate the intrinsic
value estimate will be. So we want good information to
go off of. We want to study the financials
of companies. We want to know what to expect
with their growth in the future. Now this bottom part here I
outlined the drivers of intrinsic value and I think that
this is incredibly important. When we look at the growth of
intrinsic value over time, it's primarily because of three
different factors. First of.
All. Organic revenue growth.
We've already gone over what organic revenue growth is.
We want to see strong top line organic revenue growth with a
company. We want to see strong free cash
flow per share growth with a company over time.
And we want to see predictability improving.
That is the third driver of intrinsic value.
Predictability improving means that the durability, the Moat,
the company itself is becoming more entrenched, more
dominating, more monopolistic, more predictable.
If the company's being beaten up by competitors, if there's new
products stealing customers, if the company's having lots of
employees leave and things go wrong with it, that lowers the
intrinsic value because the company is now less predictable.
So we need predictability in the mix here.
And that again is a judgment call based on studying the
company. If these three factors go up,
the organic revenue growth, free cash flow per share growth and
predictability, the company's intrinsic value is increasing
over time. My estimates of intrinsic value
are informed by the history of the company assumptions over the
financial metrics, projections about their future growth and
then what I believe the company will trade at in the future,
what their free cash flow yield will be.
Based on that, I can get an idea of what their annualized return
will be. Once I've done that, along with
studying the company, I build a range of what I believe the
intrinsic value is, where I believe the company's overvalued
and will have subpar returns and where I believe the company's
undervalued. My goal is to always buy
companies with a margin of safety close to the undervalued
category. Now there's different methods to
calculate intrinsic value. I don't believe that this is the
ultimate truth, but I believe it's an accurate way to gauge
it. And overall, these three metrics
of organic revenue growth, free cash flow per share growth and
predictability, I do believe are the most important attributes on
tracking ongoing intrinsic value changes.
Now finally we get to the portfolio management segment
where we talk about buying and selling.
I believe strongly that successful outperformance of the
benchmark is most likely to occur with a portfolio
concentrated into the highest quality companies.
Buying losers, which is something nobody wants to do,
can be usually avoided by following a discipline buying
and selling strategy. Step one is buying only
compounding machines. That is a hard rule to follow.
Many people sacrifice buying compounding machines for
different companies for all different types of reasons, or
they start to bend the rules a bit and they lower the overall
quality of their portfolio. I believe I'll have better
performance by strictly adhering to only investing in the highest
quality companies. So properly identifying and
selecting the stocks that are compounding machines is the
first step to making a new buy. The second one is buying when
they're trading below their intrinsic value estimates.
So after you study the company, you've run through the
scenarios, you've looked at the valuation and the ranges that it
trades at and you've determined an intrinsic value.
You want to buy the company when it's a bit below that intrinsic
value to give you a margin of safety.
These are two steps to buying really good companies and buying
them at good valuations. The things we want to avoid is
do not sacrifice quality for valuation.
If you're buying high quality companies, there will at every
given time, every single day, every minute of the day, be a
different company at a lower valuation that is inherent with
the quality that you're buying. There's always going to be a
cheaper company to every MasterCard trading at a 34 PE.
There's an AT&T trading at A7 PE.
Like the old phrase, in many cases you get what you pay for.
Trading quality for valuation is a recipe for disaster.
Over time, your portfolio will become lower and lower quality
until you own a lot of subpar companies trading at low
valuations because they have distressed business models.
This is not the type of investing that Warren Buffett
does or Charlie Munger. They wait to buy grey companies
that have traded below their intrinsic value.
The majority of gains in the market, the majority of
companies that push the index up higher and higher and higher are
very high quality companies. They're not the ones trading
with distressed business models. Now another common thing that I
believe is important to avoid is do not add to companies buying
more of your companies in your portfolio if they're becoming
less predictable. If you already own a company and
you've done initial research on it, but it's running into
distressed circumstances, it's becoming a little bit less
predictable, You can see the Moat fading a bit.
Those are not companies that I would add to.
I only add to positions where I believe the Moat is as strong or
even stronger than the day I first bought the companies.
I like adding the companies that are getting stronger, that are
winning more. Their durability is better than
the day you bought it. I don't like adding the
companies where they're becoming weaker over time and I can see
the fundamentals fading. So that's another thing that I
avoid. And then we have selling.
This is one of the most difficult parts of investing is
knowing when to sell a stock. There's three different areas
where I think it's good to sell a stock, three different
categories. One of them is when you made a
mistake on your original analysis.
Simply put, if you just missed something with your analysis and
you realize that there's something that's wrong with the
company that you didn't catch the first time you bought it, I
will admit the mistake in my analysis, say that I missed
something and exit the position. Now, hopefully if you've done
your job right, you can avoid these type of mistakes with
analysis, but nobody's perfect. If we do make a mistake with our
analysis, if I get something wrong that I missed and it
changes my thesis, I'll exit the position.
The other bucket that I believe selling falls into, which I
think is more common, is sell in the company no longer meets the
quality standards the originally bought the company for.
If you buy a company because you believe it's a compounding
machine, you believe it meets all of these quality
characteristics. And then as time goes on, the
quality decays, the company becomes weaker.
You can see a lot of missteps by management.
They're no longer acting like the company that you first
bought. That's a time to sell.
It's tough to sell companies in this condition because typically
they go down in price and you want to hang on for recovery.
We don't want to lose money, but in most cases, holding on to
subpar companies that are going in the wrong direction is not a
good way to get returns. Rather, sell that company and
invest it back into a company that's doing everything right.
So even if a company that I've done research on, I've made
videos about, and I'm bullish on at one standpoint, if that
company decays in its quality, if I no longer believe in the
future and it no longer meets my standards, I will replace it.
For one of the many companies on my watch list that are doing
everything right, there's a handful of really good companies
to invest in, so I don't need to hold any ones that are subpar.
And then finally, the last bucket of sells I believe falls
into this category where you sell a company because Simply
put, there's just far more of an attractive opportunity.
Now, this one's a tricky 1, because if you have a portfolio
of compounding machines, in most cases it's good to hang on to
them until the quality goes lower.
But when you have a company that offers an incredibly attractive
opportunity while meeting the high standards of quality you're
looking for, you want to raise capital for that opportunity.
In some cases, you can dig into your portfolio and find the
least attractive investment opportunity in it.
To put that money into the most attractive opportunity, there
should be a wide discrepancy between the attractiveness of
the opportunities. If they're close, then there's
no reason to take the tax burden of trading one position for
another. And this all summarizes my buy
and sell criteria. So like I said, this
presentation is meant to be a starter pack for my investment
philosophy to boil down all the ideas that I have into one
simple presentation. It's not perfect and I'll be
making additions and changes to it over time, but this version
of this investment philosophy presentation is included for
free in the PIN comment below. So you can go to the pin comment
and download it if you want. Share it with people if you want
them to learn about this type of investing and I really hope you
enjoyed it and I hope you get value from it.
If you do want to try out, Qualtrim this website that shows
you all the fundamentals of a company.
You get all this information as well as a watch list in the
scenarios tool in a portfolio tracker.
A lot of different things that we're building.
This is $10 a month. It's included as part of the
Patreon membership with exclusive content and a Discord
community, so you can try that out with a free trial if you
want. There's also going to be a link
in the description. I'll have more videos out soon
on this channel with commentary on the latest news, earnings
report and a lot more things on the market and my investing
strategy. So make sure you subscribe to
the channel if you want to see that and I'll catch you in the
next one.