"Reinvestment of earnings is the key to long-term returns. The best companies have management teams who know how to allocate capital efficiently to create future value." - Philip Fisher

Welcome to part 4 of our mini-series on identifying “Quality” companies.

In our previous instalments we covered:

• The key drivers of shareholder value creation

• We then looked a how we build these into our filtering process by looking for quality companies with growing free cash flow and high Returns on Invested Capital (ROIC)

• How profit margins impact ROIC

This mini-series will progress as follows:

• Part 4 (This Section): A deep dive into invested capital.

• Part 5: Wrapping it all up with qualitative analysis.

When it comes to invested capital there are 2 main considerations to take into account when analysing he quality of a company:

1. Low Capital Requirements: We are looking for business that do not need to invest significant capital to grow i.e. they have a low capital intensity (and a higher ROIC as a result!).

2. Investment Opportunities: We are looking for businesses that can deploy additional capital into operations at those high rates of return indefinitely.

By combining both a high ROIC and the ability to deploy additional capital at high rates the magic of compounding can truly start to take effect. This is how you drive sustainable growth in free cash flows and therefore increase shareholder value over the long term.

Let’s take each in turn…

1. Low Capital Requirements (Capital Intensity)

As a reminder, invested capital consists of two main components: working capital and fixed capital. Working capital represents the funds a company uses for its day-to-day operations, such as managing inventory, receivables, and payables. Fixed capital refers to long-term assets like property, plant, and equipment (PP&E) that are necessary for producing goods or services. Together, these two elements form the total capital a business invests to generate returns and drive growth.

Ideally, we are looking for businesses that do not need much of either working or fixed capital to grow.

The lower the invested capital required to generate a given level of profit, the higher the ROIC of the business.

Let’s look at working capital and fixed capital in turn…

Subscribe now

Working Capital

Analysing working capital is crucial for understanding:

1. A company’s operational efficiency

2. A company's short-term financial health

For the purposes of exploring ROIC we are more interested in operational efficiency, but we will revisit short term financial health when we look at the “Risk” filter in a future blog post.

To review operational efficiency we will primarily look at working capital turnover and Cash Conversion Cycle.

Working capital turnover is a measure of how effectively a company uses it working capital to generate revenue. Is calculated by dividing total revenue by the average working capital for the period.

A higher number indicates the company is efficiently using its working capital to generate sales.

I like to use Working capital turnover when analysing ROIC as it uses total revenue and therefore excludes the effect of margin on the analysis which we have already investigated. However, combining a high working capital turnover with a high margin means more profits!

Below I have plotted the working capital turnover ratio for the last 10 years. For illustrative purposes I have included an additional company Freeport-McMoRan (FCX), a mining company, into the analysis.

So, what are we looking for when analysing working capital turnover:

• There are no hard a fast rule here, but any working capital turnover ratio above 2 can be considered good.

• As always, we are also interested in any trends in the numbers. Increasing numbers can indicate an improvement in operational efficiency.

Note: this comparison is even better if you can use operating working capital instead of working capital. Operating working capital focuses on a subset of specific components directly tied to the company’s operations. It looks to exclude non-operating assets such as excess cash and marketable securities as well as certain types of interest-bearing debt. Discussion on this is beyond the scope of this article and to calculate it would require some digging into the notes of the financial statements. (This is the kind if extra work that needs to be done before investing!)

But for now, we are confident that Visa has a good working capital turnover, and it is remaining relatively stable. Notably GE started off poorly in 2014 but has been steadily improving its working capital turnover in recent years which would be worth investigating in more detail. FCX has been on a slight downward trend for the period, but the absolute numbers are still ok.

To help explain the numbers we can go one step further by looking at the Cash Conversion Cycle (CCC) for each business.

The CCC is a measure of how long it takes for a company to convert its investments in inventory and other resources into cash from sales. A shorter cycle means the company quickly recovers cash, while a longer cycle can indicate inefficiencies in managing working capital.

Generally, businesses with a shorter CCC have reduced working capital requirements compared to businesses with a longer CCC. This is how CCC looks for each business:

• Visa: Visa's CCC is generally quite low or even negative, given the nature of its business. Credit card networks like Visa typically receive payments from merchants faster than they pay banks, resulting in a favourable cash flow situation.

• General Electric: GE's CCC varies across its divisions, but due to its industrial and manufacturing operations, the CCC tends to be higher. Historically, its CCC has ranged between 80 to 100 days, reflecting the need for better working capital efficiency​.

• Freeport-McMoRan: FCX, a large mining company, has a notably long CCC. Mining operations require significant capital tied up in inventory (materials in various stages of production), which leads to a CCC that can range around 270-285 days.

The correlation between Working Capital and CCC is not perfect, but it is worth digging deeper into the company’s reports to explain the numbers and get a better sense for how each business operates.

However, for our purposes working capital is similar for each business and does not appear to be the determining factor in the differences in ROIC.

Fixed Capital

Analysing fixed capital is crucial because it represents long-term investments in assets like property, equipment, and infrastructure, which are key to sustaining and expanding a business's operations. It helps assess a company's capacity to scale production and maintain efficiency, which directly impacts profitability and return on investment.

To do this we will look at fixed asset turnover.

Fixed asset turnover is a measure of how effectively a company uses it working capital to generate revenue. It is calculated by dividing total revenue by the average fixed assets for the period.

You can see that this takes the same format to working capital turnover and we are similarly looking for:

• A fixed asset turnover ratio of at least 2

• Any trends in the numbers. Improving numbers indicates the business is more efficiently using it assets.

From the chart above it is clear this is where Visa really shines as a business and shows exceptional efficiency with fixed asset turnover ranging from 10-15x. Both GE and FCX are more capital intensive than Visa. GE is still fairly good with most years being above 2. Notably it has been improving in recent years. FCX on the other hand has always had a ratio below one. This means their total revenues each year are below that which they have invested in fixed assets.

To support this analysis, it is useful to look at number of related metrics which can be seen in the below table:

To summarise the above:

• Each metric is pointing towards Visa being a capital light and efficient business. This is helping to keep the level of invested capital down and maintain a high ROIC.

• GE has a decent Fixed Asset Turnover (based on revenues), but we can see the Return on Tangible Assets (Based on net income) is low. This is due to the lower margins of GE.

• FCX performs poorly on all fronts and the business is very capital intensive. The particularly alarming metric is that they are needing to invest more in CAPEX than net income with a net income to CAPEX ratio of 0.38x. This is never a great place to be in!

From looking at Working Capital and Fixed Capital together we can see that Visa has a low invested capital requirement which is also contributing to its high ROIC!

Note on capital light businesses: When evaluating capital-light businesses, an ROIC above 50% may warrant closer scrutiny. Such high returns could indicate that the business is not capitalizing R&D expenses, which can inflate ROIC artificially by underreporting capital investments. It's crucial to investigate how the company treats R&D or other major expenses in its financial statements before making an investment decision, as this can provide a clearer picture of true capital efficiency and profitability.

Subscribe now

2. Investment Opportunities

The second point to consider when looking at invested capital is the ability of the business to deploy additional capital (i.e. increase Invested Capital), whilst maintaining High ROIC levels to fully maximise Net Operating Profit After Tax (NOPAT) and therefore cash flows.

Doing this over the long term lets the fly wheel of compounding take hold as profits are reinvested into the business and generate incremental returns. This is the definition of a quality compounding machine and results in significant shareholder value.

“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return – even if you originally buy it at a huge discount.” - Charlie Munger

In practice this can’t go on forever and eventually the company will have to make one of the following capital allocation decisions:

• Invest at Lower ROIC levels: The business starts to invest capital at lower returns. Remember this will still be value accretive if ROIC > WACC but the compounding effect will slow.

• Pay Down Debt or Hold cash: The business can hold profits on the balance sheet as excess cash. However, this will not count as operating cash and therefore won’t increase invested capital. This won’t provide any incremental value to shareholders beyond the benefits of reducing interest expenses and improving the balance sheet.

• Buy Back Shares: The business can buy back a portion of the shares therefore increasing the free cash flow available to the remaining shareholders. This is great for a quality business, but it is only value accretive if the price is below intrinsic value.

• Pay a Dividend: Return excess cash flow to shareholders in the form of dividends. Now it is not necessarily a terrible thing to be paying out dividends, but it can indicate the business is running out of investment opportunities.

Ideally, we looking for businesses that are able to plough profits back into invested capital at high rates of return instead of resorting to one of the above.

This is best demonstrated through an example. The below diagram shows the difference in returns for a business that reinvests all its profits back into invested capital (Company A) vs one that pays it all out as dividends (Company B).

Both businesses start with invested capital of $100 and have constant ROIC of 25%.

With company A re-investing in the business, it is letting compounding take hold and the CAGR over the period is 25% (Equal to ROIC). The final value to shareholders in year 5 is the invested capital at $244 dollars.

Company B still does very well with a 25% ROIC. However, with all profits being paid out as dividends the CAGR over the period suffers and is only 19%. The CAGR will only reduce further the longer this goes on. The final value to shareholder in year 5 is the original invested capital plus the dividends received over the period totalling $200.

Granted this does not consider the fact the dividends can be reinvested. However, to achieve the same result as company A, shareholders of company B would need to find opportunities with a 25% CAGR. A tall order!

From the above it is clear for a high-quality business, with a high ROIC, it is desirable to reinvest as much profit as possible back into operations.

Identifying Businesses Struggling to Find Opportunities to Re-Invest

As can be seen in the above example If a company has been growing FCF at or near its ROIC over an extended period it indicates it is fully utilising its investment opportunities. Therefore, over the long term FCF CAGR should be roughly equal with ROIC over the period.

To analyse this, we should:

• First compare FCF CAGR and ROIC over a number of periods

• If there is a difference between the two then we should look to explain the differences by looking at how the business has been investing its capital back into operations or not as the case may be.

Let’s look at Visa as an example. In the below I have mapped ROIC against EPS growth rate for a number of periods. Note: I have used EPS growth rate as a proxy for FCF / Share growth rate as the numbers are more readily available (Remember operational cash conversion to free cash flow is close to 100% for Visa).

As we can see the EPS growth rate on average is below the ROIC for Visa across multiple periods. Let’s explore the different capital allocation decisions the business can make and see if they explain the reason for the difference:

Invest at Lower ROIC levels:

• There is no evidence that Visa are doing this. ROIC has actually been increasing in recent years.

