The EVA Monster Series: How to Fuel a Perpetual Growth Engine

With this series, we’d like to give you some perspective on the companies in our distinguished EVA Monster universe. This rare breed of quality-growth stocks is worthy of your attention, and getting to know these businesses may pay off handsomely down the road.

As a quick recap, EVA Monsters have three things in common:

  • They earn high returns on the capital they employ.
  • They have growth opportunities that allow them to reinvest most of their cash flows at high rates of return.
  • They have a sustainable competitive advantage (that Warren Buffett calls “moat”), which prevents their competitors from taking away their extraordinary profitability.

These characteristics tend to result in a strong (double-digit) fundamental return potential, meaning that no valuation tailwind is necessary to get great investment results with EVA Monsters. (These case studies explain this pretty well.)

As Charlie Munger said:

“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns 6 percent on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6 percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

We also shared the math proof of why buying EVA Monster stocks at a fairish valuation makes perfect sense for long-term investors. (Look for the “math example” in this post to alleviate your doubts.)

To round off the short introduction, we (1) try to avoid overpaying for EVA Monsters, (2) closely monitor the fundamental performance and management’s capital allocation decisions throughout our holding period, and (3) hold our positions as long as the underlying investment thesis remains intact, ideally for decades, to let compounding do the heavy lifting.

Without further ado, numbers clearly prove that Constellation Software (CNSWF) is a genuine EVA Monster and a truly unique vehicle, so it is worthy of your close attention. It is remarkable how this serial acquirer built an immensely durable (shall we say perpetual) growth engine.

Constellation Software Inc. acquires, manages, and builds vertical market software (“VMS”) businesses. These entities are dedicated to delivering mission-critical software solutions tailored to the requirements of their clientele within specific industries, catering to both the public and private sectors. Constellation’s extensive portfolio comprises hundreds of companies, spanning diverse sectors such as communications, agriculture, marine applications, utilities, credit unions, beverage distribution, and hospitality. Constellation Software Inc. was incorporated in 1995 and is headquartered in Toronto, Canada.

Mark Leonard, the founder and visionary behind Constellation Software, has been serving as CEO since the company’s inception in 1995, quietly shaping a unique success story. Despite his status as one of the lowest-profile billionaires in the business world, Leonard’s impact and capital allocation skills cannot be emphasized enough. His journey began with a decade-long stint in venture capital, during which he recognized the untapped potential of small VMS firms. This realization laid the foundation for his distinctive approach of building a growth engine around these underappreciated companies.

Constellation operates across a diverse spectrum of over a hundred distinct verticals, encompassing a portfolio that spans several hundred companies. Owing to this diversified corporate framework, no individual business unit or segment holds material significance for the organization.

Maintenance and other recurring revenue (71% of fiscal 2022 sales) primarily consist of fees from customer support on software products post-delivery and include recurring fees earned through Software-as-a-Service products. Professional service revenue (21%) comes from fees charged for implementation services, custom programming, product training, and consulting.

We believe the secret sauce in Constellation’s competitive edge lies in the culture that characterizes its acquisition approach. It aims to be a perpetual owner of the acquired companies, thereby distinguishing the business from conventional private equity firms whose primary focus is the subsequent resale of their acquired assets at a premium in the future.

Notably, the firm acquires over 100 companies each year (averaging one every other business day). This pace is only possible in a decentralized decision-making framework, which also includes the critical function of capital allocation. Constellation’s corporate headquarters grants significant autonomy to subsidiary management levels, empowering them with the authority to evaluate potential acquisition targets and make informed decisions based on their assessments.

We believe another pillar of Constellation’s moat lies in the characteristics of its portfolio members. Essentially, it’s a conglomerate composed of an army of small but moaty businesses, each characterized by high switching costs. In essence, VMS companies provide highly customized solutions to meet the needs of a specific segment.

Although we do not favor serial acquirers in general (as this feature seldom aligns with consistent shareholder value creation), we hold the conviction that Constellation’s attributes justify the designation of a wide-moat enterprise.

Source: ISS EVA, The FALCON Method

As for the future, it is worth noting that the collective organic growth rates exhibited within Constellation’s portfolio of companies have been rather modest, yielding a low-to-mid-single-digit annualized CAGR over recent years. Consequently, Constellation’s growth engine can be best understood by the principle that a firm’s long-term annualized earnings growth rate converges to its reinvestment rate times the return on its incremental invested capital. Assuming that Constellation can continue allocating 80% of its internally generated cash (NOPAT) each year at 20%+ ROC levels, we arrive at a strong double-digit inorganic revenue and earnings growth potential.

At its core, this firm can be characterized as a capital-light compounder because the VMS businesses under its umbrella require very little reinvestment. Then, recurring cash flows generated by the VMS firms are harnessed to fuel a relentless acquisition engine, resulting in consistently stellar ROC levels in the 25-30% range.

Turning to shareholder distributions, Constellation pays a tiny, negligible regular dividend. In 2019, shareholders received a sizable, ~$18 per share special dividend due to the lack of attractive redeployment opportunities. Constellation has garnered a unique shareholder base that would prefer Leonard to reinvest this money instead of distributing it. Therefore, we find it unlikely that another special payout will take place in the foreseeable future, and even the ordinary dividend could be sacrificed if a better use of cash presents itself.

Looking at the stock’s valuation, Constellation’s shares have always appeared pricey on the surface. Regardless, its EVA growth over the past 5-10 years has managed to surpass even the market’s rosy expectations. Please see below the valuation metrics of the EVA framework that remedy accounting distortions to give us a clearer picture on where the stock stands in a historical context.

(Curious why we don’t use the most popular multiples? Find out here!)

The “fair” valuation range in the future hinges on the firm’s reinvestment efficiency, and as we see potential downside risks on the growth front, we have employed more conservative assumptions in our model. Nevertheless, the market-relative valuation seems unattractive at the moment with a NOPAT yield of 2.8%. Waiting for the valuation component to become at least neutral to the total return formula seems a reasonable approach at this point.

Overall, the time to get excited is not now. The “Key Data” table and the 5-year total return potential chart speak for themselves.

Source: ISS EVA, The FALCON Method

The FALCON Method can identify much better opportunities in the current market, so we are passing up on Constellation for now.

The verdict

The most obvious risk that comes to mind is that Constellation may have reached a point where it is too large to sustain its historical growth levels. The company will have to allocate as much cash in the upcoming five years as it had in the last two decades, and this raises several questions.

Furthermore, Mark Leonard’s willingness to go outside Constellation’s core circle of competence when seeking alternative options to deploy capital brings an elevated level of uncertainty. As a true value investor at heart, he warned investors that any non-VMS deal is likely to be a highly contrarian, “eyebrow-raising” type of transaction.

While challenges like the level of key personnel risk involved in this thesis do pose threats, we would be more than happy to own this business at the right price. The collection of moaty VMS businesses, paired with the head office’s corporate culture and approach to capital allocation makes us want to be an owner of this company. As for position sizing, we would be comfortable with a 2-3% exposure.

The company ranked 28th of our 60 EVA Monsters at the time of writing, based on its 5-year total return potential. (Businesses from 12 countries are represented on our EVA Monster list.)

It is safe to say that there are far more attractive EVA Monster stocks to buy in the current market, with all the highest-ranking ten boasting total return potentials above 12% over our modeled 5-year timeframe. (You can always find the monthly Top 10 in the FALCON Method Newsletter along with our entry price recommendations.)

Want to learn more about our ranking methodology? Start with this blog post!

Hitting the Sweet Spot

“The biggest mistakes I’ve made by far are mistakes of omission and not commission.” (Warren Buffett)

This blog post is dedicated to providing a behind-the-scenes look at how subjective considerations can influence the compilation of the monthly Top 10 for the newsletter, with a particular focus on our EVA Monster candidates. While the backbone of the underlying process will always be the quantitative ranking of our investable universe constituents based on their total return potentials, we argue that a more nuanced approach produces a better outcome. This, in fact, reflects the thought process behind how our analysts manage their own money, which has to be consistent with the newsletter, as this is a pillar of our integrity.

