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!

The Compounder’s Path – The Broader, the Better? Not quite!

Welcome to The Compounder’s Path, an exclusive 4-part series where we will demystify the art of making money in the stock market, offering you a step-by-step roadmap to harness the power of time, consistency, and a proper investment strategy. Whether you’re a novice or an experienced investor, we are certain that these key principles will significantly upgrade your financial library and take you to the next level.

We will cover:

  • Why building your Investable Universe is crucial for success, and what is the best approach
  • Why conventional accounting metrics are hugely misleading, supported by several case studies
  • What metric is best suited to measure true shareholder value creation
  • The importance of qualitative analysis alongside a quantitative screening process
  • And how you can master all this in just a few hours every month

Embarking on a journey into the world of stock investing can often feel like stepping into a dense forest of endless possibilities. The vast array of companies and industries can be overwhelming, and even the most experienced investors could feel lost sometimes. Our goal is to guide you through this intricate maze, helping you to develop a system that you can count on through your journey to financial freedom.

Let’s get straight into it.

The Broader, the Better? Not Quite!

The very first step in your investing journey should be the establishment of a selection process, to arrive at a pool of companies that you are most interested in. This is what we call the birth of our “Investable Universe”, which contains the list of firms we want to gain a deeper understanding of. While the concept of building your Investable Universe sounds simple, there are many culprits along the way. Let’s check on what we believe investors get wrong most of the time.

Your initial instinct might be to cast a wide net, thinking that the broader the selection, the better your chances of finding the best opportunities. After all, if I search as broadly as possible, I should have the best chance of finding mispriced stocks that Mr. Market (temporarily) threw into the garbage bin.

In theory, this strategy sounds like a winner, and you’re not alone in believing it. However, you may have heard the saying that goes, “Jack of all trades, master of none.” In the world of stock investing, casting too wide a net can often leave you overwhelmed and confused, with no clear path to success.

Did you know that there are tens of thousands of public companies available globally? Narrowing the pool to one country, one sector, or one “theme” will still leave you with thousands of stocks.

That’s an enormous pool of potential investments, and even without going into details as to how much time you have to spend on familiarizing yourself with just one company, it is easy to acknowledge that your Universe should contain a maximum of 50-100 firms. In our experience, anything beyond that, you are surely left with either 1) an insurmountable amount of research, or 2) a very shallow understanding of every company inside the Universe.

Now that you understand why developing an Investable Universe is central to your investing success, let’s examine the most common pitfalls we see investors fall into repeatedly.

Pitfall #1: Relying on Gut Feeling

Imagine this: a friend enthusiastically tells you about a “hot” stock or a promising industry, and you think you’ve struck gold. With unwavering faith in your instincts, you dive headfirst into the investment, convinced that you’ve discovered the “diamond in the rough.” It sounds thrilling, but the reality is often different. Much different.

Take a look at this process-outcome matrix which always serves as a guiding post for us when we make investment decisions.

The truth is that while luck can certainly play a role in successful investments, relying solely on your gut feeling places you squarely in the “dumb luck” quadrant. Even a bad process will yield a good outcome sometimes, while it is also true that a good process will not always result in a runaway success. Understanding this concept has had a major impact on us.
Unfortunately, luck is not a reliable strategy for consistent success in the complex world of stock investing.

What you truly need is a well-defined process – a system backed by historically proven factors that can consistently deliver you the results you desire. You want to find yourself in the upper-left section of the matrix, where a good process leads (given that you provide enough time for a strategy to bear fruit) to your “deserved success”. Having a reproducible system is the only way that allows you to invest your hard-earned money with confidence, month after month.

Pitfall #2: Falling for the Illusion of Solo Superstars

It’s hard not to be starstruck by high-profile investors who seem to consistently hit home runs while venturing into the most obscure corners of markets. You might think of legendary investors like Mohnish Pabrai, known for his captivating Turkish adventures where admittedly, he managed to 3-5x his investments in just a few years. His successes are inspiring, and we often hear stories of similar, renowned investors’ extraordinary journeys.

But here’s the inside scoop: even he admits openly that he receives dozens of tips and ideas from his extensive network of value investors. This network is something that the average investor doesn’t have access to, making it (unfortunately) an uneven playing field. Not to mention that comparing yourself to the greatest minds in the field who have honed their craft through decades of experience may not serve your interest.

All in all, we firmly believe that trying to replicate the processes and portfolios of world-class asset managers is not a reliable path for the everyday investor (even if the financial media and some investment services would like you to believe this.)