• Reason for Difference? - No

Pay Down Debt or Hold cash:

• There have been no significant debt pay down in the period. Cash has increased in line with EPS growth at around 14% CAGR. This suggests most of the cash is operating and therefore included in invested capital. If some of this is excess cash (non-operating) then this could be marginally contributing to the lower EPS CAGR.

• Reason for Difference? - Possible minor effect dependent on operating vs excess cash

Buy Back Shares:

•  Visa buys back around 2% of its shares each year, boosting EPS growth by reducing the number of shares outstanding. However, these buybacks don't increase the company's invested capital or improve operational efficiency, meaning they have no direct effect on ROIC.

• Reason for Difference? -The effect this has is dependent on price the shares are purchased vs the intrinsic value of the stock. We will discuss this in more detail when we cover capital allocation in a future blog on the “management” filter. But for now:

  • Below Intrinsic Value: Buybacks add value, narrowing the ROIC-EPS delta by boosting EPS growth.

  • At Intrinsic Value: Buybacks are neutral, and the gap remains driven by dividends or reinvestment decisions.

  • Above Intrinsic Value: Buybacks destroy value, widening the ROIC-EPS delta because the overpayment leads to inefficient EPS growth.

• Given this requires a view of the intrinsic value of the stock when the shares were bought this is complex to estimate. For now, let’s assume that the sales were at or near intrinsic value therefore having minimal effect.

Pay a Dividend:

• To analyse dividends, we look at the payout ratio which tells you the percentage of profits that are paid out in the form of dividends. Visa has on average paid out 22% of its earnings in the form of dividends. This is 22% that is not being reinvested into invested capital.

• Reason for Difference? - Significant effect. EPS growth rate should be approximately 22% behind ROIC. We can see this roughly play out in the numbers.

From the above we can see that Visa is not reinvesting all of its capital back into the business and is paying 22% back as dividends.

This means they are still reinvesting a healthy 78% back into the business at high rates of return either through investing in operations or share buy backs.

Visa is a large mature company and inevitably it will not be able to compound FCF at 15 to 20%+ (aligning with its ROIC) rate indefinitely. However, current growth rates are above the average of the market and with ROIC increasing in recent years we are also seeing an increase in CAGR.

The dividend payout ratio and share buy backs are something we should watch moving forwards. If they start to increase it is likely Visa is struggling to find suitable additional investment opportunities at scale. At this point growth will slow but there should be a solid dividend that a shareholder could reinvest back into more shares or other opportunities.

To understand this in more detail qualitative analysis and a review of capital allocation is required.

To summarise Visa has plenty of opportunities to reinvest but paying a dividend and share buybacks indicate the business is unable to redeploy all its capital back into operations and represents a slight drag on overall growth. However, shareholders are still getting market beating EPS/FCF growth and realising value through dividends and share buy backs.

Subscribe now

Bringing it all together – Impact on Share Price

In the last 4 blog post we can have looked at the fundamentals of both Visa and GE. Our hypothesis is that Visa is a much higher quality than GE. Let’s see how this has played out with the share price of the 2 companies.

Visa:

• Growing revenues, net income and cashflows

• Growth is a consequence of a high ROIC (Which is significantly higher than their WACC)

• It appears like the high ROIC is primarily a combination of being a high margin business with pricing power and a capital light business model.

• Visa is also able to reinvest most (~78%) of these profits back into the business to kick in the magic of compounding.

Visa is therefore generating a great deal of shareholder value. Over the long term the share price follows business fundamentals and shareholder value (CAGR of 16.2%):

General Electric:

• Declining and erratic net income which fluctuates from positive to negative across years. Free cash flow also does not correlate well with net income.

• ROIC is consistently below WACC which is destroying shareholder value.

• ROIC is low due to low margins and a more capital-intensive business.

• We did not cover this in detail but in some years, GE is paying out more in dividends than it is earning and therefore not reinvesting in the business!

Over this 10-year period GE’s fundamentals have not been great, and this plays out in the share price over the period (CAGR of -1.3%):

It is clear which has been the winner over the last 10 years.

Remember over the long term the share price of the company aligns with the business fundamentals.

"In the short run, the market is a voting machine but in the long run, it is a weighing machine." – Benjamin Graham

Subscribe now

Conclusion

By assessing Free Cash Flow per Share Growth, Return in Invested Capital, Margin and Capital Intensity we now have a view on whether the numbers indicate there is a competitive advantage.

It is now our task to validate this competitive advantage and assess its durability into the future through qualitative analysis.

By combing through the numbers, we will already have a good understanding of the drivers of value which will help to guide our analysis.

In part 5 of this mini-series on quality we will look at the qualitative analysis required to identify and assess a company’s competitive advantage.

Disclaimer

As a reader of Focus Invested, you agree with our disclaimer. You can read the full disclaimer here.

"Companies with consistent high profit margins usually have some combination of great products, efficient production, and strong customer loyalty." – Phillip Fisher

Welcome to part 3 of our mini-series on identifying “Quality” companies.

In our previous instalments we covered:

• The key drivers of shareholder value creation

• We then looked a how we build these into our filtering process by looking for quality companies with growing free cash flow and high Returns on Invested Capital (ROIC)

It is now our job to try and dig deeper into the numbers causing  some businesses to have higher ROIC than others. This is very instructive and will help us later on when we start to look at the business more qualitatively.

This mini-series will progress as follows:

• Part 3 (this section): A focus on profit margins.

• Part 4: A deep dive into invested capital.

• Part 5: Wrapping it all up with qualitative analysis.

What drives ROIC?

Return on invested capital is the probably the most important metric when looking at quality companies.

ROIC can be thought of as the interest rate of the company. Higher is always better!

Return on Invested Capital (ROIC): Represents the return a company earns on each dollar invested in the business and is expressed as a percentage %.

As a reminder the formula for ROIC is:

Where:

• Net Operating Profit After Taxes (NOPAT) is the profits generated from the company’s operations after subtracting income taxes. (Margin)

• Invested capital is the cumulative dollar amount the business has invested in its operations. This includes working capital and fixed capital (Property, plant, and equipment)

This can be visualised as follows:

ROIC encompasses both the fundamentals of the business as well reflecting the quality of the management team. Businesses and their management have 4 key levers they can pull to try to increase their ROIC:

• Revenue: Increase total revenue per unit of invested capital (drive growth efficiently).

• Costs: Increase profit margins by decreasing costs per unit of revenue.

• Working Capital: Decrease working capital requirements without reducing NOPAT.

• Fixed Capital: Decrease fixed capital requirements without reducing NOPAT.

A detailed exploration of these levers requires qualitative analysis, but for now we are interested in looking purely at the numbers and the effect they have on ROIC.

Subscribe now

NOPAT and Profit Margins

"The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business." – Warren Buffet

High profit margins are always better than low profit margins.

A high profit margin indicates the business has a level of pricing power (Quality) and can also withstand temporary periods of difficulty (Safety). A company with a 20% profit margin can easily absorb a 5% drop in the margin whereas a business with a 3% margin would be loss making.

There are multiple types of profit margin, and it is worth looking at each to get a better picture of the business. Luckily, they are easy to calculate from the income statement.

The below Sankey diagram provides an overview of a typical business and how each margin is calculated:

• Gross Profit: This is the profit a company makes after subtracting the direct costs of producing its goods or services (like materials and labour) from revenue. It shows how efficiently a company produces its goods. The gross profit margin in this example is $30M/$50M = 60%

• Operating Profit (or EBIT): This is gross profit minus operating expenses such as rent, utilities, and wages, but before interest and taxes. It reflects the profitability from core operations. The operating profit margin in this example is $15M/$50M = 30%

• Net Profit / Net Income: This is the final profit after all expenses, including interest and taxes, have been deducted from total revenue. It represents the company's total earnings and is often called the "bottom line." The Net profit margin in this example is $10M/$50M = 20%

• Note: It is also important to look at the Free Cash Flow Margin. Ideally this is close to, if not the same as net Profit, when the operating cash conversion ratio is close to 100%.

Subscribe now

Key takeaways from Margin Analysis

When analysing margins, there are several things we look for:

• High Margins: We are looking for overall net profit margins of at least 10% to indicate some level of pricing power as well as provide a level of safety. Ideally margins would be higher than this!

• Positive Trends: We are also interested in identifying trends. In some cases, a growing margin may lead to accelerated FCF and ROIC. We also want to watch out for margin decline as this could indicate a loss of pricing power.

• Margin Breakdown: To support our qualitative analysis, it is worth looking at the differences in Gross, Operating and net profit margins as this highlights where the costs of the business lie.

Again, I find it useful to plot this out on a graph over at least a 10-year period. Below you can see the graphs for Visa and General Electric.

For Visa we can see that all 3 margins are remarkably high.

This starts out with a gross margin of 95%+! This indicates that the direct costs of their services are marginal. After all other expenses, interest, and tax the net profit margin ranges from 35% to 52% which is also very healthy. We can also see there is a general increasing trend over the period with low volatility each year. All good stuff.

Given the conversion of net income to free cash flow for visa is close to 100% we can state that the FCF margin for the business is also very healthy. Remember Free Cash Flow is the driver of shareholder value and therefore more important than accounting earnings.

We can therefore confidently state that the high margins are contributing to a high ROIC. This is an area we should investigate further and explain qualitatively. But for now, though let’s look at General Electric.

Here you can see a completely different story. The gross margins are all sub 25% which is below the net profit margin of Visa! If we then consider other expenses, interest, and tax, we are looking at a net profit margin which fluctuates between -23% to 13%.

This indicates that General Electric does not have any level of pricing power. There is also some volatility in the results which we would need to explain. Low margins are a significant contributing factor to General Electric’s low ROIC.

So that is Margins (The Numerator of ROIC) accounted for and we can see they are important for both Visa and GE.

In the next part of the quality mini-series, we will explore Invested Capital (The Denominator of ROIC) in more detail.

Disclaimer

As a reader of Focus Invested, you agree with our disclaimer. You can read the full disclaimer here.

"Compounding is the engine of wealth creation. Find businesses that are compounding machines—those that can take retained earnings and invest them at high returns. These are the businesses that make investors wealthy." – Mohnish Pabrai

Welcome to part 2 of our mini-series on identifying “Quality” companies.

In our previous blog we discussed the drivers of value and the following 3 key concepts:

• Key Concept 1: The value to a shareholder is based on the Cashflows produced by the business.

• Key Concept 2: Value is a function of Return on Invested Capital (ROIC) and Net Operating Profit After Tax (NOPAT) / Cash Flow Growth Rate

• Key Concept 3: Value is only created where ROIC is higher than the cost of capital for the business.