The problem with a purely quantitative ranking is that a mere total return potential figure does not fully reflect the range of possible outcomes. As a quick recap, a good rule of thumb is that we expect our typical EVA Monster to deliver an annualized fundamental return of 10-15%, comprising the firm’s EVA growth potential, share buybacks, and dividend yield. Since we derive our total return estimates by incorporating the impact of valuation, it’s unsurprising that when the total return potential significantly exceeds 10-15%, betting on a valuation rebound will likely play a pronounced role for an investment candidate.

A common theme in those situations is a rather pessimistic market perception, requiring a case-by-case evaluation with a contrarian mindset. “The best thing that happens to us is when a great company gets into temporary trouble. We want to buy them when they’re on the operating table.” The intent from this classic Buffett adage is easier said than done, as these stocks often turn out to be difficult to hold amid periods of turbulence. We reckon that when a company of EVA Monster caliber (head and shoulders above the typical S&P 500 member in quality and growth terms) gets into a dire situation, there is a good chance it will recover, much like an elite athlete having better odds on the operating table compared to a chain-smoker. Suppose an EVA Monster trades with close to zero or a negative Future Growth Reliance ratio (implying that its EVA could stagnate or shrink from the current level). In that case, it is usually a “heads I win, tails I don’t lose much” scenario. Sometimes, the market will be right, and the competitive position may have suffered damage beyond repair, serving as a bitter reminder that even though probability is on our side, this does not mean certainty. While these investment situations could offer favorable risk-reward ratios, we must also acknowledge that not all of us have the same tolerance for bearing the inherent volatility that almost always accompanies such cases.

Let’s now consider the concept of “hitting the sweet spot”. We refer to a select group of companies as “crème de la crème,” highlighting their superiority even within our elite EVA Monster universe. The common thread among them is the combination of an unassailable competitive position, exceptional reinvestment opportunities, and, more often than not, a high degree of revenue stream diversification. Microsoft, Amazon, Alphabet, LVMH, L’Oréal, and Hermès serve as prime examples of this class, although it’s important to note that this labeling represents more of a spectrum than a clear-cut categorization.

Occasionally, some of these top-tier companies come close to reaching the upper echelons of our coverage in terms of their respective total return potentials, albeit this isn’t sufficient to qualify them for the Top 10 on a quantitative basis. While our sample size is somewhat limited, we have numerous examples where companies like Microsoft, Hermès, or LVMH briefly traded at levels offering double-digit total return potentials, only to swiftly reverse their share price trajectory and perform remarkably well in subsequent periods. Hindsight is 20/20, but we argue that seizing such opportunities and including these juggernauts in the FALCON Portfolio would have been the right decision. Quoting Buffett again: “The biggest mistakes I’ve made by far are mistakes of omission and not commission. I mean, it’s the things I knew enough to do. They were within my circle of competence, and I was sucking my thumb… Those are the ones that hurt.” In these specific cases, the mistake of omission was caused by the intention to avoid compromising on the prospective return, thereby missing out on rare opportunities to become an owner of these world-class businesses.

When crunching the numbers, we must draw the line of “enough” for the total return potential somewhere, so we’ve set the goal to achieve a comfortable double-digit annualized investment return on a portfolio level. Generally, our standard approach is to pull the trigger midway between our “accumulation” and “full position” price thresholds. In practice, this means including a stock in the FALCON Portfolio when our modeled total return potential hits ~18%. This serves as a built-in margin of safety, as even if we are not entirely correct, achieving the targeted 12% total return still seems within reach.

However, there is an important distinction: the more confident we are in our modeling and the narrower the range of outcomes, the lower margin of safety should be demanded in total return terms. We argue that it is worthwhile to consider building a position in the top-notch companies even if their total return potentials “only” reach 12%, reflecting our stronger conviction that they can deliver on their modeled EVA growth trajectory. For these EVA Monsters, we would contemplate subjectively catapulting their stock into the newsletter’s Top 10, possibly coupled with inclusion in our FALCON Portfolio if they are not already members. As luck would have it, a subsequent collapse in share price can happen anytime, so buckle up for that as well. Taking advantage of those situations is the straightest path to long-term wealth building.

One thing is for sure: no matter how outstanding a business may be, its stock can always be too expensive, so we are not willing to compromise beyond a certain point. Therefore, if our model shows a single-digit total return potential, a company will never be subjectively promoted to the Top 10, let alone become a Top Pick. In such cases, we have high conviction that the valuation component could act as a headwind over the long term, likely leading to subpar investment returns. While we might be wrong at times, it is worth keeping the good old process-outcome matrix in mind to systematically judge the results of our decision-making framework. Now let’s see what the FALCON spots this time!

The EVA Monster Series: Spicing Up Your Portfolio

With this series, we’d like to give you some perspective on the companies in our distinguished EVA Monster universe. This rare breed of quality-growth stocks is worthy of your attention, and getting to know these businesses may pay off handsomely down the road.

As a quick recap, EVA Monsters have three things in common:

  • They earn high returns on the capital they employ.
  • They have growth opportunities that allow them to reinvest most of their cash flows at high rates of return.
  • They have a sustainable competitive advantage (that Warren Buffett calls “moat”), which prevents their competitors from taking away their extraordinary profitability.

These characteristics tend to result in a strong (double-digit) fundamental return potential, meaning that no valuation tailwind is necessary to get great investment results with EVA Monsters. (These case studies explain this pretty well.)

As Charlie Munger said:

“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns 6 percent on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6 percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

We also shared the math proof of why buying EVA Monster stocks at a fairish valuation makes perfect sense for long-term investors. (Look for the “math example” in this post to alleviate your doubts.)

To round off the short introduction, we (1) try to avoid overpaying for EVA Monsters, (2) closely monitor the fundamental performance and management’s capital allocation decisions throughout our holding period, and (3) hold our positions as long as the underlying investment thesis remains intact, ideally for decades, to let compounding do the heavy lifting.

Without further ado, numbers prove that Wingstop (WING) is a genuine EVA Monster and is uniquely positioned in the fast-casual food service industry, so it is worthy of your close attention. While the company may not yet have an indestructible competitive advantage, the trend of its moat looks very encouraging.

Wingstop is a franchisor and operator of fast-casual restaurants specializing in hand-sauced-and-tossed chicken wing offerings with various distinctive flavors, always cooked to order. Aside from a few company-owned restaurants, 98% of Wingstop’s units operate in a franchise model, either through individual franchisees or via a master franchise agreement. As of February 2024, the company has nearly 1800 restaurants in the U.S. and more than 250 locations in other countries worldwide.

Wingstop has three primary revenue streams. Firstly, the company generates around half of its sales from franchise fees, as each franchisee is required to pay a royalty amounting to 6% of their gross sales to the parent company, besides a one-time opening fee of $30,000.

Secondly, each restaurant also contributes 5% of its retail sales to fund national marketing and advertising campaigns, making up around 25% of the company’s top line. With that said, this is essentially a flow-through item since Wingstop is spending the entire amount on enhancing brand awareness. Lastly, the company generates the remaining ~25% of its revenues via retail sales of food in its U.S. company-owned stores.

Examining the quality dimension from a quantitative angle, Wingstop’s double-digit EVA margin and impressive return on invested capital indicate the ‘moaty’ nature of the business. However, the qualitative side of the story requires further elaboration since it is immensely hard to carve out a durable moat in the highly competitive and fragmented restaurant space.

The handful of companies that eventually succeed in doing so have a few traits in common: a strong global brand, consistent customer experience coupled with the perception of “value for money,” scale-driven cost advantages in procurement and technology, and most importantly, excellent store-level profitability that makes the opening of new restaurants an attractive business opportunity for franchisees. It is apparent to us that Wingstop is on the right path to check all the boxes.

This company has established an immensely strong digital foothold in the restaurant business, possessing behavioral and consumption-related data of more than 30 million of its customers.

The company’s marketing strategy is centered around building a ‘platform brand,’ utilizing this rich dataset, and employing targeted advertising campaigns, personalized for each user cohort. As a result of this initiative, over 65% of sales are generated via digital channels (up from a mere 6% in 2014, signaling the immense progress), and thanks to the effective personalization of additional menu items, digital orders carry a $5 higher value on average.

We believe a further moat source is the attractiveness and quality of the firm’s offerings. Based on our research of online reviews, customers seem to love Wingstop for the consistent taste and high-quality flavor of their chicken wings.