On top of that, one aspect we haven’t touched on yet is the concept of survivorship bias. Have you ever wondered how many failures these investors have encountered before discovering their successes? For every multi-bagger, there are likely numerous investments that didn’t pan out as expected. But you don’t read about those, do you?

Consider the immense amount of time they’ve spent on researching ideas that ultimately provided no value. These failures are rarely publicized, and this skewed perspective can lead aspiring investors down a misleading path. While it’s essential to learn from successful investors, it’s equally crucial to recognize that behind every victory are countless attempts that didn’t hit the mark.

Pitfall #3: The Perils of a Selection Process That Produces an Ever-Changing Investable Universe

The reality is that researching new stock prospects thoroughly is a time-consuming endeavor. Imagine you’ve found a stock screener that perfectly aligns with your investment goals and spits out companies that become a part of your Investable Universe. You diligently run it every month, just after your paycheck hits your bank account.

But here’s the catch: every month, your screener spits out dozens of new candidates that meet your criteria. It’s like trying to sip from a firehose of information.

In our experience, evaluating these candidates comprehensively is no small feat. It can take several days or even weeks just to get to know the story behind each of these companies well enough to feel comfortable investing in them. You’ll find yourself buried in annual reports, presentations, earnings call transcripts, and more.

This level of in-depth analysis is a luxury that full-time investors can afford, but for those balancing investing with other responsibilities, it’s a challenging task. An alternative would be to update your Investable Universe every year, but if the 50-100 candidates are completely different than the year before, you are left with a daunting task once again.

The key takeaway here is that even a good selection process yields little value to you if its results are changing too frequently. The stability of the outcomes (in terms of companies worthy of your analysis) is an equally important aspect to consider.
When you’re inundated with too many analytical tasks and you’re unsure about some of the firms you’re considering, you’re not getting any closer to achieving true financial freedom in every sense of the word.

Let’s recap what we have covered so far as a successful recipe for stock selection:

You should establish your Investable Universe. With the help of this, you reduce the pool of candidates to a manageable number, ideally not more than 50-100 companies. More is not better. You need a list that doesn’t overwhelm you with countless options but instead offers a reasonable selection to work with effectively.

Rely on historically proven factors. Don’t confuse your gut feeling and the stock tips of friends with a true selection system. Your investments should be based on factors with a track record of success. Only this can ensure that you have a good process that is consistently reproducible, and will prove to be very valuable over the long term. Don’t confuse “dumb luck” (which every fool can enjoy once in a while) with “deserved success”.

Avoid drawing false conclusions from the successes of renowned investors. They have resources that are not available to the average investor, while the survivorship bias ensures that you only hear about their home-run investment, and not much about their countless failures.

Don’t underestimate the value of consistency. Your Investable Universe should remain relatively stable over time. Constantly changing stocks can disrupt your focus, and lead to an overwhelming amount of due diligence needed.

But there’s one more essential element to consider. Your Investable Universe is only as good as the indicators and metrics you use in your filtering process. When you’re sifting through the stock market to separate the wheat from the chaff, it’s crucial to have the right lenses on.

You might believe that financial metrics like operating margins, earnings per share (EPS) or free cash flow (FCF) growth, and price-to-earnings (P/E) multiples can form the foundation of a successful investment process. However, the reality is that these traditional accounting metrics can paint a completely false picture regarding true shareholder value creation, and are far from sufficient.

In the second part of The Compounder’s Path Series, we will prove why these traditional ratios do not provide the comprehensive insight you need. We’ll show you why it’s vital to employ the best and most fitting metrics available that show a true picture of a company’s economic profit generation, to make informed investment decisions and not squander your precious time.

Investing should be an empowering and enriching journey, and with the right tools and knowledge, you can take huge leaps towards achieving financial freedom. Stay tuned for more!

All That Glitters is Not Gold

We never wanted the FALCON Method to be a black box. Hence, we are eager to invite you behind the scenes and give an inside view of how we operate our stock selection process. Lately, Italian company Moncler (known for its pricey jackets) provided an insightful example of how a purely quantitative approach could lead investors astray and why one should never omit the labor-intensive qualitative deep-dive phase.

