When thinking about investment opportunities, try these three frameworks.
I borrowed these from Warren Buffett, Peter Thiel, and Geoffrey Moore.
Important: These frameworks are helpful in evaluating the underlying business. Whether their stock will be a good investment is another question.
Good companies can make bad investments if the price paid is too high.
Warren Buffett wrote in his 1991 shareholder letter the characteristics of an economic franchise. He stated the following:
An economic franchise arises from a product or service that:
1. Is needed or desired.
2. Is thought by its customers to have no close substitute.
3. Is not subject to price regulation.
The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital.
Moreover, franchises can tolerate mismanagement. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.
In contrast, “a business” earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long.
With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.
This framework helps you answer the question: Does this company have a moat and how durable is it?
I ran Under Armour through this framework. Have a look. You can't edit the sheet, but you can copy and make your own.
Peter Thiel wrote a book- “Zero to One”. In the book, he discusses the 4 characteristics of a monopoly.
1. Proprietary Technology–Is your product or service difficult or impossible to replicate? How hard would it be to build a better search engine than Google? Or offer more products at lower prices with faster delivery than Amazon?
2. Network Effects–Does your product or service become more useful as more people use it? If all your friends are on Facebook, does it make sense to choose another social network?
3. Economies of Scale–Does your business get stronger the bigger it gets? The fixed costs of creating a product can be spread out over greater quantities of sales.
4. Branding–Built overtime by the ability of a company to deliver a product or service that, in the customer’s mind, is special and consistent.
Most businesses will not have all these characteristics, if any. However, the ultimate winners in a given vertical will likely have multiple.
Those are the companies you want to own and more importantly, hold onto(the hard part).
Geoffrey Moore wrote the book "Crossing the Chasm". The book is about how technology companies should market their products and how some companies with promising starts, fall prey to the chasm. See chart below.
Here are two main points from the book to think about:
The greatest point of peril in the development of a high-tech market lies in making the transition from an early market dominated by a few visionary customers to a mainstream market dominated by a large block of customers who are predominantly pragmatist in orientation.
Our attitude toward technology adoption becomes significant, at least in a marketing sense, any time we are introduced to products that require us to change our current mode of behavior or to modify other products and services we rely on.
In academic terms, such change-sensitive products are called discontinuous or disruptive innovations. The contrasting term, continuous or sustaining innovations, refers to the normal upgrading of products that does not require us to change behavior.
The second point is critical to understanding which companies have a chance at becoming the next Facebook, Netflix or Amazon. Those are the companies we want to find early and hold onto(the hard part).
We are looking for companies that fundamentally change our behavior.
In the mid-2000's, once a month, I used to go to a friends house to watch a movie. We would go to Blockbuster and pick one out if it was available.
One night, I walk in, and he had his computer hooked up to the tv.
What's going on?
He was streaming Netflix from his computer to the tv. We didn't go back to Blockbuster. The way in which we consumed movies and tv shows fundamentally changed. Our behavior changed and in the years to come so did the financial standing of Blockbuster.
It's easy to understand the concepts above, but executing them is an art. Investing is not an exact science.
The world changes, new technologies arrive and destroy old business models, people’s preferences change, and a dozen other variables can affect an investment’s competitive advantage.
As investors, we must be willing to adapt and change our mind. It's one of the great skills we can learn. I don’t believe it can be taught. I think it's an experience every investor must go through and hopefully learn from.
As investors, we won’t have all the answers, as new information comes in, we'll have to re-evaluate, and sometimes, we'll be wrong. That, however, is part of investing.
The key to investing in any asset class is to wait for the right pitch. I believe you can gain an advantage over others just by lengthening your time horizon.
I leave you with a quote from Charlie Munger. This quote is at the core of SAM's investment philosophy.
It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it — who look and sift the world for a mispriced bet — that they can occasionally find one.
And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time they don’t. It’s just that simple.