All in all, we believe if we want to assess whether a restaurant chain has carved out a moat around its business, the telltale metric to look at is store-level profitability. Wingstop absolutely trumps the competition on this front, with stores providing a ~70% return on investment (rivaling or even surpassing Starbucks, one of the strongest global brands), translating to a less than 2-year payback period for franchisees.

Source: ISS EVA, The FALCON Method

As for the future, poultry consumption is on the rise, and more importantly, the share of poultry in total global meat consumption has steadily increased over the last 20 years, and we expect this trend to continue. This phenomenon could partly be explained by the rise of eco-consciousness since raising cattle takes a much heavier toll on the environment than chicken farming.

Besides that, the underlying fast-casual restaurant market where Wingstop operates is expected to grow ~10% annually through 2031, significantly outpacing the ~5% annual expansion of the global fast food and quick-service restaurant industry.

The business requires literally zero capital to grow, making Wingstop the epitome of a capital-light compounder with already impressive and expanding 50%+ ROC numbers. Thanks to the firm’s asset-light business model, there is ample cash available for shareholder distributions.

The company does not engage in share repurchases; instead, it initiated a dividend in 2017. Besides the regular quarterly payouts, special dividends have also been declared five times since 2016, at a pretty significant scale. Management’s policy regarding these special distributions is quite interesting since the company has paid more than 2x the money it has internally generated since its IPO.

The deficit has been financed by taking on debt at really low rates (which the business itself did not need, so there was ample room from a leverage standpoint). That said, the interest rate landscape has changed pretty dramatically, while leverage ratios are now at a level where the capacity to take on more debt will mostly depend on the growth rate of Wingstop.

Looking at the stock’s valuation, the company’s current FGR of 83% seems absolutely exuberant, both from an absolute and historical perspective. The baked-in EVA growth expectations stand at ~25% annually for the next decade, which we deem very substantial, even if Wingstop is still in the early innings of what could be a decade-long profitable growth story. Please see below the valuation metrics of the EVA framework that remedy accounting distortions to give us a clearer picture of where the stock stands in a historical context.

(Curious why we don’t use the most popular multiples? Find out here!)

Regardless of how we look at it, Wingstop seems wildly overvalued at this point. The valuation component detracts so much from the otherwise stunning, 15-18% fundamental return potential that the total return potential falls into negative territory at the current price.

All in all, the time to get excited is not now. The “Key Data” table and the 5-year total return potential chart speak for themselves.

Source: ISS EVA, The FALCON Method

The FALCON Method can identify much better opportunities in the current market, so we are passing up on Wingstop for now.

The verdict

With Wingstop, we get a simple, incredibly lucrative, asset-light business model with high returns, paired with several secular tailwinds that are expanding the company’s total addressable market. This makes us believe that this firm could turn out to become an EVA Monster success story that we managed to detect at a very early stage.

That being said, since this firm rather falls in the „developing moat” category, for now, we would feel comfortable with a maximum position size of 3-5%, geared to the lower end of this range.

The most prominent risk is that much of Wingstop’s valuation is tied to its compelling international development narrative. An inability to appropriately source strong franchise partners, and build a robust development pipeline outside the U.S. (with similarly strong store-level economics) could materially hinder the company’s growth prospects and put pressure on its high valuation.

The company ranked 58th of our 59 EVA Monsters at the time of writing, based on its 5-year total return potential. (Businesses from 12 countries are represented on our EVA Monster list.)

It is safe to say that there are far more attractive EVA Monster stocks to buy in the current market, with the highest-ranking ten boasting total return potentials above 12% over our modeled 5-year timeframe. (You can always find the monthly Top 10 in the FALCON Method Newsletter along with our entry price recommendations.)

Want to learn more about our ranking methodology? Start with this blog post!

Moat Matters: Direction vs. Width

“A wide-moat company is like a soccer team that only gets to play
friendlies.” (Rob Vinall)

In the annals of overused corporate clichés, few match the immortal words of Walter Gretzky, as passed on to the world through his son Wayne: “Skate to where the puck is going, not where it has been.” While the hockey world has yet to produce another player capable of coming close to matching Gretzky’s record, that puck quote also has some relevance to investing.

As Rob Vinall, the founder and managing director of RV Capital, contemplated in one of his memos, one should pay more attention to the direction, not the width of the moat. “If you are planning on investing in a business for a long time, then it is far more important to know whether the competition is closing in on you as opposed to the absolute width of the moat.” It’s hard to argue that competitive dynamics matter over decade-long investing timeframes, but monitoring these developments with any acceptable accuracy is an entirely different matter.

Naturally, this begs the question: how do we address this issue at the FALCON Method? Frankly, assessing competitive dynamics is the most challenging aspect of qualitative analysis, yet it has the largest impact on future returns, so we cannot afford to surrender without giving our best shot. You may notice that most companies within our global EVA Monster universe have developed such wide moats that they are visible from the Moon. With these businesses, we are not speculating on future winners but instead bet on those that have already won in their respective fields when the market offers us decent odds. (We measure the latter by the stock’s five-year total return potential modeled in our EVA-based analysis framework under two fundamental scenarios.)

What could go wrong?

As expected, we are actively looking for comments from management teams on how they plan to further widen the moat. This is in perfect sync with what Warren Buffett said at Berkshire’s 2000 annual shareholder meeting: “So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that’s tenuous in any way — it’s just too risky. We don’t know how to evaluate that. And, therefore, we leave it alone. We think that all of our businesses — or virtually all of our businesses — have pretty darned good moats.”

That said, if an exceptional EVA Monster company can only defend (yet fails to widen) its already great moat, and supportive megatrends remain at work, plenty of value-creating growth and shareholder returns are to be expected. So, there’s nothing wrong with this scenario either, which makes us focus much harder on identifying the deterioration in moat characteristics. This is exactly why the “What could go wrong?” section found its way into every analysis you can read in the FALCON Method Newsletter. Alongside identifying tail risks that could possibly destroy the moat, our model’s pessimistic scenario tends to assume increased competition to reflect a negative moat trend.

Developing moats

Indeed, some companies under our coverage seem to have narrower moats, but we’d assign a positive rating to their competitive dynamics. These names make it into our EVA Monster universe, but we tend to be more conservative with our entry prices and position sizing. With these “lower-tier targets,” we may scale in near the bottom of our accumulation range or outright wait for the price to fall below our “take full position” level. Evolution AB comes to mind, with which we didn’t pull the trigger until the annualized total return potential reached 20%. Even our pessimistic scenario gives us a ~14% annualized return from our entry price. There’s plenty of built-in margin of safety, yet Evolution is not the kind of company we’d bet the farm on; that’s why the suggested 2-3% position size.

Reversing moat trends

Lastly, wide-moat companies hampered by negative trends are either excluded from our investable universe or, if identified later, they will not appear as top picks until the moat trend reverses. Also, their exclusion from the EVA Monster coverage is an ongoing discussion in our team. (T. Rowe Price, Alibaba, and PayPal come to mind.) On the contrary, Meta served as the perfect example of how a company can respond to challenges in a moat-enhancing way. Handling the Apple privacy issue with in-house machine learning solutions, fending off the emerging threat from TikTok, and actively preparing for the next wave of computing platform change all made the business more resilient. While the stock was punished, sub-$100 Meta was doing all the right things to defend and even strengthen its moat, which has been well rewarded by now. Again, competitive dynamics drive stock prices; it’s just not easy to measure and monitor them.

Skate to where the puck is going

Back to Vinall for a couple of thought-provoking observations: “Companies with wide moats are insulated to a considerable extent from competition, and this tends to make them less responsive to potential competitive threats. A wide-moat company is like a soccer team that only gets to play friendlies. Second, the problem with wide-moat businesses is that market shares are not up for grabs. The whole point of a wide moat is that market entry is exceedingly difficult. This, of course, has certain advantages, but the big disadvantage is that a great management has only limited opportunity to demonstrate its worth. When you have a company that can crush the competition, it is desirable to have a competition to, well, crush. Third, it strikes me that the best time to invest in businesses is before the moat is fully formed, provided, of course, there is sufficient evidence available that the moat will one day be formed. This is the period when the market’s reassessment of the company’s cash flow generating ability will be most dramatic.”