As per our structured process, we begin by filtering the vast universe of global stocks, applying various EVA-based quality and growth criteria. Those that stand out in every regard and thus seem capable of producing double-digit fundamental returns (as a combination of value-creating growth and shareholder returns) make up our shortlist of EVA Monsters worthy of in-depth analysis and close monitoring. The last time our team did the annual screening process, Moncler comfortably qualified as an EVA Monster candidate based on its double-digit sales growth, EVA Margin, and other quantitative characteristics. Although this business is nowhere near the size of the heavyweight luxury companies, we still found that learning more about this supertrends-supported industry may be useful regardless of how Moncler fares in our qualitative framework. And this is where things got interesting.

The deeper we dove, the more warning signs emerged. Firstly, Don Thompson’s book, The Curious Economics of Luxury Fashion, classifies Moncler as a premium brand. The key insight is that premium labels typically sell for 40-60% of the price level of luxury brands (such as Louis Vuitton or Hermès), so Moncler must compensate for this shortcoming to produce those spectacular numbers that landed it on our EVA Monster shortlist. And compensate they do! How about a “Made in Romania” badge for starters?

While real luxury powerhouses invest heavily to maintain control of the supply chain, from the crocodile farm to store décor and stick with certain countries for the final assembly or manufacturing (as seen on product labels), others are closing production sites in their home countries, considering such cost optimization a logical progression. These decisions must always be analyzed and evaluated within the context of a strategy, as luxury’s ability to sustain high prices and profitability is governed by strict rules. Cost-conscious relocators are, in reality, discontinuing their luxury strategy in favor of a fashion strategy, without explicitly admitting this. In fact, the luxury strategy is a specific business model; fashion is another, governed by a completely different set of working principles. (Burberry and Prada are great examples of this shift, while Moncler was never a true luxury brand in the strictest sense.)

Moncler’s tangled heritage began in France in 1952. (You may notice it is still a toddler compared to seasoned luxury counterparts.) Then, a 2003 acquisition uprooted the 50-year brand and moved it to Italy, marking the beginning of its premiumization, direct-to-consumer push, and global expansion. While the numbers leave nothing to be desired, Moncler follows a finely-tuned fashion strategy rather than the classic luxury playbook. No artisanship, no “handmade in France” label, but cheap Romanian production along with dubious luxury positioning. And this is far from the last red flag we discovered.

The product portfolio also qualifies as thought-provoking. Outerwear contributes 70-80% of the company’s revenue, as Moncler is essentially a mono-category, mono-brand, and mono-product business. Being the category leader in down outerwear may not be enough for long-term success as the barriers to entry are relatively low in this sub-segment, and the exposure to short fashion cycles is also a negative. (Comparatively, the leather goods and hard luxury segments boast decade-long product cycles. Think about the Hermès Birkin bag or the Rolex Daytona watch.) Overall, we consider the apparel category the least attractive and most vulnerable within the luxury space, so Moncler’s positioning is not to our liking. Our research also revealed that Moncler items lack both resale and investment value, in stark contrast with traditional luxury products like Louis Vuitton bags, Rolex watches, and Ferraris (or even Nike’s collectible shoes). A second-hand Moncler jacket exhibits no luxury traits, which is quite telling.

The mono-brand business model can work for actual luxury powerhouses like Hermès and Chanel. Those companies have the haute couture and leather bags at the top of their product pyramids, while the widely available $30 Chanel lipstick at the bottom doesn’t diminish the brand’s perceived value. We wouldn’t bet on Moncler replicating such a structure, as it badly misses the top components and is essentially an apparel firm. To make matters worse, this is a fashion company that happens to sell its products at a luxury price.

Truth be told, Moncler’s down outerwear category has grown at over 20% annually since 2009, recently driven by the wardrobe casualization trend, and they benefited greatly through excellent strategic execution. From 2012 to 2022, Moncler more than doubled its global store count, and the company aims to expand selling space by mid- to high-single-digits in the next few years. This is a remarkable growth story, hence the quantitative EVA Monster qualification. Yet the puffer coat and jacket revolution may attract competition from new players and established brands expanding into the category, and Moncler doesn’t seem to possess any kind of moat that would warrant its luxury pricing in a more competitive environment. This brings us to the key question: How long do you think this company can keep up its value-creating growth without a protective moat?

Remo Ruffini has been the CEO since 2003, and it’s no exaggeration that all the success is attributable to his leadership. That being said, we don’t feel too comfortable betting on this CEO to recreate his magic over and over with different brands to keep his firm’s growth characteristics intact. Looking under the hood revealed that Moncler is lightyears from the true luxury businesses we are keen to invest in for decade-long periods.