Within this blog we will begin to discuss how to quantitatively analyse a business to ensure it is maximising the potential of these 3 concepts.

The Quality Filter

As a reminder our stock selection funnel process looks to use a series of filters to either include or exclude companies from our buy / watchlist.

Once we are confident the business has meaning to us and sits within our circle of competence then the next most important filter is ensuring that the business has quality underlying fundamentals.

Quality: Focus on companies with strong competitive advantages and consistent performance.

Fundamentally a quality company is one which has the characteristics that can mean it can provide high levels of shareholder value over the long term.

Based on the key drivers of value it is clear that we should look for businesses with positive free cash flows, high levels of return on invested capital (Above the cost of capital) and high levels of growth. If we are also confident that these levels of return are durable and can be maintained into the foreseeable future, we can be sure we are on to a quality business.

For a company to be able to do this is must have a competitive advantage with significant barriers of entry (otherwise known as a MOAT).

"The most important thing [is] trying to find a business with a wide and long-lasting moat around it... protecting a terrific economic castle with an honest lord in charge of the castle." - Warren Buffett

To identify a quality company, we need to look at it both quantitatively and qualitatively. We will then link and compare the two to provide a holistic overview of the company.

In part 2 (This post) we will look for quantitative measures that indicate a company may have a competitive advantage. Given their importance in value creation both ROIC and Free Cash Flow per Share Growth are included in our analysis.

In part 3 we will also specifically look at Margin and Invested Capital / Capital Intensity as they make up ROIC and help us to get a better understanding of the business and what types of competitive advantages they have.

Then in part 4 we will then look at the business qualitatively to explain the numbers, its competitive advantage and assess its durability moving forwards:

• We will first look at Industry Dynamics & Business Resilience to get a better understanding of the environment the business operates in and key factors that can impact the business.

• Then we will attempt to identify any competitive advantages the business may have, assess their durability by reviewing barriers to entry and then ensuring we understand how the business will continue to deliver shareholder value into the future.

By identifying and validating that a company has a durable competitive advantage we can be confident that the business fundamentals are of high quality. Therefore, the business can deliver sustained shareholder value if managed correctly and any associated risks are properly mitigated. (Note: We will discuss each of these in future posts.)

In other words a compounding machine!

Now on to the Quantitative Analysis…

Subscribe now

Free Cash Flow per Share Growth (Quantitative)

First and foremost a quality company should be making money.

Businesses make money by selling products or services, which generates revenue—the total amount they bring in. From this, they subtract expenses like wages, materials, and other costs to get net income, or profit. However, profit does not always reflect the actual cash available. To find how much cash a business has, we look at free cash flow. This is net income, adjusted by adding non-cash expenses (like depreciation) and subtracting cash spent on things like new equipment (capital expenditures). Free cash flow shows the cash a business has to grow, pay debts, or return to shareholders.

As shareholders we are therefore most interested in positive (and preferably growing) free cash flow!

"Free cash flow is one of the most important numbers for a company because it tells you how much money the company is generating that can be used to pay down debt, buy back shares, or invest in growth." – Peter Lynch

Analysing free cashflow is the first thing I do when looking at the fundamentals of the business. I will go to the income statement and cash flow statement to look for the following:

1. Top Line – Year on year revenue growth (Of at least 5%)

2. Bottom Line – Year on year net income growth (Of at least 5%)

3. Operating cash conversion ratio – Evidence that the business can convert the majority of its net income into Free Cash Flow. (As close to 100% as possible)

I find the easiest way to see these trends is to plot revenue, net income, and free cash flow graphically over a period of at least 10 years. This helps to really brings the numbers to life.

To illustrate the point, I will compare a high-quality company (Visa) with a not so high-quality company (General Electric).  Note: I am using TIKR terminal to pull all of the data for the below.

It is easy to see from the graphs which has been the better performing company over the last 10 years:

• Visa has steadily growing revenues and net income. We can also see that Free Cash correlates very closely to net income.

• General Electric has declining revenues over the period. We can also see erratic net income which fluctuates from positive to negative across years. Free cash flow also does not correlate well with net income.

On this basis we can already see that Visa is providing greater shareholder value than General Electric and is likely a higher quality company.

To support this, it is also worth us checking earnings per share (or net income per share) and Free Cash Flow per share. This allows us to take into account stock dilution through share issuance or stock consolidation through share repurchases / buybacks. Ultimately, as shareholders of the company we are interested in the per share figures as this represents the net income / FCF flowing to us as shareholders. Over the long term our returns should highly correlate with the FCF per share growth rate.

Again, you can see a comparison of Visa and General Electric below:

Over the ten-year period share Visa has been regularly buying back shares and the number of shares outstanding has dropped from 2.5B in 2014 to 2.1B in 2013 (-16%). This had the effect of increasing EPS and FCF per share at a faster rate. Overall Visa had a compound annual growth rate (CAGR) of 15%.

General Electric also bought back a similar percentage at -13% which positively impacted the per share numbers. However this was outweighed by an overall decline in Cash Flow from the business. Overall General Electric had a compound annual growth rate (CAGR) of -16%.

To further enhance our analysis on Visa, it is worth looking at the linearity of the FCF per share growth. We can do this through plotting the FCF per share and performing an exponential regression analysis. The linearity for Visa comes out at 89% demonstrating a close correlation and low volatility in results. This helps to build the case for a durable competitive advantage and provide a foundation for valuing the business based on future cash flows. Note: More on this in blog posts!

Thinking back to the key concepts that drive shareholder value we now have fully covered Key Concept 1: The value to a shareholder is based on the Cashflows produced by the business and covered half of Key Concept 2: Value is a function of Return on Invested Capital (ROIC) and Net Operating Profit After Tax (NOPAT) / Cash Flow Growth Rate.

By now looking at Return on Invested Capital (ROIC) we will be able to fully cover key concept 2 & 3 …

Subscribe now

Return on Invested Capital (Quantitative)

If a company is growing its revenue, net income, and free cash flow, we as investors need to know how it is doing this.

The most effective way for a company to grow is by increasing sales without a proportional increase in expenses. However, this is a rare feat. Typically, companies must invest to drive growth, which often requires funding for:

• New assets to scale production.

• Research and development (R&D) to innovate products and services.

• Marketing to expand customer reach.

• Human resources to support expansion.

• Strategic acquisitions to accelerate market presence.

These investments are necessary for sustainable growth, but they also demand careful resource management to ensure profitability.

What we are really interested in is if the company is getting good bang for its buck when it comes to these investments. Or put another way is the company getting a good return on sales and profit growth for the amount it is investing to produce that growth?

This is where Return on Invested Capital comes in, which I like to think of the companies interest rate. If I had to pick only one business metric it would be the return on invested capital. The higher the ROIC the better and we are looking for companies with an ROIC of at least 15%.

Why an ROIC of 15%?

As you will remember from our key concepts of shareholder value creation Key Concept 3: Value is only created where ROIC is higher than the cost of capital for the business.

The typical range for weighted average cost of capital (WACC) is 7% to 12% for most companies depending on factors like industry, risk profile, and capital structure. It is best for us to be conservative to ensure there is a gap between the ROIC and the WACC of the company. We have therefore chosen 15% which will usually provide a positive delta of at least 3% and any growth in free cash flow should be value accretive.

Note: When we discuss valuation in a future blog post we will look at calculating the specific WACC for a given business.

"For a business to grow and create value, it must generate a return on capital that exceeds its cost of capital. Otherwise, growth destroys value rather than enhances it." - Aswath Damodaran

To analyse ROIC I again like to look at it graphically. In the below chart I have plotted out ROIC for Visa and General Electric for the last 10 years.

To demonstrate the point, I have also shaded 3 areas of the chart:

• Green: ROIC is greater than 15%. Investment & Growth is likely value accretive.

• Amber: ROIC is between 7% to 15%. This is within the range of WACC for the business and growth will likely be neither value accretive nor value destructive.

• Red: ROIC is below 7%. Investment & Growth is likely value destructive.

When studying this chart, we are looking for ROIC to be consistently above 15%. We are also looking for any trends in ROIC. A slowly declining ROIC might represent a deteriorating competitive advantage which is not something we want to be buying in to.

Subscribe now

From the chart it is clear that Visa’s ROIC is consistently above 15% (Apart from on year) and in some years exceeding it by more than 10%. Any growth in revenues is going to be value accretive! We can also see that the ROIC is generally on a upward trend which is great.

General electric on the other hand has consistently achieved an ROIC below 7% (Again apart from on year). They are destroying capital by investing!

"It's not enough to invest in companies that generate high returns on capital. What’s crucial is that they can continue to generate these high returns, while the cost of capital remains lower, allowing compounding to work in your favor over time." – Joel Greenblatt

At this point we have already done enough to show that Visa has been a higher quality company than General Electric over the last 10 years.

It is now our job to try and dig deeper into the reasons behind the higher ROIC of Visa. This is very instructive and will help us later on when we start to look at the business more qualitatively.

Join us in part 3 of the mini-series on identifying quality companies where we will discuss the Margin, Invested capital and the impact they have on ROIC.

Disclaimer

As a reader of Focus Invested, you agree with our disclaimer. You can read the full disclaimer here.

"It’s not timing the market that matters. It’s time in the market, and it’s best to spend that time in the best companies."- Terry Smith

Like Terry Smith a core concept within our investment philosophy is buying quality companies and holding them for the long term.

But what do we mean by “Quality” and why are they the best companies to hold over longer periods?

To explain this, we need to quickly look at how companies create value for their shareholders.

Drivers of shareholder value creation

"The goal of a company is to deliver shareholder value by increasing earnings over time. Earnings growth creates true value." Warren Buffett

The objective of a business should be to maximize shareholder value.

By purchasing a share in the business, you have purchased a portion of the equity of the business and are therefore an owner of the business.

You are entitled to a portion of the value the business provides so you must make sure you understand how the business create value for you!

But what do we mean by value and what factors impact the value a business provides to its shareholders?

At a high level this can be drilled down into 3 key concepts. Remembering these when investigating a business will put you in a position to understand drivers of value and invest accordingly.

Subscribe now

Key Concept 1: The value to a shareholder is based on the Cashflows produced by the business

Companies create value for shareholders (equity) and bondholders (debt) by managing capital through the following lifecycle:

1. Raise Capital: The company borrows capital from debt and equity investors.

2. Invest and Operate: It uses this capital to pay suppliers, employees, and invest in assets needed to operate and grow.

3. Generate Revenue: By providing goods and services to customers, the company generates revenue and profit.

4. Reinvest and Return Capital: The company reinvests in growth opportunities and returns surplus capital to shareholders via dividends and share buybacks, and to bondholders through interest and principal repayment.