It would be hard not to agree on this last point, yet the “how to” part needs much more elaboration. After all, even Vinall managed to misread a developing moat situation and invested a considerable percentage of his fund in a company that got to the brink of bankruptcy. So, while everyone wants to be like Gretzky and skate to where the puck is going, it’s easier said than done. Getting to know industries better and widening your circle of competence can improve your ability to identify moat trends. When Charlie Munger was once asked how he would teach a college course on finance, he said he would have 100 different case studies on why businesses have succeeded and failed in the past. As investors, we must never lose our sense of paranoia and always be on the lookout for what could go wrong with the companies we analyze. Our job is far from glamorous, yet we should stick to our rigorous research process despite all the panic or hype in the market.

Want to learn more about our stock ranking methodology and evidence-based investment approach? Start with this blog post!

Or read more like this in the Beyond Dividends book.

The EVA Monster Series: Unveiling the Surgical Revolution

With this series, we’d like to give you some perspective on the companies in our distinguished EVA Monster universe. This rare breed of quality-growth stocks is worthy of your attention, and getting to know these businesses may pay off handsomely down the road.

As a quick recap, EVA Monsters have three things in common:

  • They earn high returns on the capital they employ.
  • They have growth opportunities that allow them to reinvest most of their cash flows at high rates of return.
  • They have a sustainable competitive advantage (that Warren Buffett calls “moat”), which prevents their competitors from taking away their extraordinary profitability.

These characteristics tend to result in a strong (double-digit) fundamental return potential, meaning that no valuation tailwind is necessary to get great investment results with EVA Monsters. (These case studies explain this pretty well.)

As Charlie Munger said:

“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns 6 percent on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6 percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

We also shared the math proof of why buying EVA Monster stocks at a fairish valuation makes perfect sense for long-term investors. (Look for the “math example” in this post to alleviate your doubts.)

To round off the short introduction, we (1) try to avoid overpaying for EVA Monsters, (2) closely monitor the fundamental performance and management’s capital allocation decisions throughout our holding period, and (3) hold our positions as long as the underlying investment thesis remains intact, ideally for decades, to let compounding do the heavy lifting.

Without further ado, numbers prove that Intuitive Surgical (ISRG) is one of the top EVA Monsters that we have analyzed so far, so it is worthy of your close attention. This company has a deep moat, coupled with the tailwind of strong expected growth in the robotic surgery market.

Intuitive Surgical develops, manufactures, and markets products that enable physicians and healthcare providers to enhance the quality of and access to minimally invasive care. The company offers the da Vinci Surgical System to aid in complex robotic surgical procedures and the Ion endoluminal system, which extends its commercial offerings beyond surgery into diagnostic procedures, enabling minimally invasive biopsies in the lung. The company was incorporated in 1995 and is headquartered in Sunnyvale, California.

Intuitive Surgical has a truly interesting origin story. The research that eventually led to the development of the da Vinci system was carried out in the 1980s at Stanford. The prototype called SRI also caught the attention of the defense industry, which saw a new possible way to do “tele-surgery” on the battlefield. A physician named Dr. Frederic Moll became interested in the system and eventually, in 1995 he raised enough capital (together with two other founding partners) to acquire the rights to license the SRI device. This marked the birth of Intuitive Surgical.

Advanced robotic systems provide precise and powerful solutions with high-performance vision, expanding the capabilities of the care team to enhance minimally invasive care. Although the sales of these systems constitute the cornerstone of Intuitive Surgical’s revenue streams, they contribute only a relatively small portion to its overall revenue, accounting for 27% as of fiscal 2022. This primarily includes sales and leasing revenue from the da Vinci Surgical System, boasting an average selling price of approximately $1.5 million.

Crucially, Intuitive’s instruments and accessories have limited lifespans and will either expire or wear out with use during surgery, necessitating replacement. The company typically earns between $600 and $3,500 in instruments and accessories revenue per surgical procedure performed, depending on the type and complexity. In total, these contribute to 56% of companywide sales.

We believe that understanding Intuitive’s commercial success is best achieved by initially examining its value proposition for the various stakeholders within the healthcare system. Commencing with patients, two critical factors are procedure efficacy (a measure of the success of the surgery in resolving the underlying disease) and invasiveness (a measure of patient pain and disruption of regular activities, including the length of hospital stay and time to full recovery). Robotic surgeries represent the pinnacle of minimally invasive care, with the da Vinci Surgical System enabling surgeons to perform laparoscopy while comfortably seated at an ergonomic console, viewing an image of the surgical field.

We believe that surgeons are the stakeholders who benefit the most from the system, and they also play a crucial role in the platform’s rapid adoption. Although it is hospitals or governments that purchase the da Vinci system, Intuitive Surgical’s primary customer is the surgeon, who prefers not to be hunched over and wants to sit comfortably at the console while the robot uses force and controls precision.

Lastly, hospitals also benefit from the placement of robotic surgical systems, even though the cost per procedure is higher than open surgery and manual laparoscopy. The advantage stems from fewer complications and significantly reduced post-surgery hospitalization.

Intuitive benefits from switching costs, beginning with junior surgeons who become familiar with the da Vinci system simulators already in medical school. Additionally, hospitals that have invested in these platforms are unlikely to replace them with a theoretical competitor’s product and risk disruptions in their healthcare operations

In conclusion, Intuitive currently operates as a monopoly, and its ecosystem will likely remain very sticky even if new competitors emerge through the advancement of general robotics.

Source: ISS EVA, The FALCON Method

Based on the company’s estimates, approximately 20 million soft tissue surgery procedures are performed each year, growing at a 2-4% annualized rate, thanks to an aging population and increased access to healthcare globally. Intuitive anticipates a total of 6 million “line-of-sight” procedures, implying the current robotically addressable portion with existing products and clearances. Despite the company’s annual procedure volume exceeding 2 million, the total addressable global market, several times the size, still offers ample growth opportunities.
In aggregate, a low-double-digit revenue growth rate appears realistic for the overall company.

Turning to capital allocation, Intuitive typically reinvests around half of its internally generated cash, mainly into R&D and production capacity enhancements. These reinvestments have yielded exceptional returns, earmarked by ROC figures averaging between 30-50%. The company’s balance sheet is spotless, with zero debt and a healthy cash position.

As for capital distributions, the company has never paid a dividend and it does not expect to do so for the foreseeable future. Even though share repurchases are carried out frequently (spending a significant sum), the net effect on share count is completely muted by the firm’s stock-based compensation policy, which we believe to be very excessive.

Looking at the stock’s valuation, the company has always been highly rated by the market and this is precisely the reason why we consider a comparison to historical figures rather meaningless. At the current share price, the market implies 27% EVA growth annually over the next 10 years, which is completely bonkers in our view. Please see below the valuation metrics of the EVA framework that remedy accounting distortions to give us a clearer picture on where the stock stands in a historical context.

(Curious why we don’t use the most popular multiples? Find out here!)

Put it shortly, we would not touch this stock with a 10-foot pole today due to overvaluation concerns. The “Key Data” table and the 5-year total return potential chart speak for themselves.

Source: ISS EVA, The FALCON Method

The FALCON Method can identify much better opportunities in the current market, so we are passing up on Intuitive Surgical for now.

The verdict

While the overall thesis seems bright at the moment, we see several risks that could lead to dark clouds gathering above Intuitive Surgical. One of the most prominent questions is how the future of the entire industry will unfold. If robotic surgery fails to establish itself as a good (preferably better) alternative to manual laparoscopy in a wide array of procedures, Intuitive’s growth could slow considerably.

Moreover, the company may face much tougher competition in the years ahead. Even though it has been the sole monarch for a long time, healthcare giants like Johnson & Johnson and Medtronic are looking to enter this lucrative field. The objective of both companies is none other than to democratize robotic surgery and make it more accessible to all hospitals, reaching those with fewer resources.

While challenges like the emergence of well-capitalized competitors (trying to copy the da Vinci robot) or increased regulatory scrutiny over the firm’s monopolistic position do pose threats, we would be glad to own this business at the right price. Although Intuitive is a great combination of the healthcare and technology megatrends, we are somewhat uncertain about the risks surrounding the business, so we would stay within a 3-5% exposure in our portfolio.

The company ranked 59th of our 59 EVA Monsters at the time of writing, based on its 5-year total return potential. (Businesses from 12 countries are represented on our EVA Monster list.)