Exceptional management can be the icing on the cake once we identify a company with a durable moat, but we’d generally stay away from mediocre businesses (except for our Fallen Angel picks, where we aim for mean reversion over a ~3-year period). In the luxury space, Hermès, Ferrari, Richemont, LVMH, and Kering qualify as reasonable investment candidates, while Moncler is out of our EVA Monster universe after the in-depth analysis revealed some alarming shortcomings.

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: A Sip from Monster Beverage’s Flavor Empire

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 Monster Beverage (MNST), the best-in-class energy drink brand possesses true EVA Monster characteristics and is thus worthy of your close attention. As long as you agree with us that caffeinated beverages are not ripe for an inevitable downturn due to changes in consumer preferences, Monster could be a great addition to any quality-growth-focused portfolio.

Monster Beverage is one of the leading global players in the energy drink subsegment of the beverage industry, broadly regarded as Red Bull’s most significant competitor in the premium category. The firm relies on the Coca-Cola bottling system for production and distribution, as a byproduct of the beverage giant’s strategic investment to become Monster’s largest shareholder. The company was formerly known as Hansen Natural Corporation and changed its name to Monster Beverage Corporation in 2012.

The current leadership team has a more than respectable, lengthy background. The duo who originally led the consortium that purchased Monster’s predecessor entity is now mutually responsible for top-level decision-making (in a „co-CEO” structure). In our view, Rodney Sacks and Hilton Schlosberg have done an excellent job at creating and nurturing the premier brand image of Monster Energy, and their near-flawless execution was key to battling prominent rivals such as Red Bull.

The lion’s share of the firm’s revenue stems from its Monster Energy Drinks segment (92% of its fiscal 2022 sales). The company is responsible for the flavor development and branding of its flagship products, while the manufacturing and distribution processes are outsourced to the Coca-Cola bottling system globally.

Red Bull is broadly regarded as the creator of the energy drinks space in the early 80s, and it has remained the undisputed king of the category up until this day. The fact that the market leader stayed in private hands all the way speaks volumes about the profitability of the sector, as the firm was able to achieve this feat without relying on external shareholder capital.

Decades later, Monster emerged as the only viable competitor able to match Red Bull’s global reach, with the two forming an essential duopoly in the premium energy drinks space by now.

The firm is best described as a flavor and marketing powerhouse since it develops and manufactures the primary flavors for its flagship product lines in-house. Its ever-evolving palette ranges from traditional energy drinks to functional sports drinks, coffee, and tea derivatives, to its recently launched alcoholic beverage line. At the centerpiece of the company’s strategy is the flagship Monster brand, which certainly has a coolness factor to it, thanks to the company’s relentless marketing efforts.

Crucially, one of the most important components of Monster’s success formula is the strategic partnership with Coca-Cola, granting access to the beverage juggernaut’s global bottling and distribution network. This allows Monster’s new products to be scaled more quickly and eases retailer negotiations.

Thanks to its asset-light business model and pricing strength, the firm fares extremely favorably from a quantitative perspective, boasting enviable EVA Margin and ROC levels. Truth be told, we are finding it difficult to judge Monster’s moat from the qualitative aspect. If you believe that the energy drink category is here to stay (which we do), Monster undeniably has a sustainable competitive edge within the segment. However, compared to beverage titans such as Pepsi and Coke, the firm clearly plays in a lower league when it comes to scale and brand diversification.

Source: ISS EVA, The FALCON Method

As for the future, the global energy drinks market is estimated to grow at an 8%+ pace over this decade, fueled by humanity’s need for alternative sources of caffeine. Our back-of-the-napkin calculation revealed that even if we assume young adults in their 20s and 30s purchase all the energy drinks, it would still amount to roughly one can of Monster per week for the average U.S. consumer. This leaves plenty of room for organic volume increases, with pricing serving as a potential second growth lever.

Turning to capital allocation, the company boasts a reinvestment rate near 30%, and its capital-light nature allows it to achieve ROC figures constantly above 25%, which is more than respectable. A smaller portion of the money that’s being plowed back into the business goes toward organic reinvestments like advertising and flavor development, while the remainder is directed to bolt-on acquisitions aimed at diversifying Monster’s capabilities outside of energy drinks.

As for shareholder distributions, the firm has never paid a dividend and does not anticipate doing so in the foreseeable future. However, regular share repurchases are an important piece of the capital allocation puzzle, as Monster has cut its share count by nearly 8% over the past five years. On a sour note, the timing of buybacks signals very little opportunism, with the company regularly scooping up its shares at stretched valuation levels.

