The Investment Perspective – April 2021

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

The Business + The Business = Investing Success

Most people want to succeed as an investor (in my experience, even those who say they don’t like investing). Not everybody does. There are lots of reasons why this is so.

One of the many reasons is that people are humans and subject to colouring successful investing methodology with their own way of doing things which often involves subjective behaviour.

Simply, most investors at one time or another become overconfident when things are going well and scared when they are not, which seems to be when market conditions suddenly change.

That is why, if we are looking for investing success, we are likely best to engage strongly with the proven methodology.

It’s the how … not the where

Most people look around for investments as though, where they invest will help them to be successful long term. People can be successful with this approach however, it relies on lots of things going the right way and is not something that can be replicated at will. It leaves a lot to chance.

When we engage with a proven methodology, we have the how of investing. Reliable. Successful. The way investing is supposed to be.

The Business

The first winning approach to successful investing in productive assets is to invest in the business and not the stock. I know, you’ve heard this before from me. Although it is not main stream, many people have heard it before. Few investors though, invest this way.

‘The business’ means that we look at our investment through a different lens.

For example, valuing a business by using the P/E ratio is not the same thing as establishing intrinsic value based on how well the business uses its capital, taking into account the underlying economics of the business.

Measuring the performance of a business by comparing this year’s profit with last year’s is not the same thing as looking at the relationship between the amount of profit earned and the capital employed to generate that profit (return on equity, return on capital).

I might be starting to sound ridiculous now, but my point is that, sheep and cows (animals), gold and silver (metals), tractors and cars (vehicles), are good examples of categories and differences that are easy to see.

Unfortunately for the uninitiated, a P/E ratio or a discounted cash flow may be indistinguishable from an intrinsic value.

Profit may look no different than profitability to those that don’t understand the difference.

Chances are, those without the experience, the knowledge and the winning methodology might be enticed by simplistic encouragement in superficial information that simply sounds good.

Investing in the business then, is a very different thing to investing in the stock.

What we are doing at WISEplanning in terms of our investment research and analysis, is quite different to what share brokers and fund managers are doing.

The business … not the stock.

And the business …

So, differentiating between the business and the stock is the first thing … the first ‘business’ (in the heading at the start).
Second thing, the second ‘business’, is understanding what it looks like when we are investing in the business rather than the stock.

We’ll take a look at a couple of quick examples and then we’ll compare two businesses, line by line.

Admittedly what follows is somewhat simplistic but hopefully it will make sense for you.

For example, we’ve already talked about the P/E ratio versus intrinsic value. The intrinsic value of the business is not measured by the P/E ratio (nor other popular stock valuation ratios such as price-to-earnings growth (the PEG ratio), price-to-book, and so on.)

This is not to say that those stock market valuation ratios are of no value. But of course, they provide a simple guideline to the possible ‘value’ of the stock – but not the business.

We’ve already mentioned also profit versus profitability.

Profit as we know is what’s left over from sales after expenses (keeping it simple).

Comparing this quarter with last quarter, or this year with last year, or with the broader industry is common practice for many investment analysts and share brokers. Again, this is not to say that it’s wrong.

It is different though to measuring the performance of the business.

We could argue therefore that comparing profit from one period to the next is the share market approach to measuring performance whereas profitability is a business measure for underlying business performance (comparing the amount of profit achieved from the resources employed to generate that profit). The ability of the business to generate profit.

Another example is a solid departure from the ‘share market’. This involves the economics of the business.

For example, the competitive advantage is a business economic as distinct from a share market ratio, although these days you may sometimes hear share brokers and fund managers talk about the competitive advantage.

The point is that the competitive advantage is all about market share and dominance and therefore profitability and growth.

A strong competitive advantage is sometimes called the moat which in simple terms means it is difficult for competitors to compete with a business with such a strong competitive advantage (like the moat around the castle made it difficult for opposing forces to get into the castle way back then).

This also means that a business with a strong competitive advantage has pricing power which therefore means the use of capital and indeed the business performance is likely better when compared to another business in the same sector (and possibly other sectors too) that does not have such a strong competitive advantage.

One thing missing

The one thing missing from the conversation so far is the trading price.

The trading price of course is very much a stock market metric and is possibly the most over worked of all. It is largely irrelevant when it comes to, for example, assessing underlying business performance or discussing the underlying economics of the business.

The trading price is very much linked to the transaction rather than the business (which is why it is not part of the conversation).

Paypal and Zoom

Just for fun, let’s take a look at two businesses that WISEplanning like.

What follows is a straightforward comparison of these two businesses rather than a solid explanation of underlying business economics …

The above comparison between Paypal and Zoom may offer limited clarity around the importance of the underlying economics of the business as it overviews the financials and to a limited degree the underlying economics of each business for comparison purposes.

It is interesting to note that Zoom is an obvious disruptor of communication in the way things are done in the office and also PayPal is an emerging disruptor in terms of the way they are developing an ‘increased share of wallet’.

PYPL are developing on line ‘modern’ banking, lending and other financial services which may increasingly challenge the traditional banking system through their payments system and their increasing database, to whom they can market a variety of financial products to. PayPal represents a small but growing threat to traditional banks which may support ongoing growth (in addition to their existing payments business).

Zoom is obviously disrupting the housing of staff and the way business is conducted. Zoom represents arguably a more efficient way to communicate with staff, customers, prospects and suppliers. They are also investing in other initiatives (e.g. across the internet medical applications).

The market generally considers Zoom a beneficiary of COVID-19 and therefore less appealing moving forward. Zoom has sound business economics and may offer investment opportunity for those happy to increase exposure to Zoom as the price declines through this phase of market ambivalence taking a longer-term view around the underlying economics of the business and future innovations.

The Economics and the Financials

The share market is focused mainly on the financials.

At WISEplanning, we are focused on the financials too but more so on the economics of the underlying business because, well, we invest in the business.

It would be nice to think that investing is as simple as a traffic light system or a paint by numbers approach that is easy to understand, or a mathematical formula.

Indeed, investing can be simplified to formulas and process however below those formulas and process exist value judgment which, at a deeper level is less easy to quantify.

After all, experience and value judgment are not a mathematical formula.

“The share markets are filled with individuals who know the price of everything but the value of nothing.”

Philip Fisher