It is safe to say that there are far more attractive EVA Monster stocks to buy in the current market, with the highest-ranking ten boasting total return potentials above 13% over our modeled 5-year timeframe. (You can always find the monthly Top 10 in the FALCON Method Newsletter along with our entry price recommendations.)

Want to learn more about our ranking methodology? Start with this blog post!

Behind the Monster Hunt

“When you analyze what happened, the big money’s been made in high-quality businesses.” (Charlie Munger)

Let me kick off 2024 with another behind-the-scenes piece to show you how our analysts aim to identify new EVA Monster candidates every year. Before delving into the details, it is worth noting that our global EVA Monster database is the heart and soul of the FALCON Method service. The list of these exceptional quality-growth companies doesn’t change too often, as data reveals that good businesses seldom become bad businesses or vice versa.

As mentioned in the previous issues, our analysts seclude themselves in a rural guesthouse for several days every year to avoid distractions during this work. They comb through the raw results of our EVA-based quant screening and the ideas from select podcasts (such as Business Breakdowns), industry-specific books (like The Curious Economics of Luxury Fashion), or portfolios of other quality-growth investors worth following. In our experience, this process demands at least 40 working hours, while analyzing the new names takes roughly the same 40 hours per company. If you do the math, the newsletter’s price pales in comparison to the value provided, and we owe this to your continued support and the substantial size of the FALCON Family.

With most (if not all) of the unquestionable, high-conviction EVA Monsters already covered, we made some changes to our process. New candidates don’t automatically qualify and appear on our list but must undergo our thorough analysis first. We want to avoid situations where new names are presented in our raw data spreadsheet (published along with the newsletter) and overenthusiastic investors jump on them before our in-depth analysis could reveal possible qualitative red flags. This means our team will most likely do plenty of work without visible results (killing ideas before presenting them), but we’re fine with this as long as the FALCON service keeps improving.

Entering Uncharted Waters

As a result of our latest “rural guesthouse efforts,” seven new EVA Monster candidates appear very worthy of analyzing, with favorable odds to pass with flying colors and thus land on our global quality-growth shortlist. Additionally, more than twenty other companies made it to our “B-list” of exciting businesses that we plan to address after achieving full coverage of the higher-conviction names.

Next, let me share some of our underlying thoughts behind expanding our investable universe. One aspect influencing our decisions was the desire to broaden our circle of competence by diving deep into new industries and megatrends. For example, while Fortinet seems to be one of the best players in the cybersecurity field, we must deepen our understanding of its industry before determining the company’s EVA Monster status.

We are eager to capitalize on the growth of the experience economy, yet we have only identified two preferred business models within the tourism industry. The first is the Online Travel Agency model, with Booking and Airbnb at its forefront. These are highly scalable, dominant platform businesses, epitomizing the capital-light compounder theme with the network effect serving as their primary moat source. The second is Hilton’s scalable and capital-light franchise model, further aided by the premiumization tailwind.

Elsewhere, playing the cloud megatrend from the hardware side also sounds reasonable, so Cisco’s fierce competitor, Arista Networks, looks absolutely worthy of our ~40-hour analysis. The numbers suggest that this firm may have carved out a unique market position, becoming indispensable for cloud data center expansion through its leadership in high-speed switching for enterprise networking. Additionally, getting to know the cloud market from a different perspective may bolster our existing investment theses of affected players like Amazon, Alphabet, Microsoft, Tencent, and Alibaba, to name a few.

Exploring Competitors

The second aspect influencing our decisions was the desire to explore the competitors of already covered EVA Monsters, offering dual benefits. Besides possibly giving us new investment targets, we could also gain a more in-depth knowledge of the industry and see previously analyzed firms from a different angle. For example, Adyen is the direct competitor of PayPal’s Braintree leg, and by familiarizing ourselves with the merchant acquirer role, we get a more complete picture of the highly sophisticated payment ecosystem. While this is a challenging undertaking, Adyen’s financials speak for themselves. It is a focused, pure-play business in the field that is expected to play a more significant role at PayPal, as the competitive position of the latter’s core checkout segment seems to be weakening. Overall, the time spent analyzing Adyen may well be worth it for numerous reasons.

As for additional competitor names, Porsche came up as Ferrari’s rival. Although the level of exclusivity, average selling price, and margins do show meaningful differences, Porsche still distinguishes itself from traditional car manufacturers with its exceptional financials and ~100-year heritage. The expansion of the HNWI customer base is a nice tailwind (supporting many of our EVA Monster theses); moreover, Volkswagen’s spinoff decision made this pure-play target available and worthy of analysis. Researching Porsche may give us further insights into how the consumption attitude of the aspirational middle class differs from that of the HNWI group. It would be interesting to see whether a clear distinction could be made between Ferrari and Porsche along this line, akin to comparing Kering’s Yves Saint Laurent brand with Hermès. Either way, the efforts going into our Porsche analysis could potentially yield multiple benefits.

Quality Above All Else

To conclude, I’d like to reinforce your belief that quality investing is the way to go for the long run. Vitaliy Katsenelson says, “Whenever you look at your portfolio, think of Microsoft and GoPro.” The former is a wonderful company, while the latter was an overhyped fad stock with no protective moat around the underlying business. “The performance of your stocks in the short run tells you absolutely nothing about what you own or about the quality of your decisions. You may own a portfolio of Microsofts, and its value is going down because at this juncture the market doesn’t care about Microsofts. Or maybe you stuffed your retirement fund with overpriced fads that may not be around a year from now.” There’s no question about which route I’m willing to take with my money. To round off this piece, let me quote Charlie Munger’s 1994 USC Business School Speech: “We’ve really made the money out of high-quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in high-quality businesses. And most of the other people who’ve made a lot of money have done so in high-quality businesses.”

Want to learn more about our stock ranking methodology and evidence-based investment approach? Start with this blog post!

Or read more like this in the Beyond Dividends book.

The EVA Monster Series: Precision Diagnostics for Our Flurry Friends

With this series, we’d like to give you some perspective on the companies in our distinguished EVA Monster universe. This rare breed of quality-growth stocks is worthy of your attention, and getting to know these businesses may pay off handsomely down the road.

As a quick recap, EVA Monsters have three things in common:

  • They earn high returns on the capital they employ.
  • They have growth opportunities that allow them to reinvest most of their cash flows at high rates of return.
  • They have a sustainable competitive advantage (that Warren Buffett calls “moat”), which prevents their competitors from taking away their extraordinary profitability.

These characteristics tend to result in a strong (double-digit) fundamental return potential, meaning that no valuation tailwind is necessary to get great investment results with EVA Monsters. (These case studies explain this pretty well.)

As Charlie Munger said:

“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns 6 percent on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6 percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

We also shared the math proof of why buying EVA Monster stocks at a fairish valuation makes perfect sense for long-term investors. (Look for the “math example” in this post to alleviate your doubts.)

To round off the short introduction, we (1) try to avoid overpaying for EVA Monsters, (2) closely monitor the fundamental performance and management’s capital allocation decisions throughout our holding period, and (3) hold our positions as long as the underlying investment thesis remains intact, ideally for decades, to let compounding do the heavy lifting.

Without further ado, numbers prove that IDEXX (IDXX), being at the forefront of the animal health industry is a genuine EVA Monster, so it is worthy of your close attention. The pool of public companies that directly benefit from the humanization of pets’ megatrend is very shallow, and this firm stands out as one of the best opportunities to ride this multi-decade secular tailwind.

IDEXX is the leading provider of point-of-care veterinary diagnostic products, including instruments, consumables, and rapid assay test kits. It also offers animal health reference laboratory diagnostic and consulting services, alongside practice management and diagnostic imaging systems and services for veterinarians.

The overwhelming majority of IDEXX’s top line (91% as of fiscal 2022) stems from its Companion Animal Group (CAG) segment, making the company primarily a pet health diagnostic enterprise. Notably, within this division, instrument sales only contribute 4% to overall revenues.

The company generates substantial revenues from the sale of consumables used in its instruments, with the multi-year consumable revenue stream being significantly more valuable than the placement of the instruments. Besides its point-of-care solutions, IDEXX also operates a broad array of reference laboratories, used by veterinarian practices to address more complex testing needs.

IDEXX is the undisputed leader in point-of-care diagnostic tests and in-house analyzer equipment, generating revenues that are 10 times higher than its two closest competitors: Antech Diagnostics, a brand under the privately held Mars Petcare umbrella, and Abaxis, a fully-owned subsidiary of Zoetis.