In summary companies create additional value for their shareholders by investing cash now to generate more cash in the future!

The value they create is simply the future cash inflows minus the cost of investments made (Surplus capital or cash flow) discounted at an appropriate rate to reflect the present value. The rate at which we discount is based on the cost of capital for the business (See Key Concept 3 for more details on the time value of money and discount rates)

"The cash flow is what drives value. If you don’t have cash flow, you don’t have anything." - Bruce Berkowitz

It is worth pointing out now that anything that doesn’t impact cashflows does not impact value. The classic example is stock splits which neither add or subtract any value to the underlying business.

So, cashflows are important but what factors impact cashflows?

Note: Key Concept 1 is in relation to operating part of the business only which excludes non-operating assets like excess cash and does not consider the impact of debt. A full analysis of how to value a business (including non-operating assets and debt) will be discussed as part of the valuation filter in a future blog post.

Key Concept 2: Value is a function of Return on Invested Capital (ROIC) and Growth

A company’s cash flows, and therefore value of the business, are a function of the Return on Invested Capital (ROIC) and NOPAT / cash flow growth rate (g).

Return on Invested Capital (ROIC): Represents the return a company earns on each dollar invested in the business and is expressed as a %.

The formula for ROIC is:

Where:

• Net Operating Profit After Taxes (NOPAT) is the profits generated from the companies operations after subtracting income taxes.

• Invested capital is the cumulative dollar amount the business has invested in its operations. This includes working capital and fixed capital (Property, plant, and equipment)

ROIC is a measure of the efficiency of the business at allocating the capital under its control and therefore how well a company is using its capital to create value for shareholders.

The higher the ROIC of the business the better!

Growth (g): Is the rate at which the company’s NOPAT and cash flow grow each year and is expressed as a percentage.

ROIC and Growth are intrinsically linked. The table below provides an example of a business that is able to maintain a constant ROIC of 15% whilst also reinvesting all profits each year back into the capital of the business.

By doing this the business is also able to grow at a compounded annual growth rate (CAGR) of 15%. This is due to the invested capital of the business growing at 15% due to the reinvestment of profits. It is worth noting that this relationship only holds where businesses have ample reinvestment opportunities at the 15% rate and do not pay any dividends.

From the above it is clear that ROIC and Growth will have an impact on value given the associated increase in Profits and Invested Capital.

By combining ROIC and Growth we can derive the following formula for Value:

This is a somewhat simplified formula which assumes constant growth and a constant ROIC for the business. At this point you do not need to remember this formula and we will revisit this when we discuss company valuation. For now, all you need to remember is the relationship between value, growth and ROIC.

In most cases a higher growth and ROIC will generate more value. There is however a notable exception, and it is related the other term within the formula (WACC) …

Subscribe now

Key Concept 3: Value is only created where ROIC is higher than the cost of capital for the business.

As discussed in key concept 1 to value a company we need to discount future cash flows at an appropriate weight to determine their present value.

This is due to the time value of money principle that that states that a sum of money is worth more today than the same sum in the future due to its current potential earning capacity through investment or interest.

"Remember that time is money." Benjamin Franklin

The discount rate is used to account for this by adjusting future cash flows to reflect their present value. It represents the rate of return required to make future cash flows equivalent to current money, factoring in risk and opportunity costs.

But how do we know what rate to discount at?

This is where the weighted average cost of capital (WACC) for the business comes in. WACC represents the minimum return a company needs to earn to satisfy both equity investors and debt holders. It is the company’s cost of capital, considering its capital structure.

WACC accounts for, and is proportionally weighted by, each source of capital (equity and debt) in the company’s capital structure:

• Cost of Equity: The return shareholders expect for investing in the company, often calculated using the Capital Asset Pricing Model (CAPM).

• Cost of Debt: The interest rate a company pays on its debt, adjusted for tax benefits (since interest payments are tax-deductible).

Companies can alter their WACC by adjusting their capital structure through an increase in debt. Debt is generally cheaper than equity and therefore reduces the overall WACC, but this will also increase financial risk.

Note: We will fully discuss WACC and methods for calculating it as part of the valuation filter in a future blog. For now, we are just interested in understanding the relationship between ROIC and WACC as it is crucial for understanding a company's ability to create value for shareholders.

When ROIC is greater than WACC, the company is generating returns that exceed the cost of its capital. This means the company is creating value for its investors. Conversely, when ROIC is less than WACC, the company is destroying value, as it is not generating enough returns to cover the cost of the capital invested.

This effect is then further amplified by growth!

In the below example we demonstrate the impact on value on a number of different growth and ROIC combinations. In this example we have assumed year 1 earnings of $100, 9% cost of capital, constant growth for 15 years after which all scenarios grow at 4.5%.

Source: Valuation: Measuring and managing the value of companies, McKinsey & Company

• The base scenario where ROIC and WACC are equal at 9% then growth has no impact on the net present value of the business which is $1,100 for all growth rates.

• It is clear to see that in all scenarios where the ROIC is 7% (Below the 9% WACC/ cost of capital) then any level of growth is value destructive. Increasing growth only destroys more value as more capital is required to maintain the growth which in turn destroys more value.

• The opposite is true where ROIC is greater than WACC with growth being value accretive.

From this we can state that it is always better to improve the ROIC of a business. Whereas growth is only good in situations where ROIC is greater than WACC.

High quality companies will have an ROIC significantly larger than their WACC and therefore growth will also be value accretive.

Conclusion

In summary we have discussed 3 key concepts which drive shareholder value:

• Key Concept 1: The value to a shareholder is based on the Cashflows produced by the business.

• Key Concept 2: Value is a function of Return on Invested Capital (ROIC) and Growth.

• Key Concept 3: Value is only created where ROIC is higher than the cost of capital for the business.

By analysing companies with these concepts in mind it is clear that we should look for businesses with both high levels of return on invested capital (Above the cost of capital) and high levels of growth. If we are also confident that these levels of return are durable and can be maintained into the foreseeable future, we are definitely on to a quality business.

Within the next 3 blog posts will document how to find these businesses from both a quantitative and qualitative point of view.

Disclaimer

As a reader of Focus Invested, you agree with our disclaimer. You can read the full disclaimer here.

Subscribe now

"The least of things with a meaning is worth more in life than the greatest of things without it” – Carl Jung

Why Meaning

A life without meaning, regardless of external success can feel empty and unfulfilling.

True value lies in the connection and purpose we attach to something.

This is particularly true in investing. Investors who prioritise meaningful investments that align with their own values will:

• Find more satisfaction and fulfilment in their financial decisions.

• Have the purpose and direction required to analyse a company in depth.

• Have the greatest chance of holding onto an investment for the long-term even in difficult times.

Ultimately when you invest with meaning you will see better results from both a financial and psychological point of view!

This is why meaning is built into the very core of the Focus investing philosophy. Remember we are looking to “Find high quality business with meaning to you”.

To put this into practice, meaning is also the first filter within our business selection process.

Meaning as a Filter

The purpose of the meaning filter is to ensure we Invest in businesses we understand, find interesting and are comfortable supporting. Investing is not just about financial returns—it is a personal endeavour that should align with our values, interests, and competencies. The goal of this filter is to help us focus on businesses that resonate with us on a deeper level, both intellectually and ethically, which enhances our commitment to the investment and increases the likelihood of long-term success.

This filter helps us answer two essential questions:

• Aligned Values: Do I want to spend a significant amount of time learning about this business?

• Circle of Competence: Do I understand how the business makes money and the competitive environment it operates in?

By answering these questions up front, we are able to discount the vast majority of companies that may not align with our interests or that we may not fully understand.

This allows us to focus our time, energy and capital on businesses that hold real meaning for us, making our investment journey more fulfilling and successful.

Aligned Values

"The intersection of what you are deeply passionate about, what you can be the best in the world at, and what drives your economic engine is the sweet spot for sustained success." — Jim Collins

Do you want to spend a significant amount of time learning about this business?

This question is not just about curiosity or interest—it is a critical filter that addresses whether a business aligns with who you are on a deeper level. For you to dedicate the necessary time and energy to truly understand a business, it must resonate with your personal interests, skills, experience, and values.

Here is how each element plays into this decision:

1. Interests:

If you are going to spend countless hours reading, researching, and learning about a business, it helps if it is in an area that genuinely interests you. Passion fuels commitment and deep understanding. Ask yourself:

• What are you fundamentally interested in?

• What topics, industries, or sectors naturally grab your attention?

2. Skills:

When you invest in a company within your skillset, you are leveraging your own strengths, which can give you a competitive edge in understanding complex business models or market dynamics. Ask yourself:

• What skills and talents do you possess, either professionally or personally?

• Are there any natural talents or areas of expertise that you can apply to your analysis of the business?

3. Experience:

Experience brings familiarity, and investing in businesses within sectors you have interacted with on a daily basis or have prior knowledge of can make your analysis more grounded and insightful. Ask yourself:

• Where do you live, and how might your location give you insight into a particular industry?

• Who do you know? What personal or professional networks do you have access to that could help you better understand a company or sector?

• What exposure do you have to different businesses through your career, day-to-day activities, or personal experiences?

4. Purpose:

Ethical alignment is crucial. Investing is a personal endeavour, and it should reflect not only your financial goals but also your wider moral compass and purpose. You should feel comfortable with the impact of your investments on society and the environment. Ask yourself:

• Are there specific causes or missions you want to support through your investments?

• Are there any businesses or sectors you prefer to avoid because they conflict with your sense of purpose? (For example, defence, tobacco, and gambling industries)

• Do the companies you invest in align with your broader vision for contributing positively to society?

Once you have really thought through and built a clear understanding of your interest, skills, experience and purpose, this framework can become a tool for both generating investment ideas or assessing potential opportunities.

If a business aligns with one or more of these dimensions, then you are off to a good start. By filtering through this lens, you are likely to invest in companies which are intellectually engaging which will lead to a more satisfying investment journey.

However, before investing we need to ensure that the business lies within our circle of competence…

Subscribe now

Circle of Competence

"Know what you own and know why you own it." – Peter Lynch

Do I understand how the business makes money and the competitive environment it operates in?

This question ensures that the business falls within our circle of competence.

Understanding how a company generates revenue, what its key drivers of success are, and how it fits within its industry context is crucial for making informed investment decisions.

When we invest within our circle of competence, we reduce the risk of being blindsided by factors we do not fully grasp, and we improve our ability to assess future opportunities and challenges.