Looking at the stock’s valuation, Monster has always traded at a hefty premium to the market, and the current sentiment (albeit not ecstatic) still appears overly optimistic, even if we look at historical valuation figures. 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!)

It is worth noting that 2022 has been the worst year for the company for a long time in terms of profitability, thanks to cost inflation and sourcing difficulties, but even after assuming a meaningful recovery in margins, the company’s NOPAT yield would still sit markedly below the market average (although its quality and growth characteristics might warrant a slight premium).

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 Monster for now.

The verdict

The “alternative” beverage market is extremely competitive and the barriers to entry are quite low, which means that Monster has to continuously fend off new brands to protect its superior position.

On the regulatory front, the supposedly negative health effects of regular energy drink consumption could lead to potential proposals that aim to restrict the sale and/or advertising of energy drinks below a specified age or to restrain the venues in which Monster’s products can be sold. We cannot exclude the risk that the energy drink sector might someday be scrutinized as much as tobacco, which could pose difficulties in marketing and distribution.

The growing presence of health consciousness might also translate to shifting consumer preferences, which could dampen the growth trajectory of energy drinks as we know them today, with more focus on nutritiousness and health benefits

All in all, while we have identified numerous risks surrounding Monster’s business, we would be happy to build a position at the appropriate price. The firm has an unquestionably strong brand, attractive market dynamics with plenty of room for international expansion, and a great leadership team at the helm. On top of that, Monster makes money from small, everyday repeat purchases, and this sector is also less prone to cyclicality and downtrading in tough economic times. Nevertheless, we would shoot for a smaller, 2-3% exposure with this name.

The company ranked 30th 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 14% 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!

Winning by Not Losing

Imagine that you have a newspaper from one year into the future. The top 10 best-performing stocks from the prior year are on the front page of the paper. In addition, a large bank has stated that they will provide you with as much margin as you want with no interest charges. The question is: Assuming you start with $10,000, how much would you borrow to invest in these top 10 stocks? Allegedly, this is the question that Jim O’Shaughnessy, author of What Works on Wall Street, likes to propose to investors. Think about how you would answer before reading on.

Most people get this dreadfully wrong by saying something like, “knowing the winners in advance makes this a sure bet, so the best thing to do is borrow as much as possible and make the most of this lucky situation.” The truth is that you would go bust with such an approach. As Jim puts it, “Your problem is the margin. With $10,000 to start, if you borrowed millions, you would lose all of your equity. In fact, having a leverage ratio more than 4:1 ($30,000 borrowed) would have wiped you out in most years. It’s not a matter of if, but a matter of when.”

Although you are privileged to know that those ten stocks would give you an exceptional return by the end of the year, the problem is that hitting a bad patch of too many negative return days in a row (which is pretty normal) could wipe you out completely if you used excessive leverage. The moral of the story is that the path matters; in fact, the journey is more important than the destination. Knowing the winners’ names is not enough; you would also need to know the exact path that the stock price will travel throughout the year to make borrowing money a surefire solution to win big. Unsurprisingly, the more leverage you use, the higher the probability that you go broke, simply because even small declines in your portfolio wipe out your equity with larger amounts of leverage. It’s not rocket science. The point is that even knowing the future with 100% certainty wouldn’t make borrowing money safe, so given that we will never know the future with any degree of certainty, leverage is one of the most dangerous things you can do as a retail investor.

Even Ben Graham, the father of value investing, had to learn this the hard way. He established his investment partnership in 1926 and got off to a really promising start. Then came the Great Crash of 1929, and the fund was down 20 percent. Graham, however, was convinced that the worst was over, so he borrowed on margin and plunged back into the market. It was a terrible decision, and by 1932 the fund had lost 70 percent of its value. Graham was wiped out, forcing the family to leave its park-view duplex in the Beresford for a small rear apartment in the nearby El Dorado. His wife had to go back to work. As the famous quote attributed to Keynes says, “The market can stay irrational longer than you can stay solvent.”

This, of course, doesn’t mean that you cannot have an opinion on the economy or the stock market. You are absolutely entitled to have your own opinion, but you should still not let it affect your investment decisions. Confused? I’ll make it clear in a moment. One of the most famous value investors, Seth Klarman, summed up this approach nicely by saying, “One thing I want to emphasize is that, like any human being, we can discuss our view of the economy and the market. Fortunately for our clients, we don’t tend to operate based on the view. Our investment strategy is to invest bottom up, one stock at a time, based on price compared to value. And while we may have a macro view that things aren’t very good right now—which in fact we feel very strongly—we will put money to work regardless of that macro view if we find bargains. So tomorrow, if we found half a dozen bargains, we would invest all our cash.” It is always a good time to buy a high-quality stock that offers good value.