We think the essence of IDEXX’s competitive advantage lies in its all-in-one diagnostic suite for veterinary practices. It begins by offering diagnostic instruments, often at a discount or even without upfront costs, on the condition that the practice orders its consumables from IDEXX and utilizes its pool of reference lab services.

The company’s practice management systems create embedded integration with IDEXX’s in-clinic instruments and outside reference laboratory test results, while also offering an invaluable customer management database. In aggregate, IDEXX’s ecosystem benefits from considerable switching costs, resulting in dependable and highly lucrative recurring revenues. Notably, customer retention rates consistently exceed 95% for consumables and reference lab solutions.

Its pricing power is evident in the exceptional quantitative results, delivering strong double-digit ROC and EVA Margin figures.

Source: ISS EVA, The FALCON Method

One of the most enduring megatrends of our times is the humanization of pets. Dogs and cats are increasingly treated as family members, especially among millennials and younger generations who are less enthusiastic about having children than their parents. Multiple studies have revealed that people are willing to sacrifice other discretionary items to maintain or increase spending on their beloved pets, even in tough economic situations. Pets are living longer because of their owners’ commitment to their health and well-being, increasing the number of elderly companion animals (much like in the case of humans). This translates to a tailwind for veterinary care expenses. All things considered, IDEXX’s annualized top-line growth rate could approach 10% for years to come.

The firm maintains a prudent approach to capital allocation, traditionally reinvesting approximately one-third of its internally generated cash. These reinvestments have resulted in exceptional 30-40% ROC levels, which is truly commendable.

Regarding capital distributions, the firm has never paid a dividend, nor does it expect to do so in the foreseeable future. Nevertheless, share repurchases have been a standard practice for quite some time now, even as the focus on reducing debt levels has put pressure on buybacks. (Frankly, we don’t fully understand the strategy behind IDEXX operating with almost no debt when the nature of the business could easily support modest leverage.) Unfortunately, these automatic repurchases have often occurred at astronomical valuation levels in our view, revealing a poor use of shareholder capital.

Looking at the stock’s valuation, IDEXX hardly ever traded cheaper than the market. That being said, we believe that today’s valuation is above any reasonable fundamental estimate, with more than 17% 10-year EVA growth baked in at the current price. Please see below the valuation metrics of the EVA framework that remedy accounting distortions to give us a clearer picture of where the stock stands in a historical context.

(Curious why we don’t use the most popular multiples? Find out here!)

We would get interested when the valuation component becomes a mild tailwind to the ~12% fundamental return potential, marked by an FGR of 40% or lower.

The stock is an easy pass today. The “Key Data” table and the 5-year total return potential chart speak for themselves.

Source: ISS EVA, The FALCON Method

The FALCON Method can identify much better opportunities in the current market, so we are passing up on IDEXX for now.

The verdict

What first comes to mind when assessing risks surrounding this business model is that IDEXX must continue innovating to improve the ease of use and accuracy of its diagnostics tools and enhance its full suite of integrated offerings. Although most of its competitors are either smaller in scale or lack a singular focus on animal diagnostics, the firm needs to continuously develop and market the best products to protect its competitive position.

The consolidation of IDEXX’s customer base could be problematic. An increasing number of veterinary clinics are now owned by corporations (like Mars), and these consolidators may wield significantly higher bargaining power than standalone vet clinics.

While challenges like the shortage of veterinary professionals do pose threats, we would be more than happy to be owners of this business at the right price. The width of the firm’s moat in its niche market is more than sufficient, while the recurring nature of its revenues is a major plus. The fundamental return potential is also firmly in the double digits, so we get everything we want from an EVA Monster. As for position sizing, we would be comfortable with a 3-5% exposure, skewed to the lower end of this range.

The company ranked 43rd of our 59 EVA Monsters at the time of writing, based on its 5-year total return potential. (Businesses from 12 countries are represented on our EVA Monster list.)

It is safe to say that there are far more attractive EVA Monster stocks to buy in the current market, with the highest-ranking ten boasting total return potentials above 12% over our modeled 5-year timeframe. (You can always find the monthly Top 10 in the FALCON Method Newsletter along with our entry price recommendations.)

Want to learn more about our ranking methodology? Start with this blog post!

The Compounder’s Path – Supercharge Your Investment Journey

Let’s recap what we’ve learned so far. We’ve realized that instead of constantly changing your target list, it makes sense to maintain a relatively stable investment universe whose members meet your fundamental criteria. You should aim to curate a shortlist of “investable universe” containing outstanding companies that you closely follow. You can then allow Mr. Market to do its job with its bipolar ups and downs, hoping that sentiment shifts in your favor by offering a few of the candidates in your investable universe for sale.

We’ve also seen that quantitative screening is just the beginning and not the end, even though it can provide valuable inputs for an investment process. The list of companies that match your screening criteria is only the starting point; this is where the comprehensive qualitative analysis begins.

This way, you can form an educated opinion and make a contrarian bet at the point when you have an unwavering understanding of the underlying business, differentiating between temporary challenges and existential threats. This concept aligns with the saying that success occurs when opportunity meets preparation.

Now, onto the most challenging part.

Let’s suppose you agree with the laid-out process so far and would like to set sail to navigate it on your own. Great!

First, you want to rely on the best fundamental data to build your financial models, right?

You have the option to calculate this data manually for your targets, which would entail an Excel sheet with over a thousand lines for each company. Not so charming, is it?

And even then, you won’t have the ability to conduct a screening, as you lack a tool that can filter through years of historical data for thousands of public companies. Therefore, the only viable option is a data provider, which comes with a significant cost, often in the tens of thousands of dollars, as this is the price tag for institutional-level metrics.

Let’s assume we have taken care of this step for you…

Now you’re prepared to dive into what your screener identifies and put in the rigorous effort to separate the outstanding from the mediocre, compiling a list of truly high-quality compounders that will form the foundation of your investment universe. Just to give you an idea: our team of three analysts spent three full years completing the qualitative assessment of 60 EVA Monster candidates. If you’re doing it on your own, this adds up to a demanding decade of full-time work. Furthermore, you might have to start anew as some of the information you’ve gathered will inevitably become outdated over time.

As astonishing as this may sound, we hope that your passion for individual stocks still burns brightly, and that you’re not fond of the idea of entrusting your money to a fund manager for high fees (and the likelihood of underperformance). You probably don’t want to passively invest all your money with no control, do you?

The good news is there’s a shortcut. As a subscriber to the FALCON Method Newsletter, you gain instant access to:

  • The full list of approximately 60 quality-growth-focused EVA Monster candidates, updated yearly to incorporate new promising entries and eliminations as our conviction wanes.
  • On top of that, a monthly execution of our value-focused screening process, searching for “Fallen Angel” value opportunities from a preselected universe, based on a solid dividend history.
  • A monthly newsletter featuring a complete factsheet of the 10 most promising targets, including the top “EVA Monster” and “Fallen Angel” prospects, exclusively ranked by our modeled 5-year total return potential.
  • A list of our top picks each month, where we have the highest conviction and invest our capital.
  • An educational-focused opening piece designed to enhance your skills as an investor by offering timeless lessons on the market, insights into investment psychology, as well as our efforts to broaden your circle of competence by shedding light on secular trends, or business case studies.

Here is an excerpt from the opening piece of the November 2023 issue, which explains how our contrarian bet on Meta played out by emphasizing the crucial aspects of its fundamental puzzle:

”Meta served as the perfect example of how a company can respond to challenges in a moat-enhancing way. Handling the Apple privacy issue with in-house machine learning solutions, fending off the emerging threat from TikTok, and actively preparing for the next wave of computing platform change all made the business more resilient. While the stock was punished, sub-$100 Meta was doing all the right things to defend and even strengthen its moat, which was well rewarded by now. Again, competitive dynamics drive stock prices; it’s just not easy to measure and monitor them.”

As a final takeaway, here is a quick recap of the 7 steps of the FALCON Method:

Step#1: Screen for Top-Quality
When a business consistently earns high returns on its invested capital and operates with spectacular margins (measured by the percentage of sales resulting in real economic profit), these are telltale signs of an existing moat.

