Paul Vs The Market

I gave an overview of my investing style in “What is Paul Vs The Market?”, but I thought it might be helpful to do a deeper dive. For a few months now, I’ve tried to hone in on the key attributes in terms of what I look for in companies that I invest in. There are always things unique to certain companies that make me excited about them, but I was looking for factors that I wanted to see present in every company, no matter the industry.

Ultimately, I managed to boil it down into four distinct attributes that I look for. Clearly, in order to make these attributes memorable, I would need a catchy name for them. Who likes to be overly clever and force things into acronyms and has a name that has four letters? Two thumbs pointing at this guy.

Below, I’ll explain the four factors that I look for in a company and for each, I’ll give two companies as an example. The first example is a company that I have owned (and maybe still do) which I feel best exemplifies that specific factor. The second example will be a company that I owned (and probably no longer do) which turned into a mediocre investment because it failed in that area somehow. I’ll be using this system going forward to score investment ideas. I will be ranking each company by the four attributes on a scale from 1-5 and totaling it up for a final P.A.U.L. score.

Let’s go.

P is for “Protected”. Since I believe in investing in companies over the long term, I like the businesses that I invest in to have a durable competitive advantage. This can take many forms: It can be a network effect, where a network gets stronger the more people that join it. Maybe it’s a software ecosystem that encourages people to stick to a certain company’s products instead of buying a competitor’s. It could even be as simple as being in an industry which has a high cost of entry. It’s a lot more expensive to create a new airline from scratch than it is to make a hot new mobile app.

There are some competitive advantages that I don’t put much stock in (pun intended), though. I’m always leery of “brand” as a competitive advantage, because all it can take is one bad news story to ruin a previously sterling brand. I’m similarly wary of government regulations as an advantage because all it can take is a new administration for the entire political landscape to change and for a previous advantage suddenly disappearing or even becoming a disadvantage.

Example: Twitter (TWTR) is a good example of a company that has a strong competitive advantage because of its network effect. People want to be on Twitter because lots of their friends or famous people that they find interesting are on Twitter. As more people join Twitter, it becomes more compelling for the holdouts to join up as well because there’s a better chance that somebody they find interesting will be there. A competitor is hard to start up because nobody wants to be on a social network that nobody else is on.

I’ve yet to find a restaurant that has a strong and durable advantage that differentiates itself from its competitors over the long term. I learned that the hard way with Chipotle (CMG). I thought they had a brand and a loyal customer base that gave them a leg up on their competitors. But it turned out that once people were scared off by some stories about people getting sick, there were plenty of other fast casual restaurants where people could get a decent burrito.

A is for “Alternatives”. Confusingly, I don’t mean alternatives in the sense that there are alternative places to get a burrito. No, this is a positive use of the term. I mean alternatives in the sense that the business has many different revenue streams that it could go after in the future and has shown a willingness to pursue them. Some of my best investments have been in companies whose businesses have changed drastically since their founding. While there’s certainly a danger of a company wasting money trying to expand to an area outside of its core competency, I think it’s far more dangerous for a business to get complacent and rest on its laurels.

I get nervous when a company, no matter how dominant, is overly reliant on a single business line, with no sign of being willing to try branching out. That’s a prime recipe for turning into a dinosaur that will get disrupted by a newer, more agile competitor. A company that has stopped trying to innovate to me is a company that is just inviting competition. Alternatives also means not being too reliant on a single customer. When a single customer is responsible for the bulk of a company’s sales, it gives them too much negotiating power over them.

Example: To me, Amazon (AMZN) is the king of being unafraid to try new things and reinventing itself. They started out only selling books online. Then they moved into selling music and movies. Now, it’s almost impossible to count all the different things Amazon does. They’re a leader in cloud computing with Amazon Web Services. They’re in the hardware space with the kindle, kindle fire products and alexa enabled products like the echo. They do streaming video. They have physical grocery stores thanks to the Whole Foods acquisition. It’s mind-boggling.
Under Armour (UA) is an example of a company that tried to make bold moves into new areas with its connected fitness initiative when it purchased a variety of apps like MyFitnessPal and Endomondo. It’s an initiative that seems to have largely failed so far, and now Under Armour is back to being “just” an athletic wear company. Under Armour is a good cautionary tale that it’s not just about taking chances, but also being able to succeed on some of those chances taken.

U is for “Understandable”. Many of my worst investments can be traced back to businesses that I either thought I didn’t have to understand, or thought I did understand but really didn’t. The less that I understand a business, the more that investing in that company feels like gambling, and I prefer to restrict my gambling to the lowest minimum bet blackjack tables in Vegas. Put simply, if I don’t understand what a company does or what gives it a competitive advantage, I can’t be confident that it will outperform the market.

Examples: All things considered, Activision Blizzard (ATVI) is a relatively easy company to understand. They make the majority of their money by selling games, whether to retailers like Gamestop or directly to consumers by selling digital copies. They can also make money by selling downloadable digital content for existing games. That doesn’t mean that Activision Blizzard’s revenue will always be so easy to understand, though. In recent years they’ve begun dabbling in both movies and eSports, which could complicate their business in a hurry.

I find pharmaceutical companies much more difficult to understand. It’s hard for me to feel like I can make any kind of educated decision on which drugs that a company is working on are more promising than others. At one point, I had read articles about how Ionis Pharmaceuticals (IONS) had a deep pipeline filled with promising drugs, but I couldn’t at all explain why their pipeline was better than any others. As a result, when some of those drugs faced setbacks during trials and the stock dropped, I felt helpless in deciding what to do next and overly reliant on the opinions of others. That’s not a position I like being in.

L is for “Long Runway”. This might be the last letter in my forced acronym, but in many ways it feels like the most important. What do I mean by long runway? I mean the potential upside that a company has. Are they a tiny player disrupting a huge market with lots of business that they can steal from competitors? Is it a company tapping into a previously under-served niche? Is it creating a whole new market? How many potential customers are there for this new product or service? If the domestic market is getting overly saturated, can they expand overseas? I get excited seeing companies that only have tiny slivers of market share because it provides them so much opportunity to grow.

Examples: Redfin (RDFN) is a great example of a company with a potentially huge runway ahead of it. As of the second quarter of 2018, they only have 0.83% market share of U.S. existing home sales by value. That’s incredibly small. They could grow 50% a year for the next 5 years and still have under 10% market share. I like seeing that potential in front of them.

Starbucks (SBUX) on the other hand, is already so ubiquitous in the United States that people joke about them opening a Starbucks inside another Starbucks. Their market share among coffee shops in the US is around 40%. There do have some opportunities for growth overseas and in the home market, but their runway looks a lot shorter than Redfin’s.

What do you think?

That, in a nutshell, is the system that I use for evaluating companies to add (or remove) from the Freedom Portfolio. What do you think? Questions? Comments? Suggestions for improvement? Let me know! I look forward to hearing from you.