As a side note on holding cash or being 100% invested, what I learned at Columbia Business School’s Value Investing course is totally aligned with how I approached the question of cash management before and what Klarman emphasized above. Namely that cash should be the byproduct of a disciplined valuation approach. You end up holding a lot of cash when you review idea after idea and see nothing of interest. So, when you end up holding a lot of cash, that may be a good indicator that perhaps markets are a little bit too expensive.

At the FALCON Method, we buy the shares of companies that are out of favor. This approach is contrarian by nature, so you have to get used to buying stocks that are down and are still getting beaten up hard. There is simply no way to pick the bottom, and as Howard Marks writes, “I’ve never considered it a legitimate goal to say you’re going to invest at the bottom. There is no price other than zero that can’t be exceeded on the downside, so you can’t really know where the bottom is, other than in retrospect. That means you have to invest at other times. If you wait until the bottom has passed, when the dust has settled and uncertainty has been resolved, demand starts to outstrip supply and you end up competing with too many other buyers. So, if you can’t expect to buy at the bottom and it’s hard to buy on the way up after the bottom, that means you have to be willing to buy on the way down. It’s our job as value investors, whatever the asset class, to try to catch falling knives as skillfully as possible.” And then, this is what Seth Klarman suggests: “You must buy on the way down. There is far more volume on the way down than on the way back up and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.” (I hope those complaining about being down 10% with a stock realize that this is part and parcel of thoughtful investing. If you cannot accept temporary unrealized losses, then stock investing simply doesn’t fit you.)

Notice that even if you are an exceptional investor, the best you can do is pick quality companies where the stock price and intrinsic value seem to diverge (the price being the lower) and closely monitor the operating performance of those companies after investing. You may be right with most of your calls but certainly not all of them! Even the world’s best investors have names in their portfolios that are not winners. Nobody is right all the time. (By the way, anyone familiar with the calculation of expected value knows that the frequency of correctness does not matter; it is the magnitude of correctness that matters. Simply put, you can be a successful investor even if most of your calls turn out to be bad or mediocre as long as those few calls you get right are exceptionally profitable.)

Seriously, if you only take one piece of advice from this post, make it this one: Leverage works both ways and can easily derail your quest for financial independence. The more you use it, the less likely you are to reach your goal.

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: A Formidable Membership Business in Disguise

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 difference 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 Costco (COST) is a genuine EVA Monster and the king of physical retail, so it is worthy of your close attention. It is truly remarkable how this company has managed to carve out an undisputed wide moat in an extremely competitive landscape.

Costco operates an international chain of over 800 membership-only warehouses that carry quality, brand-name merchandise at substantially lower prices than are typically found at conventional wholesale or retail sources. Members can also shop for private label Kirkland Signature products, designed to be of equal or better quality than national brands, including juice, cookies, coffee, housewares, luggage, clothing, and detergent. The company also operates self-service gasoline stations and an e-commerce business unit. Costco was founded in 1983 and is based in Issaquah, Washington.

Costco’s culture of customer obsessiveness has deep roots that trace back to how the company’s legendary founder, Jim Sinegal, thought about building a business that would outlast all of us. He served as CEO from 1983 until his retirement in 2011, and he was well-known among workers for traveling to each location every year to inspect them personally. He also stated numerous times that the well-being of his employees was far more important to him than pleasing the insatiable need of Wall Street analysts for short-term profit maximization.

The firm derives the vast majority of its top line (98% as of fiscal 2022) from merchandise sales. Importantly, Costco’s products can only be purchased by members. Even though membership fees represent only a small fraction of the top line (2%), substantially all these revenues flow through to the bottom line, accounting for the lion’s share of Costco’s profits.

There are over 65 million paid members worldwide, with the annual fee for the Gold Star Membership currently at $60 in the U.S. Paid cardholders are eligible to upgrade to an Executive Membership (for an additional annual fee of $60) for Rewards and benefits. Notably, Executive members generated 71% of worldwide net sales in 2022. The company mainly caters to individual shoppers, but nearly 20% of paid members are businesses.

Costco is widely regarded as the originator of the “scale economies shared” business model, utilizing its operating leverage to pass on the resulting savings to customers. In turn, this results in an extremely loyal customer base, with retention rates consistently above 90% in its membership programs. Costco’s secret sauce lies in its obsessive focus on efficiency, which enables it to charge low-teens markups compared to 25-35% for a typical retailer.