Step#2: Growth is needed to drive performance
To qualify as a truly outstanding business, a top-quality company must also have growth opportunities that allow it to reinvest most of its cash flows at high rates of return.

Step#3: Introducing the EVA Monsters
Quality alone is not sufficient, while growth without quality is exceedingly risky. However, the combination of quality and growth offers phenomenal performance.

Step#4: The windshield approach to rank the Monsters
While we selected the members of this elite group with the help of historical data, we use forward-looking modeling to determine which of them are the most promising investment candidates and are thus worthy of our attention.

Step#5: Read, read, read… The qualitative aspects
Once we have those polished Excel models, we delve deep to gain a better understanding of the business. Our primary focus points in the analysis include the sources and sustainability of the moat, capital allocation, the drivers of growth, and management’s integrity.

Step#6: Fine-tuning and Conviction
We determine two entry price levels. The first (and higher) one is the buy price with the potential to provide a 15% annualized total return over a 5-year timeframe, assuming our assessment of the firm’s fundamental performance is accurate and the valuation remains within its typical historical range. We also establish a lower, very conservative entry price, which we refer to as our “5-star” or “punchcard” price.

Step#7: Who could beat the highest-ranking Monsters?
By this stage, we know exactly which EVA Monsters (quality-growth stocks) present the most attractive opportunities in the market. Rather than just publishing this valuable list every month in the FALCON Method Newsletter, we make additional efforts to explore another segment of the stock market that sometimes yields hidden gems. While quality and growth are the key factors for EVA Monsters, it is the valuation that drives returns for these once-beloved dividend darlings now found in the bargain bin. This is why we call this category “Fallen Angels.”

Upon completing Step #7, we have the list of the most attractive stocks for investment, and our process has reached its ultimate goal.

The Falcon Method Newsletter is your trusty companion, bringing you top 10 stock picks every month straight to your inbox. Say goodbye to endless hours of market analysis and hello to reliable passive income, long-term growth, and peace of mind.

The FALCON Method Newsletter offers access to institutional-level data and professional analyses for the best price possible.

With a 7-day free trial, you’ve got nothing to lose but stress! Dive into a community of smart investors and let your money work for you, not the other way around. Start your journey towards simplified, effective investing today!

The Compounder’s Path – The Power of Qualitative Analysis

In the previous part of The Compounder’s Path Series, we learned why a thoughtful screening process can serve as a compass to guide you through the labyrinth of the financial markets. We also noted that employing the right metrics can give you an advantage in the game, even though being a successful investor requires much more than mere number-crunching.

Let’s pick up where we left off and demonstrate why relying solely on a quantitative process is flawed, even when using a highly sophisticated screening framework that addresses accounting distortions. By the end of today’s article, you will understand why you must depend on comprehensive qualitative analysis and cannot avoid the rigorous task of getting to know your investment targets.

Couldn’t Keep a Lid on Success: Lessons from a Tonic Manufacturer’s Struggles

Let’s delve into the example of Fever-Tree, the once-shining early player in the premium tonic market. The company was among the pioneers in this space, with a compelling slogan: “If three-quarters of your drink is the mixer, mix with the best.” It makes a lot of sense; how often have you opted for cheap tonic water to mix with your gin, saving only a small amount compared to Fever-Tree or another premium brand?

Initially, the numbers were impressive. In the four years following its 2014 IPO, Fever-Tree’s sales and Economic Value Added (EVA) generation soared. The firm boasted sky-high return on capital and EVA margin figures, propelling it to the forefront of quantitative quality-growth screeners. Notably, this led to an explosive increase in its share price, which surged more than 20-fold, creating significant wealth for early shareholders. Take a look:

Source: Institutional Shareholder Services

However, this is where the harsh reality set in. Competitors began flooding the market, and Fever-Tree’s brand turned out not to be a differentiating factor justifying a high price for its tonics. Inflationary pressures were the icing on the cake in a negative sense. Even though one could argue that these are transitory in effect, especially as the U.S. has become Fever-Tree’s biggest market and it continues to operate almost entirely from the UK, we contend that Fever-Tree’s declining quantitative performance revealed deeper issues beneath the surface.

As Fever-Tree’s EVA generation began to approach zero, just as one would expect in a fiercely competitive market with diminishing pricing power, it became evident that the company was seriously lacking in the competitive advantage department. To borrow a famous adage from Warren Buffett, “A rising tide floats all boats… only when the tide goes out do you discover who’s been swimming naked.” Take a look at what happened to the company’s EVA generation and how its market value plummeted as a result:

Source: Institutional Shareholder Services

Here comes the million-dollar question: Could a thorough deep-dive analysis have predicted the demise of Fever-Tree’s competitive edge? In our view, starting with the right questions would have certainly helped steer us in the right direction.

  • Does the firm have an enduring moat that protects its outstanding profitability from new market entrants?
  • Does it possess a strong brand, along with a marketing budget that can bolster its brand power and translate into a widening moat over time?
  • Does it maintain a distribution network and global bottling operation that would raise barriers to entry in the market?
  • Are established beverage giants planning to enter the market with competing products, potentially outnumbering up-and-coming pure-play players like Fever-Tree due to their deep pockets and global distribution power?

We asked all these questions when Fever-Tree first appeared on our quantitative radar and anonymously concluded that the company’s moat was far from durable. Consequently, we decided against its inclusion in our EVA Monster universe.

The moral of the story is that exceptional quantitative metrics can be a symptom of a wide moat, but only the presence of durable forces that keep competitors at bay can lead to sustained above-average returns. Therefore, the cause-and-effect relationship should not be misunderstood. Just because you find a stock that ranks very high in your otherwise well-developed filtering system, it does not mean it will be a great investment. Far from it, you should never skip the qualitative deep-dive process before making an investment decision.

To help tilt the odds in your favor, you should aim to maintain a shortlisted “investable universe” of great companies that you closely follow. This way, you can form an educated opinion and make a contrarian bet when you have an unshakeable understanding of the underlying business, differentiating between temporary trouble and existential threats. This aligns with the saying that success occurs when opportunity meets preparation.

To quote Buffett again, “The best thing that happens to us is when a great company gets into temporary trouble… We want to buy them when they’re on the operating table.”

In summary, you need to have a clear understanding of the investment case. Too little information can be detrimental, while too much information, without distilling the key factors, can lead to unwanted information overload.

Here’s the most common pitfall: underestimating the effort required to form a qualitative opinion.

You might believe that understanding a company can happen overnight. Unfortunately, that’s not the case. In our experience, our team of three analysts spends several days conducting intensive research on a candidate before we form an opinion and construct our financial models based on well-informed inputs.

We believe that a minimal analysis entails reviewing the past few years’ annual reports, listening to management answering questions on various analyst calls, and assessing the competitive landscape and underlying secular trends to gain a comprehensive understanding of the business’s quality and growth characteristics. Our viewpoint and conviction about a company are then shaped through months of monitoring company-related news, listening to podcasts, reading research papers, and engaging in an ongoing analysis within the team to arrive at conclusions that define our target entry prices.

This can be a formidable task for individual investors, but we are here to assist you. In the last part of The Compounder’s Path Series, we will demonstrate how you can simplify your investment process and achieve the results you desire by dedicating a few hours to this topic each month. Stay tuned.

The Compounder’s Path – How Traditional Financial Metrics Fool You

In the first part of The Compounder’s Path Series, we delved into the crucial foundation of a sound investment strategy: building an Investable Universe grounded in historically proven factors.

We discovered that a manageable number of companies, carefully selected, can make the difference between financial success and a risky gamble. We also touched upon why blindly following your instincts or other people’s advice can be a one-way ticket to disappointment.

Today, let’s dive deeper into the heart of a successful screening process, i.e. metrics.

These numerical indicators are the compass guiding you through the labyrinth of the financial markets. They help you make informed decisions, reduce risks, and maximize returns, assuming that you follow the right approach. And while being a successful investor takes way more than pure number-crunching, understanding and employing the right metrics can put you ahead in the game.

Let’s see what inexperienced investors get wrong most of the time.

The Metric Maze

One common misconception is the belief that more metrics will guarantee better investment outcomes. It’s easy to fall into this trap, thinking that an arsenal of 37 different metrics will provide a clearer picture of a company’s potential. However, the reality is quite the opposite.