Your circle of competence will expand over time but a great place to start is by using your values as a lens. If a business aligns with your interest, skills, experience, or purpose then these is a good chance it falls within your circle of competence.

If it does not then there is a greater chance of you being able to pull the pieces together to understand the business, but it will take more effort and research.

The good new is that your circle of competence is not fixed and will grow with you as you grow as an investor.

However, it is important to recognise businesses that are truly outside of your circle of competence (for now at least!). A useful approach is to invert the questions and ask yourself: What is definitely outside my circle of competence? As Charlie Munger famously said:

"Invert, always invert: Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead. Through avoiding failure, you’ll be on the path to success." — Charlie Munger

By identifying the types of businesses or industries that require specialized knowledge beyond your current reach, you can avoid costly mistakes. Some classic examples where specialist knowledge is required include:

• Banks: Due to the complexity of financial instruments, regulations, and leverage risks.

• Biotechnology and Pharmaceuticals: Because of the intricacies of drug development, clinical trials, and FDA approvals.

• Technology: Especially emerging sectors like AI and quantum computing, where rapid innovation and technical understanding are paramount.

• Commodity Businesses: Where pricing is dictated by supply-demand dynamics and external factors like geopolitical issues.

This is not to say that these businesses are not within your circle of competence, but you will need to have a real specialism if you want to truly understand the business.

For example, I have worked within the financial services for over 10 years, and I would still not class myself as qualified to truly understand complex investment banks balance sheets and risk factors. Better to just stay clear!

Assessing your Competence

If you believe you have found a company that you want to investigate further and it appears to fall within your circle of competence, it is important to test this assumption.

One way to do this is by writing a paragraph in your own words explaining what they do, how they make their money and factors that can influence its success.

This exercise forces you to articulate your understanding and highlight any areas where you may be lacking knowledge.

Consider these factors in your analysis:

• Business Model: How does the company generate revenue? What are its primary products or services?

• Stakeholders: Who are the key stakeholders (customers, suppliers, regulators) that impact the business?

• Competitive Landscape: What does the competitive environment look like? Who are the major competitors, and what differentiates this business?

By assessing your understanding, you can ensure that the company truly falls within your circle of competence, giving you the confidence to proceed with a potential investment.

Subscribe now

Conclusion

In short, the Meaning filter is about aligning our investments with who we are as individuals.

It forces us to think beyond just the numbers and consider whether a business is something we genuinely want to be a part of.

Investing in companies that align with our values and competencies is not just good for our portfolio—it is good for our personal growth as investors.

Disclaimer

As a reader of Focus Invested, you agree with our disclaimer. You can read the full disclaimer here.

"Investing success doesn’t come from making the right guesses, it comes from having the right process." — Michael Mauboussin

You have got to have a process when it comes to investing to make money.

Remember we are looking to build a concentrated portfolio of high-quality businesses. The first step towards that goal is having a process to qualify potential investments and select businesses to purchase.

This is the meat and bones of investing, and it is a process which you will have to love if you want to succeed.

There are over approximately 40,000 public stocks listed worldwide available for you to buy. How do you narrow this down to 5 to 20 stocks?

Knowing where to start can be daunting – that is why I have developed Business Selection Process. It provides a guided approach that aligns with the Focus Investment Philosophy:

The Business Selection Process

The goal of the business selection process is to provide a consistent and efficient way to analyse any business you come across.

Running a concentrated portfolio requires you to have conviction in the businesses in which you are invested. A rigorous process allows you to build this conviction as you cover the following areas:

1. Personally, you are looking at businesses with meaning to you that are in your circle of competence (Meaning)

2. You understand the Quality of business you are investing in, the management team involved and assessed associated risks. (Quality, Management, Risk)

3. You are only purchasing when you are getting Value (Value)

This process has been designed to be used in 2 ways:

1. Filtering: When first looking at a company the process can be used as a quick filtering mechanism for sorting companies into the too hard bucket or identifying promising candidates for further detailed analysis

2. Scoring:  As a framework to score the business against specific criteria and to build a detailed investment thesis upon

Subscribe now

Filtering

With there being thousands of public companies to invest in you need an efficient process to separate the wheat from the chaff.

The goal of using the process as a filtering mechanism is to pick up any company and decide as quickly as possible as to whether it is a potential investment worth further detailed analysis.

To be considered for your watchlist the company needs to pass through each of the following selection filters:

• Meaning: Invest in businesses you understand, find interesting and are comfortable supporting

• Quality: Focus on companies with strong competitive advantages and consistent performance.

• Management: Choose companies led by trustworthy, capable, and well-incentivized capital allocators.

• Risk: Prioritize businesses with low debt and predictable earnings to minimize risk.

• Value: Seek investments with a significant margin of safety between market price and intrinsic value.

Working your way down the process and if at any point a business spectacularly fails any one of the filters it can be put in the too hard pile. (Don’t worry we will walk through how to assess each in future blog posts)

The only exception is where a business fails the Value filter only. In this case you have a high-quality business which on the surface looks overvalued currently. This should be put on your watchlist as a potential candidate for further review. The market may offer you a better price in the future!

The aim when filtering business is spending no more time than you need too on each.

Depending on where the business fails in the process this could take anywhere from a couple of minutes to a maximum of a couple of hours.

Remember we are not trying to understand every last detail about the business at this stage we are just looking to discount businesses we don’t want to invest in.

The goal of these filters is to create a repeatable and efficient process that allows us to put companies into one of three buckets.

• Too Hard: Companies that failed a filter and have been put in the too hard pile. This will represent the vast majority of stocks.

• Watchlist: Quality companies at a price that does not represent good value.

• Possible buy: Quality companies at a price that represents good value.

Assuming the business survives a first pass of the filters. Our job is to now perform a more detailed analysis and score the business.

Scoring

After a first pass if the business has made it into your buy or watch list you should be dealing with a company which on the surface is of high quality.

Your goal now is to deep dive into the business to build your conviction.

To do this we again look at each area but through the lens of additional scoring criteria (Scored between 1-10)

Each should be scored with supporting evidence and written summary. This ultimately forms your thesis for the company.

Performing the hard yards here allows you to:

• Build conviction.

• Demonstrate you to truly understand the business and turn over a number of rocks.

• Score the business and compare it more easily against other potential investments.

At this point we will provide a high-level overview of the scoring criteria which will be elaborated on further in future blog post:

Meaning

Invest in businesses you understand, find interesting and are comfortable supporting.

The purpose of this step is to ultimately answer 2 questions:

• Do I want to spend a significant amount of time learning about this business? i.e. does the business align with your values?

• Do I understand how the business makes money and the competitive environment it operates in? i.e. is this within your circle of competence?

Only you will be able to answer the question of whether a business has meaning to you. But for you to really understand a business it must have meaning.

To make money you are going to know this business inside out and better than 99% of people looking at the business.

To do this we will look at and assess the following criteria:

Aligned Values

• Do you want to spend a significant amount of time learning about this business?

• Does the business align with your interests, skills, experience and values?

Circle of Competence

• Does the business lie within my circle of competence?

• Do I understand how the business makes money and the competitive environment it operates in?

Quality

Focus on companies with strong competitive advantages and consistent performance.

"Time is the ally of great businesses, but the enemy of mediocre ones." - Warren Buffett

We are looking for quality companies that will compound over the long term. To assess this, we will review a number of Quantitative Criteria that can be found within company’s financial statements to see if there is evidence of a competitive advantage / MOAT.

We will then perform Qualitative analysis to explain the numbers through with a focus on barriers to entry and business resilience. These Quantitative and Qualitative Criteria are as follow:

Free Cash Flow per Share Growth (Quantitative)

• What is the compound annual growth rate (CAGR) of Revenue, Earnings per share and ultimately Free Cash Flow per share?

• Is growth consistent year on year or sporadic?

Margin (Quantitative)

• How profitable is the company and how efficiently are earnings translated into free cash flow?

• Is there evidence of pricing power within the business?

Return on Invested Capital (Quantitative)

• Has the company had a consistently high return on invested capital over many years?

• Is the company able to invest capital at a rate higher than its cost of capital?

Capital Intensity (Quantitative)

• How much CAPEX and working capital does the business need to operate?

Industry Dynamics & Business Resilience (Qualitative)

• Who are the key competitors and what are the key industry trends?

• Is the business globally active with a diverse customer and product base?

• How resilient is the business to interest rates, credit supply, the economic cycle and industry disruption?

Competitive Advantage: Barriers to Entry (Qualitative)

• What barriers to entry are defending the competitive advantage of this company and how durable are they?

Management

Choose companies led by trustworthy, capable, and well-incentivized capital allocators.

By investing in a company, you are handing over the stewardship of the business to the management team. You want to ensure they are working for you and are capable.

One of the reasons we buy quality companies is:

"I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will." – Warren Buffett

However capable management can make a significant difference even when running quality companies. As we plan to run concentrated position, we want to ensure that management are also high quality.

To do this we will review:

Track Record

• Does the track record and experience of management indicate that are capable and trustworthy?

• Are there any red flags?

Aligned Incentives

• Are the incentives of management aligned with those of shareholders through significant ownership stakes and renumeration policies that incentivise long term shareholder value creation?

Capital Allocation

• Has management demonstrated that capital allocation is a primary consideration in everything they do?

• How have they allocated capital across capital expenditures, expansion, debt payments, working capital, acquisitions, share buybacks and dividends?

Subscribe now

Risk

Prioritize businesses with low debt and predictable earnings to minimize risk.

By this point you have a compounding machine who is run by an incentivised and capable management team. On paper this looks like it could be a great investment.

But first we need to understand if there is anything that could derail this investment.

To do this we look first look at potential risks and then make an assessment of the predictability of earnings (and therefore the confidence we have in any valuations):

Balance Sheet Risks

• Does the business have a healthy balance sheet and manageable level of leverage?

• Are there any “hidden” liabilities such as leases and pensions that need to be considered?

• Perform an Asset Valuation to determine the replacement or liquidation value of the company's assets.

Other Risks

• Explicitly call out key risks and the impact they may have on the business.

• What could break down the barriers to entry and erode the competitive advantage the business has?

Predictability of Earnings

• How secure are the current level of earnings?

• Has past growth been consistent enough to predict and estimate future growth?

Value

Seek investments with a significant margin of safety between market price and intrinsic value.

Having reviewed the above 4 criteria in detail we can be confident that we are dealing with a high-quality business which at the correct price will be a suitable investment. The business should be well and truly on our watch list.

We now need to assess whether we are getting value at the current share price:

Earnings Power Value

• Calculate the intrinsic value of the business based on its current cash profits.