Costco’s stores are large warehouses located in low-cost industrial areas. The company sells goods in bulk packaging, which eliminates the need for extra handling and shelf stocking, and substantially reduces theft occurrences. Crucially, Costco holds a limited number of stock-keeping units (SKUs), averaging 4,000 vs. up to 40,000 for a traditional supermarket. As a result, the firm’s U.S. sales per SKU were over $40 million, 10+ times higher than Walmart’s and Target’s metrics, contributing to its negotiation leverage in procurement.

Notably, we view Costco’s private label brand as a significant moat contributor. The major aim of Kirkland is to manufacture equal or better quality products than national brands at meaningfully lower prices, thereby fostering customer loyalty. Based on various industry reports, Kirkland contributes 25-30% to companywide sales at higher margins than branded SKUs. Standalone, Kirkland would be the largest consumer packaged goods brand in the U.S.

All things considered, we believe that thanks to its unique business model and relentless culture of efficiency, Costco has carved out a wide and enduring moat in the cutthroat retail space. This results in thin, albeit consistently positive and durable EVA Margins, and importantly, ROC levels that are completely unheard of in the physical retail industry.

Source: ISS EVA, The FALCON Method

As for the future, Costco typically opens 20-30 new warehouses each year, and it has historically grown its same-store sales at a mid-single-digit rate annually. These equate to a continued high-single-digit growth potential in product sales. The growth characteristics are largely similar in the membership aspect of the business as well, so Costco should be able to grow its top line by 6-8% annually over the long run. Our models also show that Costco’s EVA growth potential could outpace its sales trajectory and reach double-digit territory for years to come.

As for capital allocation, Costco operates with a relatively low reinvestment rate, primarily aimed at new store development and enhancing its Kirkland brand. Meanwhile, ROC levels are on an upward trend as rising same-store sales are driving improved capital efficiency.

Turning to capital distributions, the company first initiated a dividend in 2004 and has been increasing it ever since at a healthy double-digit rate. The ordinary dividend uses only about 25% of internally generated cash, translating to unquestionable safety. The firm also has a history of paying special dividends to its owners. Costco also carries out share repurchases; however, restricted stock units provided to employees (generous enough to make it one of the best retailers to work for) largely negate the effect, leading to a historically stagnant share count.

Looking at the stock’s valuation, we would have eagerly acquired shares during the financial crisis when the FGR metric fell close to 0%. However, aside from a surge in EVA thanks to COVID-induced stockpiling in 2020-2021, the company’s multiples have generally remained stretched. 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!)

Regardless of how we look at it, the current valuation sits at the very high end of Costco’s historical range. 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 Costco for now.

The verdict

What first comes to mind when assessing risks surrounding this business model is that, over time, consumers might increasingly turn to digital channels to fulfill their shopping needs. If Costco were unable to successfully develop a relevant omnichannel experience (which may also come with elevated investments, hurting profitability), its operations could be adversely affected.

It’s a tough call at this point, but Amazon’s extensive network of warehouses and fulfillment centers could serve as a foundation upon which it might try to replicate Costco’s business model, leveraging its preexisting Prime membership base.

While challenges like the rise of e-commerce or Amazon’s push into grocery do pose threats, we would be more than happy to own this business at the right price. With an operating model that has thrived for over 50 years, an exceptional leadership team focused on long-term value creation, and significant opportunities for overseas expansion, we think the company has a bright future. As for position sizing, we would be comfortable with a 3-5% exposure.

The company ranked 40th 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 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!

Slaying the Sacred Cow of the Efficient Market Theory

Throughout the years, I kept emphasizing in the FALCON Method Newsletter that the current market price of a stock might have nothing to do with the value of the underlying business. While this statement is the cornerstone of value investing, it may sound disturbing for those familiar with the names and theories of reputable economists contradicting me. (Burton Malkiel, Eugene Fama, and Paul Samuelson come to mind, the latter two of them being Nobel Laureates.) There’s no way to invest successfully without seeing clearly who is right—the academics or the real investors—so it is vitally important that you understand the points I outline below.

To lay the groundwork, let me quote Warren Buffett’s letter from 1988 first. “[The efficient market theory] doctrine became highly fashionable – indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything.” According to the EMT, price equals value, and that’s it.