While a multifaceted approach is undoubtedly warranted, meaning you should consider various business characteristics like business quality, profitability, or growth, the key is to keep things as simple as possible while ensuring that your screening process is “good enough”.

When you drown yourself in a sea of numbers, it’s not clarity that emerges but rather confusion and complexity. You will not know how to prioritize among the myriad of metrics available to you. This overload can be paralyzing and lead you down a path of uncertainty.

In our experience, 4-5 metrics can tell you all you need to know about a business number-wise. When it comes to building a great screening process, the quality of inputs used in your analysis is far more important than quantity.

The Valuation Trap

Another pitfall that ensnares many aspiring investors is the tendency to prioritize valuation as the initial step in their screening process. While valuation is undoubtedly an essential factor to consider, placing it at the forefront of your analysis can lead to several issues that undermine your investment journey.

Imagine, for a moment, that your primary focus is to identify stocks trading at a discount to their intrinsic value. It seems like a reasonable approach, doesn’t it?

However, this methodology often leads to a revolving door of new names every time you run your screening process. This results in an overwhelming amount of work, tracking, and analysis, which we discussed in our previous article can be an exhausting and inefficient pursuit.

Furthermore, by primarily focusing on valuation, you may inadvertently cast a wide net that encompasses a vast variety of businesses. Some of these may be high-quality firms, while others (or shall we say the overwhelming majority) will be less reputable companies that lack a sustainable competitive advantage, or even bordering on the ‘junk’ category. These companies might appear statistically cheap at first glance, but delving deeper, you will find that they carry excessive risk and lack the fundamental characteristics of solid investments.

Consider this scenario: You’ve identified a stock trading at an unbelievably low price compared to its earnings or book value. It’s tempting to think you’ve found a hidden gem. However, what’s beneath the surface?

Does the company have any sort of “moat” around its business which protects it from competitors? Does it have sufficient growth prospects and a great management team? Focusing foremost on valuation can lead you astray in these situations, that’s why we firmly believe that valuation metrics should not be a part of your initial screening process.

The Deception of Conventional Accounting Metrics

Here comes (arguably) the most important mousetrap to consider: the undue trust placed in conventional accounting metrics as the sole determinant of a company’s true economic value creation. You have to accept the fact that accounting is not meant to help investors but to calculate taxes. Therefore, accounting numbers are easily manipulated, and any multiple based on these reports is misleading and dangerous.

We have written an entire article about proving these points, but just to summarize things:

  1. Accounting treats shareholders’ equity as free money (distorts earnings)
  2. Accounting treats two identical investment decisions differently (distorts earnings)
  3. Accounting provides ample room for management to play with certain items (distorts cash flow)
  4. P/E, P/FCF, P/EBITDA, P/BV, ROI, and ROIC are also badly distorted, thus not suitable to base serious investment decisions on them
  5. Even the PRICE component in the commonly used multiples leads to distortions because of differences in capital structures (distorts all multiples using the P component)
  6. Earnings growth can be high and still lead to shareholder value destruction (not all growth is good)

To illustrate our point, let’s examine the case of AT&T between 2009 and 2022.

The Compounders Path 2 - AT&T EPS

During these 13 years, AT&T’s EPS (the shaded green area) grew from $1.60 per share to $2.57, representing a growth of over 55% over this timeframe. However, here is the puzzling discrepancy – the share price remained largely stagnant over this time.

How can this be? The answer lies in the deceptive nature of how EPS (or FCF, EBITDA, and so on) can paint a completely false picture of true business performance.

Enter Economic Value Added (EVA), a metric that delves beyond the superficial and provides a more accurate reflection of a company’s economic profit generation. EVA takes not only the earnings into account but also the cost of capital, offering a holistic view of how effectively a company generates wealth for its shareholders.

In simple terms, EVA is a metric that measures the firm’s profit remaining after:

  1. Deducting all costs adjusted for accounting distortions one by one.
  2. Including the cost of giving the firm’s investors a full, fair, and competitive return on their investment in the business.

EVA is a comprehensive net profit score that charges for all capital used, including shareholders’ equity, which is falsely considered free money under GAAP accounting.

Let’s check how AT&T fared in the EVA framework between 2009 and 2022.

The Compounders Path 2 - AT&T EVA

The trajectory of the red bar shows a whole different story. Despite the apparent EPS growth, the company’s EVA has remained relatively flat, suggesting that while accountants were happy with the results, the firm did not increase economic value for its owners.

Stagnating levels of EVA have led to a flat share price, no matter how much EPS has grown.

Let’s look at the polar opposite of what we have just witnessed: consider the case of Amazon between 2007 and 2015.

The Compounders Path 2 - Amazon EPS

During this period, Amazon’s EPS showed little to no growth (it was $0.06 per share both in 2007 and 2015). To the casual observer, this might seem perplexing, as the company’s share price skyrocketed, growing sevenfold during the same period.

How is it possible for a company to experience stagnant EPS and yet see its market value increase substantially?

The Compounders Path 2 - Amazon EVA

The answer lies in the stellar performance of Amazon’s EVA per share, which grew nearly in line with its share price, expanding sixfold during those eight years.

In short, you must put the quality of the data you are using above everything else when putting together a robust screening process. (And that is the reason why we spend tens of thousands of dollars annually on getting this institutional-level data at the FALCON Method.)

Crafting a Superior Screener: Focus on Quality and Growth

So far, we’ve uncovered the pitfalls associated with relying solely on conventional accounting metrics and explored case studies that demonstrate the power of true economic profit generation through EVA.

Now, let’s delve into how we would construct a top-tier stock screener that will most likely guide you toward promising investments.

Our solution lies in focusing on 2-2 key metrics that revolve around quality and growth. For instance, we use Return on Capital (ROC), EVA Margin, Sales Growth (on a 5-10-year horizon), and EVA Growth for our screening process, since these metrics, when used in tandem, offer a comprehensive view of a company’s quality and true value creation.
(You could substitute EVA with Net Income or Free Cash Flow, albeit you have seen how wildly these metrics can converge from economic reality).

As a next step, we would use these 4 metrics to narrow down the field of stocks, by assigning a composite Quality-Growth score (giving an equal weight to each factor) to every company in our screener. After ranking these from top to bottom, we would select the 50-100 firms that fared most favorably in this selection process.

You may ask, why should we narrow our focus to high-quality, durable-growth companies? Let us present two compelling reasons.

Reason 1: Double-Digit Fundamental Return Potential

First and foremost, these quality compounders possess the unique ability to ensure a high, double-digit fundamental return potential. This means that their growth, combined with dividends and the effect of buybacks, can provide market-beating performance on their own.

In other words, you don’t necessarily need the tailwind of favorable valuation to achieve superior returns. This also eliminates the need for constantly finding new investment targets, mitigating the so-called “reinvestment risk”.

These companies are the only viable option for a true buy-and-hold strategy, where you can sit back and watch the wonderful effects of decades-long compounding. You don’t need to come up with new ideas every month, every year.

To help you better understand this concept, here is a snapshot of how the quantitative metrics and fundamental return of our Investable Universe compared with the S&P 500 over the past 10 years. You can see that we strived to establish a pool of companies where we get market-beating quality and growth characteristics, leading to an exceptional fundamental return historically.

The Compounders Path 2 - Chart

Reason 2: Good Businesses Seldom Become Bad Businesses (and vice versa)

Great companies seldom turn bad overnight, and conversely, businesses that have consistently demonstrated poor quality don’t miraculously transform into industry leaders.

The chart below shows a GMO study that proves that companies with high ROC levels tend to remain market leaders, and firms that could not produce outsized returns on their invested capital cannot improve on this metric over time. There is no “mean reversion”. That’s why it’s important to stay invested in good companies and avoid subpar businesses like a plague.

The Compounders Path 2 - ROC over time

This principle forms the backbone of our quality-focused screening process, and it’s a crucial factor in creating an Investable Universe that maintains relative stability over time.

Today, we have shown you how we would go about building a quantitative system that generates a few tangible stocks that are worth your attention out of more than 10,000. The quantitative boxes these companies have ticked are essential, but they represent only the tip of the iceberg.

To grasp the full narrative, we must also explore the qualitative aspects. In the third part of The Compounder’s Path Series, we will shed light on why you need to dig deep into those businesses that ranked high in your screening process, to earn a spot and more importantly, to remain in your Investable Universe. Stay tuned for more!

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