• Determine the percentage of the current share price made up on EPV and future growth.

Total Value

• What growth rate is required for the intrinsic value to reach the current share price?

• What is your best estimate for intrinsic value when incorporating growth and what margin of safety does this leave?

Conclusion

By working through the above steps, you can be confident that you have looked at the business from all angles and can build the conviction needed to invest in a meaningful way.

Scoring the business also allows you to compare other investment options and make informed decisions.

In our next blog posts, we will deep dive on each area (Meaning, Quality, Management, Risk & Value) giving you the tools to perform this analysis yourself step by step.

To wrap up the business selections posts I will also perform a detailed analysis on a quality company I hold.

Disclaimer

As a reader of Focus Invested, you agree with our disclaimer. You can read the full disclaimer here.

“You need a well-defined investment philosophy to guide your decision-making process. Without one, you’re like a ship without a rudder." – Howard Marks

In our last blog we discussed the focus investment philosophy which we built from the ground up to fully leverage the MINDSET, SCOPE, and STRUCTURE advantages we have as retail investors.

It can be summarised as:

• Find high quality businesses with meaning to you.

• Buy with conviction when you are getting value.

• Cultivate a business owners mindset and hold for the long term.

To implement the Focus Investment Philosophy, you need a process that you can follow on a day-to-day basis…

Day in the life as a Focus investor

When I first started investing, I had not properly honed my process. This led to a lot of time wasted and some poor decisions made. Ultimately these mistakes hurt my returns.

"It's good to learn from your mistakes. It's better to learn from other people's mistakes." - Warren Buffett

When you boil down what you need to do as an investor at the highest level there are only a few activities you need to perform based on decisions that need to be made.

In line with the investment philosophy this involves selecting high quality businesses, buying them when they represent excellent value, monitoring them for the long term and only selling when there is a legitimate reason.

"Investing is a process-driven endeavour. The key is to have a process and then follow it with discipline." – Mohnish Pabrai

By following this process, you will sidestep a large number of common investing traps and pitfalls.

We will cover only the high-level overview today and explore each area in more detail in future blog posts.

The process can be summarised as:

Step 1: Business Selection

Remember we are looking for high quality companies with meaning to you. We are also only interested in buying these companies when they present value to us.

There are over approximately 40,000 public stocks listed worldwide available for you to buy.

You need an efficient process to whittle this down to a concentrated list of possible buys.

To do this we will employ a selection funnel with a series of filters. These filters align with our investment philosophy and include:

• Meaning: Invest in businesses you understand, find interesting and are comfortable supporting

• Quality: Focus on companies with strong competitive advantages and consistent performance.

• Management: Choose companies led by trustworthy, capable, and well-incentivized capital allocators.

• Risk: Prioritize businesses with low debt and predictable earnings to minimize risk.

• Value: Seek investments with a significant margin of safety between market price and intrinsic value.

The goal of these filters is to create a repeatable and efficient process that allows us to put companies into one of three buckets.

• Too Hard: Companies that failed a filter and have been put in the too hard pile. This will represent the vast majority of stocks.

• Watchlist: Quality companies at a price that does not represent good value.

• Possible buy: Quality companies at a price that represents good value.

"We throw almost all decisions into a ‘too hard’ file and go onto the next one." – Charlie Munger

This is not to say that companies that make it into the too hard bucket are bad investments - some may well be great compounders. We are simply stating they are too difficult for us to have the conviction to invest meaningful amounts of capital into them. As Warren said:

"I don’t look to jump over 7-foot bars; I look around for 1-foot bars that I can step over." – Warren Buffett

The output of this process is to determine companies that are possible buys. The key word here is “possible”. Before actually making a purchase, you need to think about how this company fits into your wider portfolio as well as take the time assess your MINDSET.

This Buy Decision also needs a process…

Step 2: Buy Decision

Buying a single company should not be done in isolation. Just because you have found a high-quality company and a reasonable price it does not mean it is the best buy for you.

This is a key MINDSET principle – at any one time we are looking to deploy capital into the best ideas out of all possible ideas.

"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 that simple.” – Charlie Munger

To do this you will need to review your current portfolio as well as the wider universe of stocks available to you. Consider the following questions:

• Does this company represent the best use of my capital? Are there other options currently within my portfolio with better risk adjusted returns?

• How does this company fit into my current portfolio? Are there any correlated risks that impact multiple holdings?

• How much capital should I invest and what weighting should the investment be within the portfolio?

Any buy decision should be as measured and deliberate as possible.

For those who have read “thinking fast and slow” by Daniel Kahneman we are looking to employ system 2 thinking here to reduce the chance of jumping into a wrong decision. (p.s. those who have not should put it on their reading list!)

To support this time should be taken to:

• Build a final concise thesis for the purchase. Taking the time to do this will slow the decision down and ensure you have considered all angles.

• Confirm Key Performance Indicators (KPIs) that you will track moving forwards to assess progress against the thesis.

• Take the opportunity to review your decision against a “Investing Mindset Checklist”. This checklist will include frequent questions designed to highlight any common misjudgements and biases we may have. (More to come on this in later blog posts)

“Checklists provide a cognitive net. They catch mental flaws inherent in all of us—flaws of memory and attention and thoroughness” - "The Checklist Manifesto" by Atul Gawande

Step 3: Monitor

Once purchased companies need to be monitored on an ongoing basis.

If you have done your job well in buying a small, concentrated set of quality companies for your portfolio then the burden here should be reduced.

The trick with monitoring your portfolio is taking a balanced approach:

• On one hand we want to stay up to date with the company, its business fundamentals and anything effecting its intrinsic value.

• On the other hand, we do not want to get lost in the minutiae of every press release and stock price change. Over monitoring can lead to rash decisions.

The key focus should be on the underlying business fundamentals and not the stock price or other people’s commentary.

Properly performing the steps within the “Buy Decision” will mean you have entered a position with your eyes open:

• You have already built a thesis and know what key indicators to monitor.

• You have bought the company for the long term and have a business owners mindset.

• Your original purchase was based on the intrinsic value of the company, and you were not speculating on price.

This should help to reduce quick sell decisions.

However, there will be times when something happens that impacts your thesis and the fundamentals of the business.

At these points, a recalculation of the intrinsic value should be performed based on the latest updated business fundamentals. Where the intrinsic value of the business has deteriorated a sell decision needs to be made… 

Step 4: Sell Decision

If you have picked quality companies, you should rarely be selling.

Remember we are looking to hold for the long term to let the magic of compounding take its course!

"Time is on your side when you own shares of superior companies." – Peter Lynch

As discussed in the buy decision - at any one time we are looking to deploy capital into the best ideas out of all possible ideas.

In that respect the sell decision is just the other side of the coin of the buy decision. If there are better opportunities, you should sell and deploy that capital elsewhere.

In practice there are only really a few valid reasons to sell:

1. Your intrinsic value for the stock is significantly below the current stock price because the business fundamentals have deteriorated.

2. Your intrinsic value for the stock is significantly below the current stock price because the stock price has increased without a corresponding increase in business fundamentals.

3. There are opportunities out there that represent a significantly better estimated rate of return.

4. You need the capital for a life event such as buying a house, putting your kids through school, retirement etc.

Given our business owners mindset and long-term perspective, a sell decision should not be taken lightly. There should be a significant burden of proof supporting one of the above reasons.

Again, like the buy decision this an opportunity to slow down and employ system 2 thinking:

• Write a concise exit thesis

• Demonstrate a deterioration against KPIs where applicable and the effect on intrinsic value

• Take the opportunity to review your decision against a “Investing Mindset Checklist”.

After taking these steps you can be more confident in your decision to sell.

Remember most of the time you should be holding onto you winners, doing nothing, and letting the magic of compounding take hold…

Step 5: Compound

Great, so you have a portfolio of high-quality compounders, they are reasonably priced, and their business fundamentals are on track. What now?

Do nothing!

"The hardest thing to do is to do nothing." — John Bogle

For me this is the hardest part of investing. The reason I enjoy investing is I love studying businesses and how they work. This means I am always looking at potential investments.

If you are not careful this can lead to “Shiny Object Syndrome” which is the tendency to new and exciting ideas while neglecting existing ones.

Remember a solid strategy and sticking with what you know often leads to better results than constantly jumping to the next new thing.

To counteract this, you need to have more to your game than pure technical investing ability. You need to approach investing with the right mindset and practice:

• Study your existing holdings: You should aim to be as knowledgeable as the management teams themselves. Remember, know what you own!

• Compound your learning: Take the time to read and learn about other subjects. You will be surprised by how this can enhance your investing acumen.

• Patience: Work on your mindset and develop the patience to hold your investments for the long term, focusing on business fundamentals rather than short-term market movements.

Conclusion

You should now have a sense of how the investment philosophy can be put into practice.

In the next couple of blog posts we will deep dive into Step 1: Business Selection.

Business selection is the meat and bones of the investment process and is the most technical in nature put of all the steps. Do not worry we will be simplifying the process down to what truly matters!

Disclaimer

As a reader of Focus Invested, you agree with our disclaimer. You can read the full disclaimer here.

As discussed in our previous blog a small underperformance can have a dramatic impact on your returns over the long term.

At this point it is worth committing to an approach. You have 2 high level options:

• Option 1: Passively invest and achieve average market returns. This is probably the correct course of action for 90%+ of people. Without an interest in investing your focus is best spent on other endeavours.

• Option 2: Commit to becoming a focus investor by:

  • Taking your financial future into your own hands

  • Learning and developing yourself into an independent investor

  • Leveraging the advantages you have to beat the market.

Because you are reading this blog, I presume you are at least interested in option 2. Let’s dig a bit deeper…

As a reminder to outperform the market you must leverage the advantages you have as a retail investor:

• Mindset: Developing the right mindset is crucial. This includes maintaining a long-term perspective, managing emotions, and focusing on the big picture.

• Scope: Retail investors have the freedom to explore a wide range of opportunities. This includes investing in small companies and less popular industries or regions, where there is often less competition and more potential for mispricing.

• Structure: Retail investors are not bound by the same constraints as professional money managers. This flexibility allows for making bold decisions, taking concentrated positions, and being tax efficient.

To do this however requires an investment philosophy and a process to put that philosophy into action.

Subscribe now

The Focus Investment Philosophy

The focus investment philosophy is the approach that I take with my own investments. It has been built from the ground up to fully leverage the MINDSET, SCOPE and STRUCTURE advantages we have as retail investors.

The philosophy acts as the foundation of my investing approach and all decisions are made with this philosophy in mind.