Now let me show you two real-life examples that may make you think twice about what this theory says. On January 4, 2000, Yahoo! stock was selling for $500 per share. The business had a market cap of $505 billion at the time. The earnings were $47 million, and the PE ratio was 11,478! As value investor Phil Town writes, “Assuming the earnings were growing at some astronomical rate, say 36 percent a year, how long before we’d get our money back? Sixteen years. Never mind that no company ever grew that fast for that long starting that big. […] Oh, and if it did somehow grow that fast, the earnings would be over $300 billion. Exxon just had record earnings in 2008 of $45 billion. Earnings of all of the U.S. stocks traded regularly that year added up to about $300 billion, so Yahoo! all by itself would have to become pretty much the whole stock market to make sense out of that price. Yes, Professor, stocks do get mispriced from time to time. Just a bit.”

Scott McNeely was the CEO of Sun Microsystems, one of the darlings of the tech bubble. At its peak, his stock hit a valuation of ten times revenues. A couple of years afterward, he had this to say about that time: “At ten times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for ten straight years in dividends. […] That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next ten years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

As a side note, you don’t have to look further than the tech sector to find companies trading at 10 to 15 times revenues today. I don’t know if they will follow the same path Sun did, but it certainly looks like there are tons of investors who will, at some point in the future, be asking themselves once again, “what were you thinking?”

I hope these two examples managed to highlight that the stock price and the value of the underlying business can diverge from time to time. The hypothesis of a totally efficient stock market simply doesn’t stand. After all, if you spot one single black swan, you have to abolish your hypothesis that all swans are white. And these examples show glaring market inefficiencies! On the other hand, the efficient market theory (EMT) is not 100% wrong either. The truth is somewhere in between, as Warren Buffett writes:

“Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.”

In fact, Professor Malkiel, a pioneer of EMT, came to similar conclusions when he was asked after the 2000 to 2003 stock market debacle how some very good businesses could see their stock prices drop by 90 percent if the market was truly efficient. Very interestingly, he came as close to junking his theory as an academician ever could when saying, “In the long term, I think that [markets] are generally efficient. Though I’ll admit, they do go crazy from time to time.” So, Professor, the stock market is efficient, but sometimes it’s not. Sounds funny, but this is exactly what Buffett and other value investors have been saying for the past 50 years. And that “sometimes it’s not” part is what creates windows of opportunity for thoughtful investors. (By the way, did you know that Nobel-winning proponent of EMT, Paul Samuelson himself, invested in Berkshire Hathaway stock?)

Honestly, which camp looks stronger at this point: academics or real investors? For my part, I’d let economists keep their Nobel prizes while I’m becoming a rich statistical anomaly according to their models. That’s fun, believe me! After all, if you accept that the market price of stocks and the values of underlying businesses can diverge from time to time, all you need is the patience of a hunter to do nothing when companies are overpriced and to strike aggressively and buy when companies are priced far below their value. Did you know that a giant crocodile can go without eating for 12 months, waiting for the right opportunity to pounce on its prey? When learning this at Dubai Mall’s Aquarium, I already thought this was the exact kind of virtue true investors need to possess. We only strike when something appetizing comes along; in the meantime, we wait.

For value investors, cash size is usually a result of not being able to find anything to buy, and that’s the right approach. Rather than going to cash as a strategy and trying to time the market, it comes naturally for value investors as we do not like to overpay.

One thing to keep in mind, though, is that your standard reaction to a steep decline in the price of your stocks involves typical efficient market theory thinking. “Why is the price going down? There must be a serious problem that I don’t understand. Time to cut my losses and run away.” Whenever such garbage crosses your mind, please remind yourself that the market price of a stock can and does deviate from the underlying value time and again. The hypothesis of a totally efficient stock market has been proven dead wrong, and even one of its Noble winning proponents was investing with Warren Buffett.

In summary, value investors have every reason to be grateful for how Mr. Market operates. Most of the time, this bipolar fellow is taking his meds, so on most days, he’s pretty lucid and rational about the prices he buys and sells at. That means most of the time, the price of a business is pretty close to its value. On some days, however, he gets overwhelmed by his mood swings and gives us opportunities to pounce on. If you only remember one sentence from this writing, make it this one: If markets weren’t short-term inefficient, we would make no money, and if markets were not efficient in the longer term, we would make no money. The long-term efficiency part of the equation is needed so that valuation multiples can revert to their mean, giving us a nice capital appreciation in addition to the dividends collected along the way. Now you know why the market is perfect just the way it is.

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.

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