It can be summarised as:

Find high quality businesses with meaning to you 🏆

There are many ways of making money in the market, but we are seeking an approach that leverages the advantages you have as a retail investor, as well as one that will work over the long term to let the magic of compounding take effect.

Quality companies fit this bill.

Our definition of a quality company is one that over the long term consistently generates positive and growing free cash flow per share. It is as simple as that!

The catch is that very few companies actually fit this definition…

The world of business is a competitive place and to grow free cash flow over the long term the business needs a durable competitive advantage.

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors." – Warren Buffett

A lot of my time is spent assessing the quality of businesses and make up of their competitive advantages. I will teach you how to do this in future blog posts.

Now coming back to how the philosophy leverages the advantages we have as retail investors.

Remember as a retail investor you have the SCOPE to find business of all sizes, industries and regions. This means you can find high quality business where the professionals are not able or willing to look.

Having the right MINDSET is an essential part of picking companies well. Finding companies with meaning to you means they are within your circle of competence, and you have the deep interest required to fully understand the business.

This sets you up well for making an informed decision when buying the company but also makes it easier to hold for the long term. You are able to truly focus on your investments with this approach.

Buy with conviction when you are getting value 💰

Quality companies are hard to come by.

Harder yet is finding a quality company which is undervalued or even at a fair price.

When you find one of these gems you need to buy with conviction. This means your portfolio should be focused on a small number of companies which you know well and are confident will outperform the market.

There is nothing worse than finding a great company to invest in at an attractive value to then only invest a tiny sum into the business. This can severely limit your upside and the positive impact on your overall portfolio. You will not outperform the market this way.

"The idea of excessive diversification is madness. It's a confession that you don't really understand the businesses that you own." – Charlie Munger

As a retail investor you have the STRUCTURE to buy with conviction so you should take advantage of this. Note: We will discuss appropriate position sizing in future blog posts.

No matter how good a company is it can be a poor investment at the wrong price. Buying overvalued stocks both limits upside potential and increases the risk of loses.

But what do we mean by value? This is best demonstrated through understanding the Price-Value relationship:

• Value is the intrinsic value of the company based on its fundamentals. It reflects the company’s real economic value.

• Price is the market price at which a company’s stock is trading at on any given day.

Over the long run value and price correlate, over the short term they certainly do not. This leads to opportunities where stocks are mispriced.

We are looking for companies where the market price is equal to or lower than the intrinsic value of the business. The larger the difference the larger the margin of safety on the investment.

To determine this, you need a solid approach to understanding intrinsic value and methods of estimating it. Note: We will discuss valuation methods in future blog posts.

So, you are looking for stocks with a margin of safety and you have the SCOPE to be finding value in places where others are not willing to look.

Cultivate a business owners mindset and hold for the long term ⌛

We are picking businesses not stocks.

This is the most important MINDSET shift that separates winning investors from speculators.

Stocks are not trading cards. They represent a minority stake in a business.

The long-term valuation and total shareholder returns are dependent on the underlying business fundamentals of the company.

Look at the majority of the wealthiest people in the world. They held concentrated positions in quality businesses for the long term:

• Jeff Bezos: Amazon

• Bill Gates: Microsoft

• Bernard Arnault: LVMH

• Mark Zuckerberg: Facebook/Meta

They let the magic of compounding take effect!

"If the job has been correctly done when a common stock is purchased, the time to sell it is almost never." - Philip Fisher

To emulate this, you should treat each investment and your portfolio as a whole like a business.

You should aim to treat stocks like a small business owner who owns a 100% stake.

• Your focus should be on the intrinsic value of the company and not the price action of the stock.

• You should focus on business fundamentals not macroeconomics.

• Work on your MINDSET to allow you have the patience to hold for the long term.

Subscribe now

The Philosophy as the Foundation

We now have the core of the focus investment philosophy and explained how it leverages the advantages we inherently have as retail investors.

The principles within it act as foundation of the approach domain within the wider Focus Invested Framework. However, you will notice influences from the focus, mindset and practice domains also.

Read more here on the wider focus invested framework:

Going forward, our investment decisions will be grounded in this philosophy and its underlying principles.

In the next blog post we will be exploring the first steps of putting the philosophy into practice through the day in the life of a focus investor.

Disclaimer

As a reader of Focus Invested, you agree with our disclaimer. You can read the full disclaimer here.

Even with a respectable average return of 10% annually you will more than 17x your money in 30 years.

It is easy to underestimate the impact of small gains. Even a couple of percentage points of outperformance can dramatically improve results over the long term.

As seen below, increasing your rate of return by 3% leads to more than doubling the absolute number equal to a 39x of your original investment. This is the magic of compounding!

https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator

The most powerful thing you can do when pursuing financial freedom is to achieve market beating results with your investments.

However, beating the market is not just a matter of luck; it requires a focused, disciplined approach.

To do this you need to understand market, the main players and find your own edge to exploit.

Subscribe now

What is the market and who are the main players?

When we talk about "the market," we are specifically referring to the stock market. The stock market is a collection of exchanges where investors can buy and sell small shares (Ownership stakes) of publicly traded companies.

Over the long term the performance of the market it dictated by the underlying performance of the companies that make up the market.

The majority of the market's investments are managed by professional money managers through various funds. These funds take one of 2 approaches.

• Passive indexing – Passive indexing is a strategy where investors buy a broad market index. Fees are low as there is no active management. Investors can expect to consistently achieve the market average.

• Active management:  Fund managers actively buying and selling securities in an attempt to outperform the market. Fees for this approach are higher than for passive indexing due to the costs associated with research, analysis and more frequent trading. Investing is a zero-sum game so by definition all the returns of all active managers should equal the average of the return of the market. However, when taking into account fees active managers underperform the market on average. This is balanced by the fact there is also a chance for overperformance…

Beating the market by investing in funds is hard:

Only 17 per cent of actively managed equity funds managed to beat the index over the last decade, according to a new report from Morningstar. Morningstar’s Active/Passive Barometer found that European fund managers are terrible at beating their benchmarks. It analysed over 26,000 funds. - https://www.morningstar.com/en-uk/lp/european-active-passive-barometer

https://www.morningstar.com/en-uk/lp/european-active-passive-barometer

This aligns closely with the Pareto Principle, which suggests that 80 percent of outcomes often come from 20 percent of efforts.

Given the zero-sum nature of the market this means the 20% overperformance is equal and opposite to the 80% underperformance over the long term.

To put it another way, the losses from the 80% are flowing to the 20% of overperformers as gains. (Note: Excluding losses for fees)

The problem for your average investor is how do you consistently pick winning fund managers?

The answer is this is very difficult if not impossible, so the standard advice is to just passively invest.

"The winning formula for success in investing is owning the entire stock market through an index fund, and then doing nothing. Just stay the course." - John C. Bogle, the founder of Vanguard Group and a pioneer of passive investing

This is sensible for the majority of people but what if I told you there is a 3^rd option for those who are willing to focus on:

• Taking your financial future into your own hands

• Learning and developing yourself into an independent investor

• Leveraging the advantages you have to beat the market.

But if the majority of professional money managers cannot beat the market. How are we as retail investors supposed too?

How can you compete with all the “smart moneys” MBA’s, resources and time?

The answer is you cannot if you are playng the same game. You need to focus on the advantages you have as a retail investor.

The Advantages you have as a Retail Investor

It is very easy for each of us to list off the advantages that the professional money managers have and write off active retail investing as a not a viable option. They would have you believe that their fancy degrees, ample capital and access to management provide them with an insurmountable edge.

Let’s challenge that assumption…

Fortunately for us, retail investors have some lesser known but hard-hitting advantages.

There are written rules and intrinsic constraints that do not apply to retail investors that make it so we don’t have to play the same game as the “Smart Money”.

Focus on leveraging advantages in each of the 3 following areas to beat the wider market.

MINDSET 🧠

The most important aspect of investing is developing the correct MINDSET and associated behaviours. This is an area that is almost impossible to do optimally when working in the world of professional money management. As Charlie Munger said:

"Show me the incentive and I will show you the outcome."- Charlie Munger

Professional money managers incentives are just not conducive to long term out performance and that is because they are not playing the same game.

• Risk Aversion and Career Risk: the most important thing to remember is that money management is a job. The biggest incentive for the money manager is keeping that job and this trumps any over goal such as beating the market. The incentives to take a contrarian view are just not there and leads to behaviours like closet indexing. This is summed up best by the saying "Nobody ever got fired for buying IBM.” This saying reflects the notion that buying well-known, established companies like IBM is seen as a safe choice. Even if the investment does not perform well, the decision is less likely to be criticized because it follows conventional wisdom and industry norms.

• Short term focus: Money managers are generally measured on a quarterly basis and therefore they have a lot of incentive to look good in the short term. This leads to following the crowd and buying recent winners that may not necessarily be the best option for long term outperformance.

• Bureaucracy in Decision Making: Money managers typically need to go through multiple layers of approval and committees to make decisions. This can mean market beating opportunities are missed and bold innovative ideas can be watered down due to the need for consensus.

• Pressure to Conform: We are all social animals and the pressure to conform can lead us to make suboptimal decisions. From an evolutionary standpoint staying with the pack means safety. Operating in a work environment when trying to make decision can make it that much more difficult to control your emotions and make the right choice.

The above can be summarised by the term frequently known as the “Institutional Imperative”.

"Rationality frequently wilts when the institutional imperative comes into play." – Warren Buffet

This is not something we as retail investors are subject to (at least to the same degree!). This is not to say we cannot fall into the trap of our own biases and adopt a suboptimal approach.

The key thing is to focus on developing your MINDSET and leverage the following advantages:

• Long Term Perspective: You are investing for the long term and your aim is to outperform the market in the long run. All decisions should be made with this long-term goal in mind. Let the magic of compounding run its course!

• Emotional Control: Employ mental models, checklists and have an awareness of common biases. Put yourself in an environment where you are able to execute on your ideas and focus!

Subscribe now

SCOPE 🎯

Funds typically have a limited SCOPE in terms of what they can invest in. For example, funds may limit based on location, size and/or industry.

Sometimes these limits are defined with the funds mandate and in others practical considerations limit the number of suitable investments available to them.

• Mandated Exclusions: Funds with a specific mandate are by definition excluding a portion of the market from their investable universe. This can work well in some instances as it focuses the analysis on a specific region or industry. However, at times those regions or industries may be falling behind the wider market and the fund manager is limited in what they can invest in.

• Small Companies: Dependent on the size of the fund they are managing professional money managers struggle to invest in smaller companies. A fund managing $1 billion dollars is not going to be able to invest in a company of circa $50 million it is just not worth their time. Even I the manager was to purchase 10% of the available stock in the company the company ($5 million) this would be 0.5% of the overall portfolio. Returns here will not move the needle. Purchasing at these levels also adds additional risk in that the shares become less liquid and trying to exit the position quickly could cause issues. This all means that the professional money managers are not looking at smaller companies.

As retail investors we want to take advantage of the fact that we can dictate our own SCOPE. The amount of capital available to us does not prohibit us from investing in smaller companies:

• Wide Investable Universe: Remember we are looking for absolute returns and we do not particularly care where they come from as long as we are comfortable with the associated risk. Focus investors should leave their investable universe as wide as possible up front. I will teach you how to properly filter this universe down into a smaller list of suitable investments.

• Ability to invest in Smaller Companies: With fund managers not investing in smaller companies there are less eyeballs following the stocks. This means there is less competition and there is more likely to be a mispricing in the valuation of the stock. This is what we are looking for! This combined with the fact that over the long-term smaller companies generally outperform larger companies means that a small cap bias should be incorporated into our portfolio.

STRUCTURE 🏗️

Professional investors are subject to various regulations and fund specific mandates that dictates how they can invest. The very nature of managing money for other people also brings with it some unique challenges. This STRUCTURE limits professional money managers options and flexibility in the following ways:

• Position Limits: Most funds have a fairly arbitrary percentage limits on how big any one position within their portfolio can get. In many cases this means that they are unable to let their “winners run” to avoid breaching these limits. This is the complete opposite of what you want to do!

"Some people automatically sell their 'winners' and hold on to their 'losers,' a strategy that's been called 'pulling the flowers and watering the weeds.' You should instead be pruning the weeds and watering the flowers." – Peter Lynch

• Capital Outflows and Volatility: Volatility is the enemy of professional money managers. In times of significant drawdowns fund investors will typically withdraw their money and shelter within the perceived safety of cash. These significant capital outflows happen right when the fund should be investing in undervalued assets. This leads to managers attempting to limit volatility on the downside which also has the effect of limiting volatility to the upside!

• Significant fees and Taxes: Money managers need to take into account significant fees and taxes when buying and selling. Capital gains tax is a silent drag on returns that adopting a buy and hold approach negates.

Retail investors have the STRUCTURE to be flexible with their decisions and take full advantage of any opportunities that come their way. Leverage the following:

• Flexibility: It is your portfolio, and you make the decisions. You can take focused positions in your best ideas, double down when others are bailing out and let your winners run into significant positions within your portfolio. Flexibility combined with the right mindset allows you to make the optimal decision for your portfolio over the long term.

• Tax Efficiency: Retail investors can manage their investments in a tax-efficient manner. Take advantage of tax-advantaged accounts (IRAs, Roth IRAs, ISAs, Pensions) and strategically time trades to manage capital gains taxes. This alone can provide you with a couple of percentage points advantage in the long term.

Bringing it together

As you can see from the above there are advantages that us retail investors have that when properly leveraged can provide market beating results.

Unfortunately, most investors are either not aware or don’t have a framework in place to do so.

That is where the focus investment philosophy comes in. This will provide you with the framework to leverage these advantages in practice and will be the subject of our next blog post… (Sneak Peak below!)

Disclaimer

As a reader of Focus Invested, you agree with our disclaimer. You can read the full disclaimer here.

Financial freedom is attainable only to those who Focus

Among the many paths to financial freedom, investing and harnessing the power of compounding is the most effective route for the vast majority.

While everyone knows they should be investing, many lack the knowledge and discipline to turn that awareness into action.

This blog is your guide to developing the skills and mindset necessary to achieve financial freedom through investing.

But first a little about myself

Hi, I'm Jim, the author of Focus Invested.

• A seasoned strategy consultant and successful Amazon FBA business owner, I am passionate about self-development and investing.

• I've read over 200 books on investing and self-development, and this blog distils all I've learned into practical principles and frameworks.

• With more than 10 years of experience applying these principles and refining my skills, I am here to share my knowledge and help other investors on their journey to financial freedom.

Join me as we explore the path to financial independence, providing you with the tools and insights needed to succeed. Stay focused, stay invested, and let's unlock your potential together.

Subscribe now

Financial Freedom through the Magic of Compounding

Financial freedom is when you no longer need to be employed to finance your lifestyle. To me the benefits of this are profound and include:

• Spending quality time with family and friends

• Living and working on your own terms

• Pursuing your life’s passion and travelling

Achieving financial freedom is not just about accumulating wealth; it is a key pillar in creating the life you want to live.

One of life's main purposes is to learn, build, and iterate. The human mind needs a project to wake up to each morning. For me, that project is mastering the art of investing. Investing is a vast and deep field. It provides a perfect framework for lifelong learning and development.

The power of compounding is a fundamental principle in life and investing. It can produce extraordinary results with time.

Compounding occurs when the returns on your investments generate more returns. When left to run this creates a snowball effect that accelerates growth.

Investing and learning are two areas where compounding can produce transformational results:

“A stock that returns about 20% per year for 25 years multiplies your money by a factor of 100x. An investment of $10,000 in that case becomes $1,000,000.” - Christopher Mayer

“If you are investing in your education and you are learning, you should do that as early as you possibly can, because then it will have time to compound over the longest period.” – Warren Buffet

Investing is not only about financial gains; it’s also about intellectual growth. The true magic of compounding is achieved when you combine and focus on these 2 areas.

• By consistently learning and applying new knowledge, you can enhance your investing skills and improve your decision-making process.

• The synergy between learning and investing then amplifies the compounding effect.

• Financial and personal development are the foundation of making market beating returns.

I have been focusing on and compounding both areas in my life for over 10 years. This blog documents what I've discovered through the Focus Invested Framework I've developed.

The Focus Invested Framework

To me investing is both an art and a way of life and to succeed a integrated approach that intertwines money management, investing principles, and personal growth is required.

I have developed the focus invested framework for that purpose. It represents the high-level view of how to think about and approach investing. It will also form the basis for the content of this blog.

The framework consists of 4 domains which if you consistently work on, and let the magic of compounding take effect, you cannot help but achieve great things.

We will cover each of these areas in more detail moving forwards but for now here is an overview of each:

Focus 🔎

Central to everything we do, ensuring you stay committed and disciplined.

You will notice Focus is at the core of the model and the included in the name of this blog!

This is because it is the most important domain and forms the very foundation of everything we are discussing.

The definition of focus in the oxford dictionary is “the centre of interest or activity” which is very fitting. Focus forms the foundation of the model in the following ways:

• It represents the intention and dedication required to master the art of investing.

• It represents a resource each of us have which can be invested into the 3 other domains .

• It represents the integration of learnings from the three other domains back into the core, forming a comprehensive model.

• It represents a focused approach to investing through deep research and concentrated positions

To some this may sound somewhat new age, but I promise you without focus you will not succeed in investing (or anything in life for that matter!)

Like anything, focus is a skill that can be cultivated through practice, and we will be sharing practical steps on how to develop and optimise your focus.

Approach 📝

A structured method for identifying high-quality investments and making informed decisions.

This domain is my focused investing approach that I have built over the course of my investing journey. It will provide you with the foundational skills and practical steps to achieve market beating results.

At its core the approach can be summarized as:

• Finding high quality businesses with meaning to you.

• Buying with conviction when you are getting value.

• Cultivating a business owners’ mindset and holding for the long term.

With this approach you will have a framework to base you investing decisions upon and if applied correctly make market beating returns. Within this area I will teach you how to:

• Turn yourself into a compounding machine and establish a solid foundation for growth

• Focus on leveraging the advantages you have as a retail investor over the wider market.

• Analyse any business from the bottom up and intrinsically value the company.

• Make buy/sell decisions and establish a portfolio of quality compounders.

Mindset 🧠

Building the mental models and resilience needed to navigate the complexities of investing.

“You’ve got to have models in your head, and you’ve got to array your experience – both vicarious and direct – onto this latticework of mental models.” – Charlie Munger

You can have the all the knowledge in the world but without the right mindset and mental models you will not go far in investing. There are too many mental stumbling blocks.

This is part of the reason I love investing as an art form. It not only requires the technical expertise but also requires mastery of the way that you view the world and how you handle your emotions.

This is an area that a lot of investors neglect at their own peril. Remember:

• Mindset is why investors buy high and sell low.

• Mindset is why investors follow the crowd and jump into the next hot stock without doing their own research.

• Mindset separates those that will beat the market vs those that won’t.

A significant proportion of this domain is inspired by my personal hero the late great Charlie Munger. Charlie is Warren Buffets right hand man who influenced him to focus on high quality companies and look how that turned out!

Within this domain I will distil relevant content to help you develop the right mindset and mental models required to consistently outperform the market:

• Understand how the mind works, what influences our thinking and common biases that can negatively impact our results.

• Develop a latticework of mental models and integrate principles from areas such as Physics, Psychology, Philosophy and Mathematics into your investing journey.

• Tips on how to foster a Long-Term Focus and embrace the life long journey of learning and investing.

Practice 💪

Putting theory into action through consistent, deliberate efforts and learning from real-world experiences.

The difference between dreams and reality lies in the actions we take. Practice is the application of both the approach and mindset domains through focused action.

You only learn through action, and this is where the real fun of compounding both knowledge and money begins.

However, you are not alone and to guide you on your way I will be documenting my own journey and investments. This will provide you with investment ideas, crystalise teachings through examples and practical resources to support you along the way.

To guide you I will be sharing:

• My personal portfolio of high-quality companies that follow the focus invested approach.

• Deep dive investment cases for individual companies detailing my thought process and buy/sell decisions.

• Practical resources and tools that I use daily to improve workflow and focus on what matters.

Ready to take control of your financial future and embark on a journey of personal growth?

Subscribe to Focus Invested now and join a community of like-minded individuals dedicated to mastering the art of focus investing.

By subscribing, you’ll get:

• Three insightful articles each week covering topics across the focus invested framework (Focus, Approach, Mindset and Practice)

• Full access to our comprehensive library of data-driven articles

• Insights into our portfolio of high-quality stocks

• Detailed investment cases on compelling companies

Don’t miss out on the opportunity to transform your financial life. Subscribe today and stay focused on your path to financial success and personal growth!

Subscribe now

Stay focused, stay invested, and unlock your potential with Focus Invested!

Disclaimer

As a reader of Focus Invested, you agree with our disclaimer. You can read the full disclaimer here.